Do Valuations Matter? by Jack Moller, CFP®, President

When I look at the investment landscape, it just seems to me that most investment alternatives are quite expensive by historical standards. This is what happens when we have a relatively long period of rising prices as we’ve seen since the depths of the Great Recession in March of 2009. The question is – “how do we invest when assets are expensive?”

It’s a Pretty Expensive World Out There

Some thoughts on the state of the markets:

• U.S. Stocks. When we look at valuation, it is not the absolute price of a stock or level of an index but rather its level in relation to something else, typically an economic item such as earnings, sales, etc. So while most indices have traded at new all-time high levels recently, the valuation levels are nowhere near the extremes of the 2000 Internet Mania. Yet my concern is that if we exclude the extremes of 2000, current valuations are in many ways near historically overpriced levels. We don’t spend much time as a firm assessing valuations, though I do read many, many columns/articles. It seems that those sounding an alarm about these levels are no longer the fringe, perma-bear types but rather many of the well-reasoned analysts whom we respect.
• U.S. Bonds. Zero percent interest rates! That sort of says it all … how much value is there in getting no return? On the other hand, we can increase the return all the way to almost 3% if we purchase 30-year treasury bonds. Wow! We can lock up our money for 30-years to get 3%, where virtually all the return will likely be inflated and taxed away. Basically the U.S. treasury market is obscenely valued and only attractive if you anticipate an impending Depression. (None of the experts see any indication of recession on the near-term horizon, let alone depression.)
• Cash Alternative. Obviously, keeping our money in really safe, short-term investments or money market funds and savings accounts ensure no return. I guess that beats much of Europe where many of the short-term interest rates are actually negative. Nonetheless, putting money in money markets is not very attractive either.
• Momentum Fairly Strong. It’s a well known principle of investments that valuations are not helpful in the short-term. Expensive markets can and regularly do become more expensive just as cheap markets can keep getting cheaper. As legendary economist John Maynard Keynes once said, “Markets can stay irrational longer than you can stay solvent.” In other words, “the trend is your friend” regardless of valuations. Yet, when it ends, and everybody is rushing for the exits at the same time, previous gains can be wiped out quickly.
• Outside the U.S. While U.S. stocks and bonds are quite richly priced, some stock markets overseas may represent value. For example, in Asia while Chinese markets have been on a tear lately they still have not recouped the losses since 2008-09; Japan is stunningly still down about 50% from its highs set over 25 years ago, and most of Europe outside of Germany and England have not yet recovered to the 2008 highs. Certainly in this slow growth world economy, there are valid reasons for concern but also probably some good opportunities. As an aside, I cannot see a bond market in the world representing any kind of value with virtually all but the riskiest yielding next to nothing!

What to Do? New Portfolio Management Paradigm

Of course, we are financial advisors and can’t just say “markets are expensive and risks are high”. We need to advise people on where to put their money to build and/or preserve their wealth so they can get the growth they need without getting clobbered during the inevitable sell-offs. Traditional risk control strategies may not work too well. Traditional portfolio management involved essentially managing risk through diversification – spreading out investments into various asset classes, the primary ones being stocks and bonds. Theoretically, when the economy slowed and stocks sold off (because earnings fell or stopped growing) bonds would cushion the fall by increasing in value and continuing to pay a steady stream of income. Then when the economy recovered, stocks would do well while bonds would languish and/or cheapen. Many invested in what came to be known as the “60-40 balanced” portfolio strategy with 60% in stocks and 40% in bonds. Of course, this strategy worked well over the past 35 years as we’ve experienced epic bull markets in both stocks and bonds, only interrupted periodically by the 1987 stock crash, the Dot-Com blow up, and the Great Recession. There will come a time when both stocks and bonds decline together.I just had to say this because most of us have no investing experience in such an environment.

Risk Management Focus

We believe that a new approach involving somewhat more active portfolio monitoring may be the best way to move forward, particularly for those in or nearing retirement. Our Moller Financial approach to risk management tracks portfolio and asset class volatility to directly manage risk exposure while also monitoring relative and absolute performance to find the right blend. While this approach does involve more trading, it importantly remains systematic and non-discretionary. In other words, we are not attempting to “call the market" but follow a strict set of rules that we follow rigorously. We strongly believe in these non-discretionary, systematic approaches that maintain that buffer between our emotions and our portfolios. While no strategy works well in all environments, we are quite confident in this approach’s ability to help us successfully navigate through the full cycles of bull and bear markets. If you are interested in finding out more, we’d love the opportunity to explain the details and philosophy behind this portfolio strategy.