Lately, I’ve read several articles voicing concern over the stock market. They warn, “The market is overvalued!”, and “The Magnificent Seven are in a bubble!”
And I’ll tell you right now: yes, the market is overvalued.
But does that mean you should trim back on your stocks?
Not necessarily.
How Stocks Are Priced
We can distill the price of any stock down to two things:
- The value of the company’s balance sheet, and
- The cash flows (profits) it will generate going forward into the future.
Figuring out the balance sheet is easy enough.
But for those cash flows, we’ll need to discount them all back to today’s dollars. After all, a dollar today is worth more than a dollar in the future.
The “discount rate” we use is essentially the expected return on that particular stock. Different companies will have different discount rates depending on their risk and outlook.
A startup that isn’t yet profitable will need to offer investors a higher expected return. So, its cash flows get discounted more heavily. After all, they may not even have future cash flows!
On the other hand, a large, stable company with predictable earnings (a utility company, for example) would justify a lower discount rate. That’s because investors are willing to accept a lower return in exchange for the safety of more reliable cash flows.
What Makes a Stock Overvalued?
A stock’s price can look high either because:
- Investors expect stronger future growth, or
- They’re discounting those future cash flows at a lower rate.
But when you look at a stock’s price, how do you know which of these is the one that’s making it overvalued?
And if high valuations do reliably predict lower future returns (and they do), everyone would be selling based on this, right? If that’s the case, why doesn’t the stock’s price drop instantly to a “fairly valued” price?
That’s because stocks tend to stay overvalued for long periods of time.
On the surface, this doesn’t make sense.
But once we zoom out and see that the stock market has a long history of going up over time, it does.
And that’s your case for not selling stocks when they’re overvalued.
What Should You Do?
We expect to have down years in the stock market — typically one year out of every four or five. So, if the market goes down and valuations drop, we’ve planned for that.
But over a longer time horizon, it’s a different story. Yes, large growth stocks like the Magnificent Seven look expensive. If you own one, or all, of these stocks, does that mean that you expect a negative return going forward?
Of course not. They’d be out of business.
More likely, we should expect Mag 7 stocks to have returns that are closer to the market’s historical averages than what they’ve done over the last few years.
And remember, the average annual return for the S&P 500 is 10.4%.
But not every corner of the market is frothy. Small value stocks, for example, have valuations that are closer to their historical norms. And non-U.S. markets aren’t overvalued.
So, what should we do?
- Stay diversified. If you own small value and international stocks, you own stocks that aren’t as overvalued as the ones you’re reading about in the news.
- Remember your plan. Your portfolio probably isn’t 100% in stocks. Since our time horizon is measured in years and not quarters, today’s valuations matter far less.
- Stress-test your numbers. If you’re still worried about the market being too high, go back and test your financial plan with lower expected returns. I’m guessing that you’ll still be okay.
Is This Time Different?
The story I’m seeing a lot of is that AI is the new, hot “thing” that’s causing a bubble. Remember, people said the same thing about the railroads, cars, computers, and the internet.
There will always be ups and downs. But this is the perfect time to remember Sir John Templeton’s famous warning:
The four most dangerous words in investing are: this time is different.
A stock would never have a negative expected return. If so, it would be worthless, and the company would go bankrupt.
High valuations may mean these Mag 7 stocks may not keep up this incredible streak, but it also doesn’t mean you should dump them (or the market in general).
Now, let’s hope that, by writing all of this, I haven’t invoked Murphy’s Law.
If you’re still stressed about the market and would like someone to help you stress-test your plan, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.
