If there were a mood to this year’s market, it might be apprehensive. Despite modestly positive year-to-date returns across most asset classes as of the end of the third quarter, recent market gyrations indicate that there is “another shoe” out there, the potential for a stock market correction, just waiting to drop again (if it hasn’t already by the time you’re reading this).
Have stocks become overpriced? It depends on who you ask. In our last quarterly Market Commentary, we described the Sharpe Ratio and its namesake Nobel laureate William F. Sharpe. This past quarter, there was another ratio frequenting financial headlines, co-developed by Nobel laureate Robert J. Shiller: the CAPE ratio. Standing for “cyclically adjusted price-earnings,” it is meant to measure how high or low current prices are compared to long-term stock prices. In an August 16 New York Times column, Professor Shiller declared the CAPE ratio to be “hovering at a worrisome [high] level.”
But before we conclude that stocks are overdue for a take-down, consider another article in the August 27 Wall Street Journal by Burton G. Malkiel, author of the classic finance book, “A Random Walk Down Wall Street.” Professor Malkiel compares the CAPE camp’s “worrisome level” with a capital-market camp viewpoint that the higher stock prices may be warranted based on today’s low fixed income interest rates. In assessing which camp is right, Professor Malkiel proposes that “both may be.” Shiller himself notes, “The CAPE was never intended to indicate exactly when to buy and to sell. The market could remain at these valuations for years.”
It’s no wonder many investors are confused! We have our own proposal to make. We are glad that scholars from Sharpe to Shiller continue to study market pricing theory. Through the years, their findings have shaped the principles that guide our investment strategy to this day.
But abandoning your own, carefully constructed investment portfolio based on the clash of the academic titans as they debate real-time market pricing (or based on the market’s own near-term movements) is like building a new home every time a new design trend is introduced. It’s stressful, expensive, and unlikely to make you any happier in the long run.
Instead, the truth is, you have little control over whether stock prices are over-priced or fairly valued in the near term. But you do have control over your personal portfolio. How much market risk and expected return should you build into your investments in pursuit of your desired goals? How can you most cost-effectively employ evidence-based strategies such as asset allocation and global diversification to help manage the market risks that you do take on? These are the questions worth focusing on.