Adam Strauss

Price-Insensitive Investors of U.S. Stocks

August 17, 2017 By Adam Strauss Leave a Comment

James Montier at GMO just penned a white paper called “The S&P 500: Just Say No” that echoes many of the same themes discussed in our recent client letter and also in my post on Overpayment Risk. I want to discuss one of his points, which is that price-insensitive investors who are investing passively in the S&P 500 Index are taking significant risks.

James Montier on Passive Price-Insensitive Investors

In the white paper, Montier says:

The decision to be passive is still an active decision – and we would suggest one with important risks that investors are not paying adequate attention to today. As more and more investors turn to passively-managed mandates, the opportunity set for active management increases. A decision to allocate to a passive S&P 500 index is to say that you are ignoring what we believe is the most important determinant of long-term returns: valuation. At this point, you are no longer entitled to refer to yourself as an investor. You may call yourself a speculator, but not an investor. Going passive eliminates the ability of an active investor to underweight the most egregiously overpriced securities in the index (we obviously prefer a valuation-based approach for stock selection as well). When faced with the third most expensive US equity market of all time, maintaining a normal weight in a passive index seems to us to be a decision that will likely be very costly. Yet despite this, it remains a popular path, with around 30% of all assets in the US equity market in the hands of passive indexers (see Exhibit 9).

According to Montier, passive investors are, importantly, ignoring price when they are buying a passive U.S. stock market index. Instead, they are making investments for reasons unrelated to the relationship between price and value. In my view, these investors are doing so to chase performance. Passively investing in the S&P 500 Index is indeed likely to be very costly for those passive investors who are crowding into an already crowded and very expensive trade.

In addition, these price-insensitive passive investors are causing an overvalued U.S. stock market to become even more overvalued. They are just pouring more fuel on the fire.

Besides passive investors, other price-insensitive investors are also worth mentioning, including corporations and central banks:

Corporations

Corporations have taken advantage of the low-interest rate environment to issue debt and use the proceeds to buy back shares of their stock. In the chart below, it is clear that the primary buyers of equities since the financial crisis have been corporations. Corporate buyback activity has exceeded $100 billion per quarter over the past several years.

Management teams and boards make these buyback decisions to maximize the value of their equity grants, stock options, and other forms of equity-linked compensation. Because corporate buybacks are driven primarily by management compensation considerations, corporations, like passive investors, should generally be categorized as price-insensitive investors.

Corporations, like passive investors, are driving the S&P 500 Index far beyond intrinsic value. What happens when corporations can’t leverage further to continue buying their shares?

Central Banks

In recent years, certain central banks have turned to printing money and buying stocks with that newly-printed money. The Swiss National Bank, for example, owns about $80 billion in U.S. stocks. Thus far in 2017, the Swiss National Bank has invested $17 billion in U.S. stocks. You can see some of their major holdings in the chart below:

Unlike private investors, central banks like the Swiss National Bank do not make investment decisions to generate economic profits; they make investment decisions to meet monetary policy goals. Like passive investors and corporations, the relationship between price and value is not a consideration; they, too, are price-insensitive investors who have driven up U.S. stock prices.

What Happens When Price-Insensitive Buyers Turn into Sellers?

Unfortunately, price insensitive buying ultimately leads to poor capital allocation decisions. Also, just as price insensitive buying can boost the prices of stocks, price insensitive selling will do the opposite. When the next market turn occurs at some undetermined point in the future, many price-insensitive buyers will likely become sellers, potentially exacerbating the next market downturn.

In my opinion, James Montier is right. If you care about the relationship between price and value, you are better off saying no to the S&P 500 Index.

Are you currently invested passively in the S&P 500 Index? If so, why?

Q2 2017 Letter: On Overvalued U.S. Stocks

August 16, 2017 By Adam Strauss Leave a Comment

Long ago, Ben Graham taught me that

’Price is what you pay; value is what you get.’

Whether we’re talking about socks or stocks,

I like buying quality merchandise when it is marked down.

— Warren Buffett

Our quarterly market commentary is now online, where we talk about the overvalued U.S. stock market and what that might mean for your investment portfolio and retirement plans.

“Your Robo-Advisor May Have a Conflict of Interest,” and so too Might Your Warm Blooded Financial Advisor

July 28, 2017 By Adam Strauss Leave a Comment

Bloomberg published an excellent article about the conflicts of interest that exist among the big banks which are rolling out and promoting robo-advisor programs for their wealth management clients. If you plan to use one of these robo-advisor programs, you should be aware that you are probably going to be placed into funds and ETFs which are probably not in your best interest to own. Instead, the investment decisions will be driven in no small part by the compensation that these banks are receiving from various fund companies.

Robo programs could favor mutual funds and exchange-traded funds from companies that make such payments, according to disclosures by the banks. The practice is known as revenue-sharing, or paying for shelf space. It includes sponsoring conferences for bank employees at luxury resorts and lavishing top brokers with gifts and entertainment.

Conflict of Interests: It’s Not Just a Robo-Advisor Problem

While the Bloomberg article addresses the conflicts of interest at some robo-advisors, it’s important to keep in mind that the conflicts that exist at these brokers also pertain to their large staff of warm-blooded human financial advisors.

If you work with a financial advisor who is registered as a broker, you should be aware of these conflicts.

The conflicts of interest described in the article are unrelated to whether you are working with a person or a computer; they are related to whether or not you are working with a financial advisor who has a fiduciary obligation to keep your best interests in mind when selecting your investments.

Whether you are counting on a computer or a person to manage your money, you should seek to work with a financial advisor who has a fiduciary obligation with your account (Rule #3).

Problems with Revenue Sharing with Robo-Advisors and with Financial Advisors

The revenue-sharing practices described in the article create problems for you if you happen to be one a wealth management client at Morgan Stanley or Merrill Lynch.

First, revenue-sharing adds to the cost of the funds that you own, because you pay the cost of sponsored conferences, gifts, and entertainment in the form of higher fund fees. On average, the cost of these funds and ETFs is going to be more expensive than the cost of owning funds and ETFs that do not have to make such payments.

More importantly, revenue-sharing means that you are likely going to own suboptimal investments. For example, Vanguard Group, which offers a wide selection of excellent, low-cost mutual funds, is not available for purchase on platforms like Morgan Stanley or Merrill Lynch because they refuse to “pay-to-play.” The choices are limited to those funds that make appropriate payments rather than those funds which might be the best investment for you.

John Strauss (no relation) has some appropriately harsh words to say about these conflicts of interest.

John Strauss, chairman of FallLine Securities LLC and a former wealth management executive at UBS Group, JPMorgan Chase, and Morgan Stanley. ‘When I’m a client of one of those firms, I think I’m seeing the best ideas,’ says Strauss, whose business helps advisers go independent from big brokerages. ‘Really, what you’re seeing are the ideas they have arbitrarily decided they can make enough money on to show you.’

Given his work history, Mr. Strauss should know better than most how the game works. These financial advisors do not have a fiduciary duty to their clients. Because they are not acting as fiduciaries, they are allowed to place clients into products which are not in their best financial interest. If you are a participant on one of these robo-advisor programs, it’s a good idea to assume that you will own investments that are not the ideal choice for you.

Mr. Strauss’s former employer, Morgan Stanley, revealed in its disclosures that some companies provided it with as much as $550,000 per year for “sponsoring seminars or paying the meal, travel, and hotel expenses of brokers attending sales events.” In addition, some companies provide as much as $500,000 per year for data about mutual funds and as much as $550,000 for ETF data.

I would make two points here. First, I interpret these payments as amounts provided to Morgan Stanley per company. Across all of the fund companies that seek to be available on the Morgan Stanley platform, this must add up to many millions of dollars each year. Second, it’s not just Morgan Stanley; all of the large brokers have similar disclosures involving their material conflicts of interest.

Does your financial advisor have a fiduciary obligation with your account? If not, why do you choose to work with them?

5 Reasons Why a 10%+ Gold Position Makes Sense in a Diversified Investment Portfolio

July 26, 2017 By Adam Strauss Leave a Comment

Michael Batnick recently wrote an interesting post about how financial advisors think when it comes to investing in gold. In the article, he suggested that most investors, including financial advisors, fall into one of two camps. Either they own almost no gold (3%), or they own a 50%+ gold allocation. He went on to share his own view on gold, which was the following:

“I see nothing wrong with a permanent 10% position in gold, for example, but the problem is, I’ve never heard of anyone actually keeping 10% of their portfolio in gold. It’s either 50% or 3%, which does nothing.” — Michael Batnick

This statement struck me when I read it. The reason is, for many of my clients, I actually do keep a 10%+ permanent position in gold. When gold goes up in price relative to other investments, I trim the gold position to rebalance. Similarly, when gold goes down in price relative to other investments, I add to their gold position to rebalance.

Michael didn’t explain why he thought a 10% permanent position in gold makes sense, so I thought I would share a few of my reasons why many of my clients own a 10%+ permanent position in gold.

Bad Reasons to Invest in Gold

Let’s begin with a list of weak reasons to own gold (in my opinion). If you are going to own an investment, whatever it is, your reasoning should be defensible. If your logic for investing in the first place isn’t sound, then you may end up selling for a wrong reason too.

You shouldn’t buy gold because you don’t like Donald Trump, and you also shouldn’t buy gold because you do like Donald Trump. I would not make any asset allocation decisions based on politics, with gold or with any other asset class.
You shouldn’t buy gold because you expect the dollar to collapse. The dollar is the global reserve currency and will continue to be widely used, even as its value gradually depreciates over time. The likelihood of the dollar collapsing in price one day like the Venezuelan Bolivar is extremely remote.

Not a good reason to own gold — **Not a likely path for the U.S. dollar.**

You shouldn’t buy gold because you don’t trust financial markets. Like them or not, markets have been around for hundreds of years, and they aren’t going anywhere. The same holds true for central banks.

Gold is worth owning, in my view, but not for the reasons listed above. You should have sound, defensible reasons to own a permanent position in gold.

Good Reason #1: Opportunity Cost of Owning Stocks and Bonds

The opportunity cost of a holding a long-term 10% position in gold is currently low. U.S. stocks are expensive, while bond yields are near a 5,000 year low. Traditional investments such as U.S. stocks and investment-grade corporate bonds currently do not pay investors appropriately for the risk involved. During the past thirty years, the typical 60/40 (stocks/bonds) investment portfolio has performed remarkably well for investors. However, that same 60/40 portfolio is not likely to work as well going forward. With U.S. stocks and corporate bonds expected to generate anemic returns during the coming decade, why not allocate some of your capital elsewhere?

Good Reason #2: Financial Repression and Negative Interest Rates

Financial repression is a term used by economists to describe a set of monetary policies whereby interest rates are kept below the rate of inflation for a multi-year period. When interest rates are lower than the rate of inflation, that means that real interest rates are negative. Investors tend to buy gold when real interest rates are negative because they expect gold to hold its inflation-adjusted value over time better than bonds. Currently, we are in a period of financial repression that could last as long as a decade or more, which suggests to me that an increasing number of investors are going to build an investment allocation to gold to keep up with inflation, and that should lead to higher gold prices.

Good Reason #3: Low Correlation to Other Asset Classes

Gold prices have demonstrated a low historical correlation to both bond prices and stock prices. Gold often goes up in price during periods when stocks or bonds go down in price. Similarly, gold could go down in price when stocks or bonds go up in price. Constructing an investment portfolio where you own a bunch of uncorrelated asset classes and rebalance regularly works better with gold as a part of the mix.

For example, owning a meaningful gold position would have provided downside protection during the bear markets shown in the chart below; during most of the bear markets of the Post World War II era, gold prices appreciated considerably.

By owning uncorrelated assets, including gold, you reduce volatility in your investment portfolio and, in doing so, you should be able to improve your long-term risk-adjusted returns.

Good Reason #4: Contrarian, Undervalued Investment

Most Western investors don’t own gold. Hardly any institutional investors own gold. Gold remains an unpopular investment, which might be why Michael Batnick doesn’t own gold. Most investors would rather own traditional financial assets like U.S. stocks and U.S. corporate bonds because that’s what has been performing so well during the current bull market in both stocks and bonds.

However, astute investors know to look for investments which are unconventional, unpopular, unloved, and are priced accordingly. Remember Rule #2: The price you pay for a long-term investment will likely be the primary determinant of your risk and your reward.

The chart below shows the relative price of real assets like gold compared to financial assets like stocks and bonds. As the title suggests, real assets are at all-time lows relative to financial assets. Eventually, this will mean revert, and it’s worth positioning your investment portfolio accordingly.

Good Reason #5: Dollar Depreciation

In 1971, President Nixon closed the gold window (a.k.a. “End of Bretton Woods” in the chart above). Since then, the U.S. dollar has served as the global reserve currency. As a result, most international trade transactions since the 1970s have been conducted in U.S. dollars, including cross-border transactions in which the United States is not even a party.

Today, however, the international monetary system is in the midst of a significant regime change.

Foreign countries are beginning to transact in other currencies besides the U.S. dollar, such as the Chinese Yuan. As the dollar gradually loses market share to regional currencies such as the Yuan and the Euro, foreign central banks are going to diversify their foreign exchange reserve holdings by owning fewer U.S. Treasuries. Indeed, since 2014, central banks have been net sellers of U.S. Treasuries and net buyers of gold.

For many years, foreign central banks were an important source of demand for U.S. Treasuries and an important source of support for the dollar. Without that support, and with a continuing current account deficit, the dollar should depreciate versus other currencies over time, and, relatedly, the price of gold should rise.

How Much Gold Should You Own in Your Portfolio?

Without knowing your individual financial circumstances, I can’t provide a personalized recommendation to answer this question for you. However, in my opinion, a 10%+ position is appropriate for many investors, and especially so if the rest of your investment portfolio is somewhat domestic and dollar-centric.

In my view, owning a 0-3% position in gold is a mistake. By holding virtually no gold, you will probably have a larger allocation to more expensive U.S. stocks and low yielding U.S. bonds. Your portfolio will be less diversified because you won’t be taking advantage of gold’s low correlation to U.S. stocks and bonds. If financial repression continues for an extended period, you might find that the purchasing power of your investment portfolio declines over time.

At the same time, owning a 50%+ position in gold is also a poor idea, because you are putting too many eggs in one basket. To take advantage of the benefits of diversification (see reason #3 to own gold above), you should not own too much of any single asset class unless you are willing to risk steep losses should that asset class decline significantly in price.

You don’t want to own too little gold, and you don’t want to own too much gold. In my judgment, for many investors, a 10%+ position sounds about right.

What is your exposure to gold, and, more importantly, how did you come to that decision?

What Does a Chicago Bankruptcy or an Illinois Bankruptcy End Game Look Like?

July 15, 2017 By Adam Strauss Leave a Comment

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

– Ernest Hemingway, The Sun Also Rises

Chicago and Illinois are in dire financial straits today as a result of decades of financial mismanagement. While not yet technically bankrupt, Chicago and Illinois are headed into a bankruptcy-like restructuring of their financial obligations at some point within five years. I provide this opinion without any inside knowledge of Chicago or Illinois politics; I read the same newspaper articles that everyone else reads. I am basing my opinion about a looming Chicago bankruptcy and Illinois bankruptcy on simple math and finance concepts.

**What Happens to Chicago as It Approaches the End of the Road?**

If you are a saver and an investor, the law of compound interest is a wondrous phenomenon. With compound interest, your net worth grows over time as you generate income on your invested capital which you can then reinvest to generate even more income. It’s particularly important to save early in your life, so that time and the compound interest has more time to grow before you eventually retire.

If you are a significant debtor, as Chicago and Illinois are, the law of compound interest is a toxic force which can drive you into bankruptcy just as soon as its lenders stop providing the financing. Moreover, compound interest is particularly toxic when a municipality mismanages their finances for decades like Chicago and Illinois have. With compound interest, debts and pension deficits compound over time until they eventually become unmanageable.

After many years, the debt level and pension obligations of Chicago and Illinois have become so large that there is no way out, short of a miracle (such as a Federal bailout).

Brief Overview and Quantification of the Financial Problem for Illinois and Chicago

For Illinois, the state has $31.5 billion in general obligation (GO) bonds, $15 billion of unpaid bills that are due, and, most importantly, an unfunded pension liability which grew to $251 billion on June 30, 2016. The Illinois House and Senate passed tax increase over the Governor’s veto in July 2017, but it wasn’t enough to keep Moody’s from putting the state on negative outlook with a threat to downgrade Illinois bonds to a junk rating.

A junk rating means that an issuer’s bonds are too risky and not credit-worthy enough to be considered investment grade; for now, there are no states with a junk credit rating.

Unlike Illinois, Chicago’s bonds are already junk rated (Ba1) by Moody’s and are also under review for another possible downgrade. Relatedly, the deep junk bonds of the Chicago Board of Education, already rated B3, are under review for a further downgrade due to state budgetary pressures. The pension systems of Chicago and the Chicago Public School system are also deeply underfunded, by $35 billion and $9.5 billion, respectively.

Here is how the vicious cycle is currently working:

Debts are rising exponentially.
Pension underfunding levels are increasing exponentially.
Because of #1 and #2, interest payments and pension obligations are consuming state and city budgets.
Because of #3, taxes and fees keep rising, while service levels keep declining.
Because of #4, taxpayers are leaving the city and state, making the financial problems even worse.

It’s obviously not a pretty picture. It’s easy to blame current politicians for the current mess, but the truth is that everyone is doing their best to sort through a bleak and impossible-to-fix financial mess.

How Are You Going to be Affected by this Mess?

The fiscal quagmires in Chicago and Illinois will cause significant problems for many people:

If you are a resident or business owner in Chicago or Illinois, this could affect your taxes and your property value. Services will also keep declining, which means fewer police officers and larger classroom sizes.
If you are a current or former employee of the city of Chicago or the state of Illinois, this could affect your job, your salary, and your pension.
If you are a municipal bond investor who bought Chicago and Illinois muni bonds due to the juicy yields they provide, this could affect your ability to get 100% of your principal back.
If you are a municipal bond insurer, you might have a significant financial obligation if Chicago or Illinois default on their bonds.
If you are one of the cities and states across the country with similar pension problems as Chicago, this could raise the interest rate that you have to pay for the bonds that your municipality issues.
If you are a U.S. policymaker, this could create financial instability that might hurt the fragile U.S. economy.

In short, this is a problem will directly or indirectly affect a lot of people.

The comparison between Illinois and Greece is not an altogether bad one. For both Illinois and Greece, financial insolvency is eroding civic life in both places. In some ways, Greece is actually better positioned than Chicago, because Greece owns a couple of ports which are strategically located in the Mediterranean Sea and coveted by China. Earlier this year, Greece recently sold the Port of Piraeus to China to raise much-needed funds. Chicago has Navy Pier and Oak Street Beach, which are both great places, but China couldn’t care less about them.

A Framework for Interpreting Future Events as they Unfold

As this the finances of Chicago and Illinois continue to worsen at an accelerating pace, it’s important to keep the following four ideas in mind:

#1: Illinois and Chicago policymakers will do their best to kick the can down the road to delay a reckoning. Both Democrats and Republicans do not want to see a bankruptcy on their watch. Instead, they will continue to provide band-aids, hoping that they will be out of office by the time a default happens. Politicians never choose to make unpopular decisions until outside forces force the issue, and all of the choices they currently face are unpopular ones.

#2: Two chances exist for a grand compromise fix: slim and none. In the current partisan environment, Republicans will almost certainly avoid compromises that result in higher taxes, while Democrats will resist any compromises that cut spending. Also, even if there is a grand compromise, the toxic force of compound interest is too large to stop at this point.

#3: The longer the wait, the worse it will be for all stakeholders: The delay until an eventual default is bad for almost all stakeholders involved except the politicians. With continued delay…

…the pension underfunding situation will worsen, harming pensioners who are counting on Chicago and Illinois to deliver on their promises.
…city and state services will continue to decline, which will affect the effectiveness of the schools, public safety, and the quality of life.
…more taxpayers will flee the state due to declining services and higher taxes.
…and the debt burden of Chicago and Illinois will worsen, as the city and state issue more bonds to push off the inevitable.

#4: There’s a reasonably good chance for a Federal bailout. The Federal Reserve does not want to create financial instability because the U.S. economy is just too fragile to handle it. To provide financial stability, the Federal Reserve has already provided capital to support or bail out banks, the housing market, stocks, bonds, and mortgage-backed securities during the past decade. The municipal bond market is an enormous, $3.7 trillion market, and, according to Bloomberg, the municipal pension underfunding situation nationwide is approaching $2 trillion. These figures are easily large enough to get the attention of Congress and the Federal Reserve.

**The Math of Compound Interest Applied to Pension Funds**

#5: If a default occurs, expect a wealth transfer from creditors to debtors. Investors in Chicago municipal bonds and Illinois municipal bonds, who are typically high net worth individuals in the highest income tax bracket, will see steep haircuts on their investment principal. Pensioners, which include middle-class retirees, many of whom used to be teachers, policemen, and firemen, should fare much better.

What is the Likely Catalyst for a Chicago Bankruptcy or an Illinois Bankruptcy?

As long as bond investors are willing to buy the bonds issued by Chicago and Illinois, the party will continue as the financial distress slowly worsens. To use Hemingway’s terminology, Chicago and Illinois are still in the gradual phase of becoming bankrupt.

The sudden phase of bankruptcy, in all likelihood, occurs when one or more of the following occurs:

The economy enters another recession, which would suddenly have a detrimental impact on tax revenues.
The stock market declines significantly, which would suddenly blow a large hole in pension plans that are dependent on 7% annualized investment returns.
The bond market decides it doesn’t like risk anymore, which would suddenly make it difficult for municipalities with a risky credit profile to issue more debt.

How Does this Affect Your Financial Situation?

I don’t know what your individual financial situation is, so it’s impossible for me to provide specific personalized financial advice. However, I will provide make some general comments.

If you are a resident of Chicago or a resident of Illinois, you should prepare and budget for higher taxes. Illinois just raised income taxes, but you will probably experience more tax hikes in the coming years.
If you are a municipal bond investor, you might want to consider investing in municipal bonds outside of Illinois where the risk/reward profile looks more attractive.
If you are a former employee of Chicago or Illinois and you have the option to roll your Chicago retirement plan into an IRA, you should consider doing so. I have a client who is a former teacher that did exactly this.
If you are a current or prospective investor in Chicago real estate, you should prepare and budget for your property taxes to rise.

How do you think the end game plays out? Please share your view in the comment section.

Overpayment Risk: Why U.S. Stocks Could Decline by 40%+

July 4, 2017 By Adam Strauss Leave a Comment

You may not know what your investment exposure is to U.S. stocks. If that’s the case, you probably should figure out what your exposure is sooner rather than later.

Stocks are always risky, of course, but the long-term risk/reward profile of owning U.S. stocks is sometimes particularly attractive, and at other times it is sometimes particularly unattractive.

Today I judge the risk/reward profile to be particularly unattractive.

I’m not suggesting that you should go out and sell all of your U.S. stocks. I am suggesting that you should know what you own and be comfortable with whatever exposure you have. And, relative to the investment exposure range that represents your comfort zone, you probably want to be nearer to the low end of that range.

At the moment, three important factors are adding to your risk of owning U.S. stocks at the present moment.

The Federal Reserve is raising interest rates, which is slowing down credit expansion and, relatedly, the economy.
The economy is in the ninth year of a bull market.
The stock market is trading today at nosebleed prices.

I am calling this third factor, “overpayment risk.”

Overpayment risk is the risk of paying too much for an overvalued investment. When you pay too much for an investment, your long-term investment return will probably be poor. Depending on the situation, you might even generate a long-term investment loss.

During the past twenty years, many investors have learned much about overpayment risk. Investors lost a big chunk of their savings when the dot-com bubble burst and again when the housing bubble burst. Unfortunately, overpaying for investments has had devastating financial consequences for many families’ financial plans.

If you own excessively priced U.S. stocks or broad U.S. index funds today, you should be aware of your overpayment risk.

Whether or not you define the current U.S. stock market as a “bubble,” stocks are significantly overvalued. That doesn’t mean that a stock market crash is imminent. It does mean that your long-term returns from owning a diversified portfolio of U.S. stocks are likely to be poor.

The Devastating Consequence of Excessive Overpayment Risk

**The housing bubble was an example of overpayment risk.**

During the housing bubble, home prices surged, even while salaries and rent levels remained flat. House prices were not growing due to economic prosperity or even due to wage inflation; they were rising due to investment speculation, fuelled by cheap debt and the willingness of regulators and policy makers to look away. By 2009, after the subsequent bust, the home price/median income ratio and the home price/median rent ratio came back down to earth.

In retrospect, the housing bubble was a perfect example of overpayment risk. Many families who bought an overpriced home in 2005 generated negative returns for years. If you overpaid for your home and also used a lot of debt, you might have even lost your home. For many families, buying a home destroyed their long-term financial plans. In Chicago, where I live, more than 20% of homeowners are still trapped in underwater mortgages.

Of course, years before investors who were giddily overpaying for houses, investors were giddily overpaying for tech stocks.

In 2000, the U.S. stock market in general, and large cap growth stocks in particular, had become an investment bubble. Stock prices back then reflected ludicrous optimism about future growth and profitability.

Cisco Systems was the most valuable company in the world for a short period during 2000. At its peak, Cisco traded at a nosebleed 125x Price/Earnings multiple. Investors described companies like Cisco as “one-decision stocks” that would just keep going up in price. The optimism surrounding Cisco’s share price was unjustifiable and unwarranted.

**Cisco Systems was an example of overpayment risk in 2000.**

The Cisco optimists were partially correct. Cisco was a great company, and its prospects in 2000 were indeed promising. Since then, Cisco has generated a five-fold increase in earnings per share. Unfortunately, Cisco shares are trading today at just 50% of its 2000 price. The problem with investing in Cisco in 2000 was the excessive overpayment risk. If you bought Cisco shares, the only way you could do well as an investor was to convince another investor to overpay by even more than you overpaid. That’s what happens during investment bubbles.

Once tech spending began to decelerate, and investors began to sell, Cisco’s share price plummeted. Overpayment risk affected other stocks, too. In fact, the S&P 500 Index and the Nasdaq Composite generated a negative investment return during the subsequent decade.

I bring up the housing bubble and the implosion of Cisco’s shares as illustrative historical examples of overpayment risk. To be a successful long-term investor, you have to pay attention to value (Rule #2). The price you pay for an investment will likely be the primary determinant of your long-term return.

Current Overpayment Risk in U.S. Stocks

If you think passive investing in broad index funds without regard to overpayment risk is a good idea right now, I urge you to reconsider. Many asset classes are significantly overvalued right now, not the least of which is U.S. stocks. The Price/Earnings ratios of many U.S. companies are impossible to justify. Like Cisco shares after 2000, the share prices of many U.S. companies are ludicrously overvalued.

Also, as I mentioned above, we are now in the ninth year of a bull market in stocks. After nine years, many investors have forgotten to pay attention to value. This forgetfulness about risk often happens during extended bull markets. In many respects, the market today feels very much like the extended bull market of the late 1990s.

Let’s look for a moment at the elevated level of the Shiller P/E ratio (see chart below) today. Robert Shiller, an economist at Yale, developed the Shiller P/E ratio. Also known as the Cyclically Adjusted P/E (CAPE) ratio, the Shiller P/E ratio is a useful valuation measure for stock markets.

**Overpayment Risk: The Shiller P/E Ratio**

The Shiller P/E ratio is calculated by dividing the price of a stock market index by the average earnings over the past ten years. The ten-year earnings average normalizes corporate profit levels which tend to fluctuate over the course of an economic cycle.

Today, as I write this post, the current Shiller P/E ratio is at 30.1x, compared to a historical median of just 16.1x. The stock market would have to decline by 46.5% to reach the median historical Shiller P/E ratio of 16.1. Again, I’m not predicting an imminent crash of 46.5%, but the elevated Shiller P/E ratio should make you cautious about the expected return and the expected risk of owning U.S. stocks.

Importantly, the 1998-2000 period is the only time in the past one hundred years where the Shiller P/E ratio was higher than it is now. U.S. stocks are trading at a Shiller P/E ratio that is greater even than 1929, which is the year the stock market peaked just before a 90% decline in U.S. stocks at the onset of the Great Depression.

Overpayment Risk Today Affects Small-Cap and Large-Cap Stocks Alike

**The U.S. stock market is overvalued across small, mid, and large cap stocks.**

I came across the remarkable chart above a few days ago after Meb Faber posted it on Twitter. It examines the P/E ratio of U.S. stocks broken into size deciles. The largest decile of U.S. stocks is on the X-axis is at 1, and the smallest decile is on the X-axis at 10. It takes a moment to study and figure out the chart, but it’s well worth your time.

I glean the following insights from it:

#1: In 1999, large cap stocks, like Cisco, were significantly overvalued, but the overpayment risk at the time was limited to large cap growth stocks. In stark contrast, small cap stocks were inexpensive and undervalued. As a result, investors that bought small cap stocks generated excellent returns during the following decade.

#2: Today, U.S. stocks are overvalued across all sizes of companies, from the 1st to the 10th decile. Large-cap, mid-cap, and small-cap stocks are all expensive relative to history. In other words, the overpayment risk is high today, regardless of company size. Whether you are looking at large-cap or small-cap U.S. stocks, your returns are likely to be low over the next ten years because U.S. stocks are simply too expensive relative to their earnings.

An Important Caveat on Overpayment Risk

Elevated overpayment risk is not a useful prediction indicator of an imminent market crash. Overvalued stocks can remain overvalued for years if not decades. However, various valuation measures, such as the Shiller P/E ratio, are useful indicators for forecasting subsequent 10-year stock market returns.

In other words, a high level of overpayment risk does not mean that the stock market is about to crash, but it does mean that U.S. stocks will likely generate paltry investment returns during the next ten years.

Side-Stepping Overpayment Risk

A good way to side-step overpayment risk is to move your capital into a more attractive asset class. In 2000, this meant going to cash or, even better, investing in small-cap stocks rather than large-cap stocks. In 2005, it meant renting instead of buying a home.

Today, side-stepping overpayment risk is a much more challenging task. Without a doubt, it means allocating more of your investment portfolio away from U.S. stocks and into other investments. It also means investing in asset classes where overpayment risk is far lower.

What are you doing to side-step overpayment risk today?