Asset Allocation

Got Gold? Got 10% Gold?

June 1, 2018 By Adam Strauss Leave a Comment

I have previously suggested that a 10% gold position makes sense for many investors who want to generate attractive risk-adjusted returns in a diversified investment portfolio.

During my discussion, I spent little time talking about why a 10% position per se makes sense, as opposed to either a 2% position or a 50% position. Instead, my discussion focused on why it makes sense to own a meaningful position in gold.

For some people, a meaningful position is 11% in gold, while for others, it might be 20%. The correct allocation depends on each person’s risk tolerance, return goals, time horizon, and overall financial situation. That’s why my recommendation was “10%+” rather than 10%, or 12%, or 15%; I wanted to give room for the adjustments that must occur due to individual circumstances.

Yesterday, Incrementum published the 2018 version of my favorite annual gold report, “In Gold We Trust,” which I will discuss further in future posts. The extended version of the report is over 200 pages long, and I’m still in the process of slowly reading through the whole thing. Nevertheless, I want to share two tables I found which shed some light on the question of how much gold one should consider owning.

Risk/Reward Implications of a 10% Gold Position

The first interesting table, originally published by Goldman Sachs, analyzes the portfolio impact of adding a 10% gold position to a portfolio of 60% stocks and 40% bonds during the period since 1970. As you can see from the table below, adding a 10% gold position has enhanced returns and reduced downside volatility.

Goldman’s analysis also looks at the impact of adding a 10% position in GSCI (Goldman Sachs Commodity Index), in 30-year U.S. Treasuries, and in cash. Unsurprisingly, U.S. Treasuries and cash reduced risk, which is a good thing, but they also reduced returns. While cash and U.S. Treasuries certainly have a role in a diversified portfolio, these asset classes are not able to boost returns and risk in the same way that gold can.

Obviously, past performance is no indicator of future performance. That said, given how overvalued U.S. stocks are and given how leveraged the financial system is at the present moment, I expect the positive impact (on risk and return) of adding a 10% gold position to a 60/40 investment portfolio to be even more significant over the next ten years than it has been over the past forty years.

What are Central Banks Doing?

I also discovered that the world’s major central banks are on the 10%+ gold plan. To be more precise, central banks own a 13.73% gold position relative to all foreign currency reserves. For central banks, gold serves as a hedge against a decline in the rest of their foreign currency reserves, all of which are fiat currencies and most of which are U.S. Treasuries.

To be fair, the range is enormous, from China at the low end with a 2.25% gold position to Europe at the high end with a 42.64% gold position. While China’s gold position appears low, I suspect that China owns more gold than its official figures suggest due to the enormous volume of gold that has been imported into China over the past five years.

The key takeaway from this second table is that central banks understand the important hedging role that gold can serve in a portfolio of assets, and they have invested their own assets accordingly. Also, they are seeing that the need to hedge is increasing rather than decreasing because their gold positions have been rising year-after-year ever since 2008.

History suggests a 10%+ gold position makes some amount of sense. Central banks are acting accordingly. Furthermore, I expect that President Trump wants to see a weaker dollar, and any kind of a trade war will most likely result in accelerating inflation.

What are you waiting for?

My Barron’s Interview on South Korea Stocks

September 1, 2017 By Adam Strauss Leave a Comment

Barron’s interviewed me to discuss my thoughts on South Korea in a piece they called “Sabre-Rattling Creates Discounts in Korea.”

I’m not sure I love the headline, as my view is closer to “Discounts Have Existed in Korea for Years. Ignore the Sabre-Rattling and Buy.” If you don’t have a Barron’s subscription, you can read about my South Korea stock market view here.

Stock Market Math: Why Long-Term Returns will be Sub-Par

August 31, 2017 By Adam Strauss Leave a Comment

In the short-term, stock market returns are nearly impossible to forecast reliably; I have yet to come across anyone who can do this well on a consistent basis. Traders and speculators try to make short-term predictions; sometimes their calls are right, and sometimes their calls are wrong. In the long-term, however, which I define as a ten year period, it is possible to make a pretty good forecast. It requires applying stock market math concepts to determine probabilistically which markets are attractive and unattractive based on valuation and to even construct a crude forecast of average annual investment returns.

I have been making the case that U.S. stocks are a currently a high risk, low reward proposition for long-term investors, due largely to the fact that U.S. stocks are overvalued. While U.S. stocks are generally expensive, I am also coming across increasing evidence that U.S. small cap stocks, as measured by the Russell 2000 Index, are particularly expensive.

However, before I write any further about small-cap stocks, I want to discuss a question that a client asked me which got me thinking about stock market math.

Why I Love Talking to Clients

In our recent quarterly letter, we explained why U.S. stocks are overvalued and, as a result, likely to be a high-risk, low-return proposition for investors with a ten-year investment horizon.

After studiously reading the letter, one of my clients sent me an unsolicited email commenting on the letter. He said, “The two charts comparing value and 10-year forward annual return correlate beautifully. As you caution, they suggest sub-par returns in the future.”

I copied and pasted the two charts to which he was referring just below. They do indeed correlate beautifully.

While I agreed with his assessment, his comment suggested that the relationship between valuation and stock market returns might be a spurious one. As I considered how I might respond, it became apparent that we did a poor job of explaining why high stock market valuation levels lead to anemic 10-year equity returns going forward.

To put it simply, it’s all about the math.

Stock Market Math 101

I would suggest that your long-term investment returns from owning stocks will be approximately equal to the sum of the following three sources of investment return:

Dividend yield, plus
Revenue growth, plus
Increase (decrease) in the cyclically adjusted Price/Earnings (CAPE) ratio

Each of these factors contributes to stock market returns, sometimes to a greater extent and sometimes to a lesser extent, depending on the period in question. While dividends and revenue growth are almost always positive contributors to stock market returns, with the CAPE ratio, valuation can become a positive or a negative contributor to investment returns. If you start out the year with the S&P 500 Index at a 20x CAPE ratio, and then you end the year with the S&P 500 Index at a 10x CAPE ratio, you just experienced a 50% stock market crash (without considering the impact of dividends or revenue growth).

From the long-term chart of the CAPE ratio below, you will see that an expansion of the CAPE ratio was a major contributor of the S&P 500 Index since the financial crisis in 2008. The strong U.S. stock market has not been a function of strong revenue growth or a high dividend yield — it is simply a function of an expanded valuation as expressed through the CAPE ratio.

Likewise, you can see that a compression of the CAPE ratio was a significant driver of negative stock market returns between 2000 and 2009. If you get anything else from this chart, it should be that changes in valuation are an important driver of overall stock market returns.

Applying Stock Market Math to 1982

To better understand how stock market math works, let’s apply these three investment return drivers retroactively to the S&P 500 Index in July 1982, which was right at the end of a sixteen-year bear market.

(As an aside, yes, it is indeed possible to generate a negative return from owning stocks for sixteen years.)

Dividend Yield: In 1982, the dividend yield was 6.2%. In other words, even if stocks stayed flat, as long as companies continued to pay out the same level of dividends, you were going to generate a 6.2% return owning the S&P 500 Index. Today, a 6.2% return from owning U.S. stocks would be lovely.
Revenue Growth: Between 1982 and 1992, the U.S. economy expanded at a nominal rate of almost 5% per year. Between the dividend yield and revenue growth, thus far we are already at a double digit return from owning the S&P 500 Index, but we are just getting started.
CAPE ratio: The cyclically adjusted P/E ratio was at a generational low in 1982. During the subsequent decade, the CAPE ratio expanded from 6.6x in July 1982 to over 20x in July 1992, which means that the stock market tripled from CAPE multiple expansion alone.

Between July 1982 and July 1992, an investment in the S&P 500 Index generated an annualized return of approximately 18% between 1982 and 1992. It was a great decade to own U.S. stocks.

As I said, this stock market math model is a bit crude, but it is simple and useful in illustrating why valuation matters to long-term stock market returns.

Applying Stock Market Math to 2017

Today, the economy and the stock market are in a different position. In 1982, investors were worried about inflation, whereas today investors are worried about deflation. Interest rates were near a generational high, whereas today interest rates are near a generational low. Importantly, in 1982, U.S. stocks were inexpensive, whereas today U.S. stocks are incredibly expensive.

Let’s break down the math for the 2017 stock market:

Dividend Yield: The dividend yield of the S&P 500 Index is currently 1.9%. If stocks stay flat, as long as companies continued to pay out the same level of dividends, you are going to generate a 1.9% return. This is about 25% of the dividend yield that U.S. stocks were generating for investors in 1982.
Revenue Growth: During the past five years, real growth has been 2.2% and nominal growth has been about 3.7%, but that was before productivity started to decline at the end of 2016. That said, inflation could accelerate. Let’s assume revenues grow at a nominal rate of 4% per annum during the next ten years.
CAPE ratio: The cyclically adjusted P/E ratio is at a multi-year high of 30.5x, which is 50% more expensive than the 20x CAPE ratio of 1992 and 460% more expensive than the 6.6x CAPE ratio of 1982. Let’s assume that the CAPE ratio declines over the next ten years to the 1992 CAPE ratio of 20x. Such a contraction of the CAPE ratio would generate an annualized negative return of -4.1%.

Putting it all together, albeit, with several simplifying assumptions, an investment in the S&P 500 Index is set to generate an annualized return of 1.8% between 2017 and 2027. That 1.8% figure is equal to a 1.9% of dividend yield, plus 4% from revenue growth, minus 4.1% from CAPE ratio contraction.

Your approximate return from owning the S&P 500 Index, under my assumptions, would be positive, but not by all that much. And if the CAPE ratio contracts to 15x, your return would be negative.

For a 1.8% return, plus or minus, my question is, why take the risk?

You have much better options to consider which reduce your risk, enhance your likely return, or both. For example, you could buy a ten-year Treasury note and earn 2.1% per annum over the next decade. Owning U.S. Treasuries, you would generate a commensurate retrun while taking less risk. Alternatively, you could invest in other countries like South Korea where there is certainly risk, but where the valuation is far more reasonable and your likely return will be more attractive. Finally, you could selectively pick individual securities where the stock market math looks more appealing.

Why the South Korean Stock Market Appears Attractive, Despite North Korea

August 18, 2017 By Adam Strauss Leave a Comment

The South Korean stock market is a great place to find value, and particularly right now when the U.S. stock market is so overvalued. In my view, the investment returns over the next 7-10 years are probably going to be more attractive in South Korea than the United States.

The Korean Stock Market (KOSPI) – A Top-Down Valuation Approach

If you look at the Korean stock market, also known as the KOSPI, the Price/Book ratio is barely above book value, and the P/E ratio is less than 10x. Furthermore, the Korean market is even cheaper than these surface-level valuation measures suggest because many Korean businesses own the shares of other Korean companies which have real value but are not captured by the traditional valuation metrics that are picked up on a Bloomberg screen.

StarCapital provides a free tool to help you understand which countries are cheap and which countries are expensive. Across several valuation measures, including Price/Book, Price/Sales, Price/Earnings, and the Shiller P/E ratio, South Korea comes up as the #1 cheapest country in the world. The table below shows the ranking of the most undervalued 12 countries:

South Korean stock market attractive — **The South Korean Stock Market (KOSPI) – an Attractive Value**

As an aside, you might be wondering what the most expensive country in the world is. If you have already read my posts about overpayment risk and the rise of price-insensitive investors, you would probably guess that it’s the United States.

And, if you did guess the United States, you’d be correct (see table below).

U.S. stock market overvalued — **The U.S. Stock Market (S&P 500 Index) – an Unattractive Value**

It’s important to remember that valuation measures are only useful for making long-term investment decisions. The more undervalued a particular stock market is, the more likely you will be in generating more attractive returns over a seven to ten-year period by investing in that market. Valuation measures are usually not helpful in predicting near-term stock market returns. In 1998, U.S. tech stocks, already grossly overvalued, continued to rally for two years before finally correcting severely. If you are a long-term investor, you are better off paying attention to valuation and trying not to worry about short-term price fluctuations, in my view.

Why is the Korean Stock Market Cheap?

It’s a difficult question to answer definitively. To be honest, I’m not exactly sure why Korean stocks are cheap. I’m also not sure that it matters.

However, I can confidently say that Korean stocks are not cheap because of current headlines related to a potential armed conflict between the United States and North Korea. I say this because South Korean stocks have been cheap for years, and Korean stocks have rallied in 2017. That rally has occurred despite the fact that the risk of armed conflict with North Korea has increased substantially. Go figure.

My speculation is that Korean stocks are cheap for two reasons.

First, it’s difficult to invest in individual Korean stocks as a U.S. investor. There are few ADRs that you can buy in the United States (although I will discuss one ADR below), and you can’t directly own individual Korean stocks without opening up a brokerage account in South Korea.

Second, South Korean companies do not typically return cash to shareholders as aggressively as U.S. companies do. That’s a knock against South Korea and a lot of other countries. On the other hand, Korean companies also don’t abuse stock options and other forms of equity-linked compensation as aggressively as U.S. companies do.

These are certainly drawbacks, but, in my view, Korean stocks pay you well for living with these drawbacks.

What Happens if There’s a War between North Korea and the United States?

I believe a war is highly unlikely. Such a war would involve at least two countries with nuclear weapons. Including Russia and China, four countries with nuclear weapons could become involved. All four countries understand the game theory behind mutually assured destruction (MAD). For that reason, I expect all parties involved to pursue their national interests through diplomacy.

While I believe this is the most likely outcome, I could be wrong in my optimistic assessment.

If I am wrong, that means a major war that will break out in Asia, potentially involving nukes. Along with North Korea, South Korea will be hardest hit. The South Korean stock market will go down in value. To put it incredibly mildly, that wouldn’t be a good development at all.

However, South Korean semiconductors power the world, from computers to smart phones to cars to data centers. A war would disrupt the global semiconductor supply chain. Such a disruption will affect world markets, not just the South Korean stock market. The risk to financial markets is not at all limited to South Korea.

In summary, if a war happens, it will likely be world markets that go down in value, not just South Korea. If a war doesn’t happen, South Korea has more long-term upside than a lot of other countries, in my view. The risk-reward profile looks attractive, despite the threat of an outbreak of war between the United States and North Korea.

Finally, if you are worried about market risk, you should have a diversified investment portfolio with a meaningful allocation to cash and gold. If war breaks out, these investments should perform well, even if world stocks do not perform well.

South Korea Stock Picks

The three Korean stocks that I particularly like are Samsung (005930-Korea), SK Telecom (SKM), and Hyundai Home Shopping (057050-Korea). Full disclosure, I am an investor in all three of these companies as I write this post; I also might choose to buy more, trim, or sell my positions in these companies at some point in the future.

Samsung currently represents about 25% of the KOSPI index, so Samsung’s undervaluation drives the undervaluation of the larger South Korean stock market. Samsung has been an excellent investment over the past year or two, but its shares are still inexpensive, in my view, and especially so compared to the U.S. tech companies that trade on the Nasdaq. The company is trading at 10x next year’s earnings and with a 2017 EV/EBITDA multiple of 3.8x. Its current free cash flow yield is 9%, despite the fact that cash and investments represent about 15% of Samsung’s market cap.

SK Hynix represents another 10% of the Korean stock index, where SK Telecom is a major holder. SK Telecom is like the Verizon of South Korea. The company is trading at P/E 2018E of 9x, a current free cash-flow yield of 12%, and an EV/EBITDA multiple of just 2.3x after adjusting for the company’s investment in SK Hynix. Importantly, SK Telecom offers an ADR with the ticker SKM, so it’s an easier stock to buy if you are a U.S. investor.

Hyundai Home Shopping runs a home shopping network in South Korea, similar to QVC in the United States. For whatever reasons, home shopping is more popular in South Korea than the United States. The company is profitable, growing, and generating healthy levels of free cash flow. Adjusted for the company’s cash and investments, Hyundai Home Shopping is trading at an adjusted EV/EBITDA of just 2.0x. The valuation of Hyundai Home Shopping is remarkable, in my opinion.

What are your favorite South Korean investments?

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.

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?

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?