As of this writing, we believe the S&P 500 is roughly 10% below fair value. This surely doesn’t qualify the market as vastly undervalued, especially in light of the significant risks that are out there, but it does provide some cushion.
For us, our analysis always comes back to valuations. There is never a shortage of things to worry about (see our “media” article on the back), but understanding the extent to which those risks are already being reflected in market prices is the key to making good investment decisions.
A very simplistic analysis of return expectations goes something like this: assuming that valuations return to “fair,” that we collect about 2% per year in dividends, and that earnings grow at 3% on average (a conservative number, which is about half their long-term average growth rate), we’d be looking at returns of roughly 7% for the S&P. These valuations also tell us that some level of pessimism is already priced into stocks, so the market is discounting a less-than-rosy outcome. And even if returns end up being only modest, we’d expect our investments to be able to add a bit of extra return above what the market provides.
What’s an investor to do in such an environment? As our natural bias is to err on the side of conservatism rather than exuberance, we are, for the time being, content to hold slightly below-average positions in high-quality bonds and neutral weightings in stocks. This is not exactly an exciting strategy but we are not inclined to take on more portfolio risk until the Fed’s monetary tightening cycle (raising interest rates) is closer to a peak.
Our obligation to you, as always, is to understand the risks associated with your portfolio, and select the investments that best reflect your tolerance for risk and the realities of your financial situation. Further, due to the ever-changing nature of world economic conditions and political events, we continue to do this on an ongoing basis.