With the stock market setting records by the week, how much higher can it go? Many investors are worried that we could be in for a sharp correction. If that’s the case, what should you do?
Well, in terms of how much higher could it go, we can look at history to see how high market valuations have been in past cycles. Today’s bull market is the second longest in history. What was the longest one? The bull market that ended in the year 2000.
Photograph by Ellen Jaskol
In terms of “expensive,” at the end of the longest bull market in 2000, the stock market was about 25 percent more expensive than it is today. (Based on S&P 500 price-to-earnings ratios.) Moreover, the 2000 bull market lasted 13 years and the current bull market is in year 8. So yes, stock market valuations could go higher and have gone higher in the past. And there are plenty of reasons why it could continue to run. The main reason is low interest rates.
When it comes to investing for retirement, there are basically two asset classes that compete for your money: stocks and bonds. The relationship between these two can impact market valuations and returns.
If interest rates on safe bonds, like U.S. Treasury bonds, were 10 percent, you might not put much money in stocks. Why take the risk of loss in stocks if you could get a safe 10 percent? But today, with interest rates at about 2.3 percent, you will likely need stocks to both grow your wealth and live off of it. As long as bond yields remain low, there will be further demand for stocks. That demand continues to push up prices.
While you want to pay attention to stock market valuations and understand what to expect, with your retirement planning, the real question is how much should you invest in stocks vs. bonds? The challenge is stocks are expensive and bonds provide little return, but you have to do something, so how should you deal with the current situation?
The first thing to recognize is that your retirement obligations are usually long-term obligations. Thus, you have to think about which asset class is likely to help you reach your financial goals over the long term.
To give you a sense of what’s at stake, if your bonds yield 2.3 percent, it will take you 32 years to double your money. Stocks traditionally have provided a long-term return of about 10 percent. At that rate, it takes about seven years to double your money. But, with stocks being expensive, it’s probably not wise to assume they’ll return 10 percent going forward. If they return 7 percent, then it takes 10 years to double your money. If they return just 5 percent, it will take 14 years. Each of these is a better alternative than the 32 years with bonds.
That doesn’t mean you abandon bonds. Most investors need some defense and more stable assets to handle unforeseen expenses, particularly if you are retired and living off your money. But bonds carry their own risks in the form of a fixed, low return.
The bottom line is you shouldn’t let the short-term risks and valuations in stocks distract you from what you need to do to reach your long term goals. Yes, stock markets decline and sometimes crash, that’s the risk you have to take to reach for returns above 2.3 percent today. And for most of us, we need returns above 2.3 percent, so we have to invest in stocks to some degree. Plus, this will not be the last expensive stock market you face in your long career as an investor. You have to get used to the risks.
Because most investors have to be in stocks, there are some things you can do to help manage the risks. First, consider whether you are adequately diversified. If you diversify into something like an S&P 500 index fund, this helps ensure that you are not concentrated in stocks that are riskier than the market in general.
If you want to go further and try to reduce more risk, you can consider increasing your allocation to a diversified portfolio of quality dividend paying stocks. Historically, these companies have held up better in bear markets. Plus, as long as the dividends are coming in, you are making money on your stocks, even if prices fall.
There are no easy answers these days to the challenges of an expensive stock market and low bond yields: we’ll all face the likelihood of lower returns in both stocks and bonds going forward, but the question still is which one will help you meet your long-term retirement funding goals. Those costs certainly are not going down.
Charlie Farrell is chief executive of Northstar Investment Advisors LLC. He is the author of “Your Money Ratios: 8 Simple Tools for Financial Security.” This column is for information and education purposes only.
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