You may or may not hear pundits discussing valuation levels of the stock market or other assets. The conversation ebbs and flows but isn’t ever too far from the center stage. Valuation is not the same as price. Price is what you pay for something while valuation puts the price into a context to allow for comparison to other comparable assets. For example, you may pay $150 for Apple, which you might consider to be expensive or inexpensive, but Apple’s Price-to-Earnings ratio (its valuation) may be 50.0x, relative to a peer average of say 25.0x. Such a scenario would imply Apple as being twice as expensive, on a Price-to-Earnings basis, relative to its peers, all else equal. Many would consider Apple to be expensive under these circumstances.
The stock market today continues to approach an all-time high Cyclically Adjust Price-to-Earnings ratio. This fact doesn’t mean much in and of itself. Sure, investors are basically bullish on stocks but a high valuation doesn’t imply stocks are set to go down any time soon. They could continue to rise for all we know.
What high valuations in the form of the CAPE ratio tell us is that future returns are likely to be quite a bit lower than they have been in recent years. The other thing high valuations tell us is that when the stock market cracks, it could go down a lot. This is one very important reason why you should have a diversified portfolio across multiple asset classes, including defensive assets. We’ve been preconditioned to expect quick snapbacks in stock prices after large drops. That hasn’t always been the case historically and shouldn’t be assumed to be the base case. I conclude with the words of Ray Dalio, “Diversifying well is the most important thing you need to do in order to invest well.”
Source: Robert Shiller, GIM