When is this stock market going to crash? Can you believe the stock market is so out of touch with the economy these days? These are just a couple of the questions I’ve been getting on an almost daily basis. It seems the rising stock market has its share of skeptics. Perhaps it is just part of the “whatever goes up must come down” thinking, or else they are looking for confirmation from me that it would be OK to sell and get out of the stock market.
The stock market has indeed registered some impressive gains since the March 2009 low. The compounded annualized return is better than 20%, and rivals the returns of the late 1990s. The stock market rally ended back then with the tech wreck of 2000 to 2002. One big difference between then and now is stock valuations. Stocks in the late 1990s were trading at a much higher price to earnings ratio then they are today. This prompts some analysts to predict stock prices have a lot of upside potential before becoming overvalued.
Another significant difference between 1999 and today is interest rates. The yield on the 10-year treasury was over 6% at the end of the 1990s. The current yield is less than 2%. To understand the relationship to stock prices, answer this question: How much of your portfolio would you put into a riskier investment, like stocks, if you could get 6% in a low risk treasury note? Would the allocation change if your low risk investment options were yielding less than 2%? Most investors would allocate more to stocks in a low interest rate environment because it wouldn’t take much of a return on their stock portfolio to beat a 2% treasury yield.
Just because stock prices appear to be undervalued doesn’t mean the market won’t go down. No one can accurately predict short term fluctuations in the market. In our opinion the best defense against market volatility is to establish an allocation between stocks and bonds, and rebalance as the market rises and falls.