Boy do I hate it when faux “market experts” try to instill doubt and fear into the psyche of inexperienced investors. To novice investors, these scare tactics can prompt them to make wholesale changes in their portfolio and abandon their long-term investment plans. On many occasions, clients will call me and tell me that some random “pundit” offered a dire forecast for an impending stock market crash. As seasoned long-term investors have learned, timing the stock market is generally a fool’s errand with questionable value. Despite the frequency of bull and bear market cycles, a well-diversified portfolio of equities (i.e. the S&P 500) has achieved annual returns of around 10% over the longer term (1928 to November 2024). These returns have enabled a large cohort of working-class Americans to graduate from the “middle class” into the category of “upper class.”
But as we enter the third year of an unusually steady and robust bull market in the U.S., driven mainly by a small cohort of large capitalization technology stocks, I am growing increasingly concerned about overvaluation in certain sectors of the market. I do not believe that a bear market is necessarily just around the corner. Rather, I am looking askance at the steadiness and narrowness of this bull market. Several conventional measures of valuation of the stock market may be signaling that the stock market overall is approaching unsustainable levels. When equity prices reach valuations at the high end of historical norms, I become more focused on where to find shelter from the danger of a potential “reversion to the mean.” In other words, if the ebullient market begins to gravitate to more modest valuation levels, I want to own stocks that can better withstand the fallout of such a correction.
Misery Loves Company
To be sure, I am not the only investment manager that is raising yellow flags. One of the most prolific investors of all time has seemingly turned rather cautious. Warren Buffett has a history of coining aphorisms that highlight his belief that investors should never try to time the market or “bet against America.” In his annual letter to shareholders in 2021 Buffett wrote the following:
“In its brief 232 years of existence, however, there has been no incubator for unleashing human potential like America. Despite some severe interruptions, our country’s economic progress has been breathtaking. Beyond that, we retain our constitutional aspiration of becoming “a more perfect union.” Progress on that front has been slow, uneven and often discouraging. We have, however, moved forward and will continue to do so. Our unwavering conclusion: Never bet against America.”
But these words were penned just as the US was recovering from the Covid-19 pandemic. Moreover, valuations at that time by most measures were still relatively attractive. More recently, Buffett has been an active seller of equities and has been building up a cash pile that exceeds the market value of all US companies other than a few dozen. To further illustrate my point, Berkshire Hathaway could buy all the shares of large U.S. companies including General Motors, Fedex, Boeing and Target at current market prices and still have some cash left over. But, in fact, Berkshire Hathaway has net sold about $127 billion in stocks from its investment portfolio in the first 3 quarters of 2024, leaving the company with about $325 billion in cash.
Is Buffett Betting Against America?
If legendary investor Warren Buffett believes that it is never wise to bet against America, then why is he raising so much cash?
I believe that the answer to that question has much to do with the seemingly endless rise in stock valuations versus mean historical metrics. These heightened valuations are demonstrated in financial metrics such as:
Dividend Yield: A recent article in Barron’s Magazine noted that the S&P 500 index dividend yield of 1.18% (as of November 12, 2024) is now the lowest in 20 years. This is partly due to the heavy weighting of technology stocks (which generally favor reinvesting in the business rather than paying dividends), which make up an historically large share of the index.
The CAPE ratio: Another measure of stock under/overvaluation is Yale Professor Robert Schiller’s CAPE ratio (Cyclically Adjusted Price-to-Earnings ratio). Similar to the more popular Price-to-earnings ratio, the CAPE ratio measures the relative valuation of earnings over a 10-year period rather than just the current year. On that basis the CAPE ratio was 37.97x as of February 2025, the highest level in 25 years, which coincidentally preceded the dot-com bust in the early 2000’s. (The CAPE ratio has a mean of about 17X over the past 150+ years).
Equity Risk Premium: This is a measure of how an investor is compensated for taking on risk (i.e. investing in stocks) versus investing in a risk-free asset (e.g. 10 year US Treasury Note). In the past few years, as equity prices have hit record highs while interest rates on Treasury securities have been rising, the equity risk premium (based on the average earnings yield of the S&P 500 and the yield on 10 year Treasurys) has steadily declined to nearly zero. This feature was summed up in a recent Wall Street Journal op-ed by Andy Kessler:
“The S&P 500 risk premium, which is the earnings yield of stocks minus the 10-year Treasury yield, is basically negative. In effect, investors are paying for the risk of owning stocks instead of bonds. Weird. The last time this happened was in 2002.”
What About American Exceptionalism?
Let me be clear and reiterate my confidence in the wisdom of long-term investment in the US stock market. There is no question that the United States economy is doing quite well and especially relative to the rest of the world. Even on an absolute basis, the incredible advances in home grown technology and innovation have been a vote of confidence for investors in the domestic stock market. But we believe that the exuberance of stock investors, manifested by the historically high valuation of stocks of late, could be a warning sign of lower future returns.
Time to Ring the Register?
Does it make sense to sell all one’s stocks and sit on the sidelines. I am not willing to make that bet. However, I am motivated to strategically broaden my exposure across many other under-loved sectors of the stock market with the aim of maintaining the upside while hopefully limiting the downside. Our next article will focus on those segments of the stock market that I believe have significantly less risk than the S&P 500 as well as greater upside potential.
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The S&P 500 index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The index is unmanaged and cannot be directly invested in. Past performance is no indication of future results.