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by
Adam Strauss

You may not know what your investment exposure is to U.S. stocks. If that’s the case, you probably should figure out what your exposure is sooner rather than later.

Stocks are always risky, of course, but the long-term risk/reward profile of owning U.S. stocks is sometimes particularly attractive, and at other times it is sometimes particularly unattractive.

Today I judge the risk/reward profile to be particularly unattractive.

I’m not suggesting that you should go out and sell all of your U.S. stocks.  I am suggesting that you should know what you own and be comfortable with whatever exposure you have.  And, relative to the investment exposure range that represents your comfort zone, you probably want to be nearer to the low end of that range.

At the moment, three important factors are adding to your risk of owning U.S. stocks at the present moment.

  1. The Federal Reserve is raising interest rates, which is slowing down credit expansion and, relatedly, the economy.
  2. The economy is in the ninth year of a bull market.
  3. The stock market is trading today at nosebleed prices.

I am calling this third factor, “overpayment risk.”

Overpayment risk is the risk of paying too much for an overvalued investment. When you pay too much for an investment, your long-term investment return will probably be poor. Depending on the situation, you might even generate a long-term investment loss.

During the past twenty years, many investors have learned much about overpayment risk. Investors lost a big chunk of their savings when the dot-com bubble burst and again when the housing bubble burst. Unfortunately, overpaying for investments has had devastating financial consequences for many families’ financial plans.

If you own excessively priced U.S. stocks or broad U.S. index funds today, you should be aware of your overpayment risk.

Whether or not you define the current U.S. stock market as a “bubble,” stocks are significantly overvalued. That doesn’t mean that a stock market crash is imminent. It does mean that your long-term returns from owning a diversified portfolio of U.S. stocks are likely to be poor.

The Devastating Consequence of Excessive Overpayment Risk

The housing bubble was an example of overpayment risk.

During the housing bubble, home prices surged, even while salaries and rent levels remained flat.  House prices were not growing due to economic prosperity or even due to wage inflation; they were rising due to investment speculation, fuelled by cheap debt and the willingness of regulators and policy makers to look away.  By 2009, after the subsequent bust, the home price/median income ratio and the home price/median rent ratio came back down to earth.

In retrospect, the housing bubble was a perfect example of overpayment risk.  Many families who bought an overpriced home in 2005 generated negative returns for years. If you overpaid for your home and also used a lot of debt, you might have even lost your home. For many families, buying a home destroyed their long-term financial plans. In Chicago, where I live, more than 20% of homeowners are still trapped in underwater mortgages.

Of course, years before investors who were giddily overpaying for houses, investors were giddily overpaying for tech stocks.

In 2000, the U.S. stock market in general, and large cap growth stocks in particular, had become an investment bubble. Stock prices back then reflected ludicrous optimism about future growth and profitability.

Cisco Systems was the most valuable company in the world for a short period during 2000. At its peak, Cisco traded at a nosebleed 125x Price/Earnings multiple. Investors described companies like Cisco as “one-decision stocks” that would just keep going up in price. The optimism surrounding Cisco’s share price was unjustifiable and unwarranted.

Cisco Systems was an example of overpayment risk in 2000.

The Cisco optimists were partially correct. Cisco was a great company, and its prospects in 2000 were indeed promising. Since then, Cisco has generated a five-fold increase in earnings per share.  Unfortunately, Cisco shares are trading today at just 50% of its 2000 price.  The problem with investing in Cisco in 2000 was the excessive overpayment risk.  If you bought Cisco shares, the only way you could do well as an investor was to convince another investor to overpay by even more than you overpaid.  That’s what happens during investment bubbles.

Once tech spending began to decelerate, and investors began to sell, Cisco’s share price plummeted. Overpayment risk affected other stocks, too. In fact, the S&P 500 Index and the Nasdaq Composite generated a negative investment return during the subsequent decade.

I bring up the housing bubble and the implosion of Cisco’s shares as illustrative historical examples of overpayment risk.  To be a successful long-term investor, you have to pay attention to value (Rule #2). The price you pay for an investment will likely be the primary determinant of your long-term return.

Current Overpayment Risk in U.S. Stocks

If you think passive investing in broad index funds without regard to overpayment risk is a good idea right now, I urge you to reconsider. Many asset classes are significantly overvalued right now, not the least of which is U.S. stocks. The Price/Earnings ratios of many U.S. companies are impossible to justify. Like Cisco shares after 2000, the share prices of many U.S. companies are ludicrously overvalued.

Also, as I mentioned above, we are now in the ninth year of a bull market in stocks. After nine years, many investors have forgotten to pay attention to value. This forgetfulness about risk often happens during extended bull markets. In many respects, the market today feels very much like the extended bull market of the late 1990s.

Let’s look for a moment at the elevated level of the Shiller P/E ratio (see chart below) today. Robert Shiller, an economist at Yale, developed the Shiller P/E ratio. Also known as the Cyclically Adjusted P/E (CAPE) ratio, the Shiller P/E ratio is a useful valuation measure for stock markets.

Overpayment Risk: The Shiller P/E Ratio

The Shiller P/E ratio is calculated by dividing the price of a stock market index by the average earnings over the past ten years. The ten-year earnings average normalizes corporate profit levels which tend to fluctuate over the course of an economic cycle.

Today, as I write this post, the current Shiller P/E ratio is at 30.1x, compared to a historical median of just 16.1x.  The stock market would have to decline by 46.5% to reach the median historical Shiller P/E ratio of 16.1. Again, I’m not predicting an imminent crash of 46.5%, but the elevated Shiller P/E ratio should make you cautious about the expected return and the expected risk of owning U.S. stocks.

Importantly, the 1998-2000 period is the only time in the past one hundred years where the Shiller P/E ratio was higher than it is now. U.S. stocks are trading at a Shiller P/E ratio that is greater even than  1929, which is the year the stock market peaked just before a 90% decline in U.S. stocks at the onset of the Great Depression.

Overpayment Risk Today Affects Small-Cap and Large-Cap Stocks Alike

The U.S. stock market is overvalued across small, mid, and large cap stocks.

I came across the remarkable chart above a few days ago after Meb Faber posted it on Twitter.  It examines the P/E ratio of U.S. stocks broken into size deciles.  The largest decile of U.S. stocks is on the X-axis is at 1, and the smallest decile is on the X-axis at 10. It takes a moment to study and figure out the chart, but it’s well worth your time.

I glean the following insights from it:

#1: In 1999, large cap stocks, like Cisco, were significantly overvalued, but the overpayment risk at the time was limited to large cap growth stocks. In stark contrast, small cap stocks were inexpensive and undervalued. As a result, investors that bought small cap stocks generated excellent returns during the following decade.

#2: Today, U.S. stocks are overvalued across all sizes of companies, from the 1st to the 10th decile. Large-cap, mid-cap, and small-cap stocks are all expensive relative to history. In other words, the overpayment risk is high today, regardless of company size. Whether you are looking at large-cap or small-cap U.S. stocks, your returns are likely to be low over the next ten years because U.S. stocks are simply too expensive relative to their earnings.

An Important Caveat on Overpayment Risk

Elevated overpayment risk is not a useful prediction indicator of an imminent market crash.  Overvalued stocks can remain overvalued for years if not decades. However, various valuation measures, such as the Shiller P/E ratio, are useful indicators for forecasting subsequent 10-year stock market returns.

In other words, a high level of overpayment risk does not mean that the stock market is about to crash, but it does mean that U.S. stocks will likely generate paltry investment returns during the next ten years.

Side-Stepping Overpayment Risk

A good way to side-step overpayment risk is to move your capital into a more attractive asset class. In 2000, this meant going to cash or, even better, investing in small-cap stocks rather than large-cap stocks. In 2005, it meant renting instead of buying a home.

Today, side-stepping overpayment risk is a much more challenging task. Without a doubt, it means allocating more of your investment portfolio away from U.S. stocks and into other investments. It also means investing in asset classes where overpayment risk is far lower.

What are you doing to side-step overpayment risk today?