Problem With High Stock Valuations

In theory, the price of a stock should reflect its value. After all, stocks represent ownership in a company and investors are paid for the privilege of holding those shares. But as with purchasing other goods and services, there are several factors that can impact the prices people pay for stocks. The most obvious factor is supply and demand: the more people want to buy a stock, the higher its price. This is especially true if the demand is driven by speculation or by investors using a particular stock to hedge other positions.

Another factor is earnings growth, which can drive up High Valuations if it is sufficiently strong. The last decade has been a period of unusually strong earnings growth. As such, stocks have come to market at historically high levels by one measure, the Shiller CAPE 10.

Finally, investors may simply overestimate future returns, which can lead them to invest at rich valuations. This is often the case during bubbles, when stocks can get inflated by a combination of speculative buying and excess venture capital funds fueling startup companies that never produce any actual revenue or profits. This is what happened during the tech bubble in the early 2000s, and it also helped create the housing bubble that preceded the Great Recession.

The Problem With High Stock Valuations

While all of these factors can affect the prices of individual stocks, the overall market is likely to be most affected by investor confidence and sentiment. If the public gets sour on an industry, for example, all the stocks in that sector will suffer, regardless of their individual performance. Conversely, if investors are bullish on stocks, they will increase demand and push up prices.

This means that investors who are nave about current valuations risk projecting overly optimistic return scenarios for their portfolios, which could cause them to under-save for retirement (which will be made even more difficult by rising long-term care costs and governmental funding challenges for Social Security and Medicare). For this reason, many advisors are working hard to address the challenge of high US stock valuations by increasing allocations to international stocks and alternative investments.

The key to success in navigating high valuations is patience and discipline. The data on stretched valuations delivering lower returns over time is robust, and it typically takes years for the full effect to play out. However, investors must be prepared for a market correction, and the longer they have invested in the stock market, the more likely they are to see a steep downturn in their portfolios. If they remain patient, and they continue to focus on their investment goals, their portfolios will be well positioned for the long-term.