Written By: Tom Lee
The underlying index for the C fund within TSP is the S&P 500 Index.
Is the S&P 500 currently over valued?
If so, what does that mean for potential C fund performance, and what does the work of Nobel Laureate Robert Shiller indicate?
How should this inform your TSP strategy?
Try This.
Google “Is the stock market overvalued?”* and you are likely to find a near consensus. Here is what we found recently.
“Stocks are extremely overvalued.”
“The stock market looks bizarrely overvalued.”
“The stock market’s valuation is getting ridiculous.” [In other words, ridiculously overvalued]
“The American stock market currently appears to be overvalued by 68%.”
Perhaps we are framing the question to produce results in line with the case that the stock market is overvalued. Fair enough. Google, “is the stock market undervalued?” You will likely find websites featuring a few individual stocks that are undervalued, but it may be hard to find those who claim that the overall US stock market is undervalued or even fairly valued.
Another word for an overvalued stock market is a “bubble.”
Perhaps the foremost expert on asset bubbles, Robert Shiller of Yale University won the 2013 Nobel Prize in Economics for his study of bubbles. According to the Nobel Prize website, “Robert Shiller discovered that stock prices can be predicted over a longer period, such as over the course of several years.” We feel that one of the most important facts about the stock market is that it does not return 10% per year every year. This might seem obvious, but we, and probably you, have seen projections done that assume a 10% return every year for the stock market. The likelihood of this happening is close to zero. We also feel it is downright dangerous to assume a 10% return for the stock market. More on that later.
Now that we have established the stock market is not going to return 10% per year every year, are there reasonable ways to project returns going forward? Enter Robert Shiller. He might the be first to admit that predicting one year returns for the stock market is impossible. But how about 10 years? As we shall see, the Shiller PE has been uncannily accurate in predicting returns of the stock market over 10-year periods. Professor Shiller created the Cyclically Adjusted Price to Earnings ratio (CAPE) to measure the valuation of the stock market. This ratio is also known as the Shiller PE. The CAPE is essentially the price of the S&P 500 Index divided by earnings averaged over 10-year periods. It is meant to smooth out the volatile nature of stock prices and earnings over shorter periods.
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Let’s examine the Shiller PE ratio.
https://www.multpl.com/shiller-pe
As of this writing, the Shiller PE is at 35.5. Notably, as you can see, the historical average is somewhere around 16 or 17.
Yikes! We are twice the historical average.
Does this mean the stock market is going to crash?
It certainly could crash. One might even posit that the risk of a market crash is elevated. However, we think it would be foolish to time the stock market. For example, during the Coronavirus Crash in March 0f 2020, stocks were down close 40% in one month. By the end of the year, the stock market was positive! More recently, in 2022, the stock market was down close to 20%. By then end of 2023, it had almost completely recovered. Today the stock market is significantly above where it was at the end of 2023. Let’s return to the CAPE ratio. You’ll notice that there were historical relative peaks. In other words, there were times when the Shiller PE rose, peaked, and then fell. These relative peaks occurred in 1902, 1929, 1937, 1965, 2000, and maybe 2021. 2021 might not be considered a relative peak if the Shiller PE soon rises above the 2021 peak. So, what happens after these peaks? Unfortunately, the picture is not pretty.
https://www.multpl.com/s-p-500-historical-prices
You may have noticed that stock prices were close to flat or sharply lower for 10 years or longer after each of the relative peaks. Dividends, which historically are about 2% for the S&P 500, would not have done much to help.
As one might expect, the Shiller PE has undergone systematic analysis. Dr. Michael Finke, professor of wealth management and the Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services,** has provided such an analysis.
Professor Finke notes, “67% of the time the [10 year] return was plus or minus 1.37% from the CAPE model prediction; and 95% of the time the actual return was within 2.74% of the future 10-year predicted returns. CAPE’s ability to predict 10-year future returns during the last 25 years has been remarkable.” For example, if the Shiller PE (CAPE) is predicting that the S&P 500 will return 5% per year over the next 10 years, 95% of the time the actual 10 return falls between 2.26% and 7.74%. Do you remember what the CAPE is at the time of this writing? 35.5. As you can see, it is off the charts! With the CAPE at 34, the predicted 10-year return is between 1.9 and 3.8% return. A CAPE of 35.5 would have even lower predicted returns. Conversely, when the Shiller PE is low, for example at 10, the expected return is over 15% return per year! The problem, of course, is that it is hard to have the courage to invest fully during these times. Businessweek published the now infamous article “The Death of Equities” at the end of “lost decade” of the 1970s.
https://ritholtz.com/1979/08/the-death-of-equities/
The Shiller PE was below 10. The following 20 years was widely regarded as the greatest bull market ever.
So, are we predicting 0% returns for the next 10 years for the stock market?
No, but one can certainly make the case that market risk is particularly high right now.
If you are young, keep investing in the TSP stock funds. There may be some opportunities to buy when the market is down. If you are retired or close to retirement, make sure you are properly diversified or work with your financial advisor to make sure you are properly diversified.
Incidentally, though the current 4%+ return in the G Fund is tempting, we are not recommending over-weighting in the G Fund except for the most conservative clients. Investing in the G Fund for long periods or trying to time the stock market with the G Fund, frequently leads to disappointing returns.
With all this said, we feel it may be a good time to review your investment allocation.
Good luck.
*For the purposes of this article, the stock market is the S&P 500 index.
**The American College of Financial Services is dedicated to furthering the education the financial services profession for the benefit of society.
Written by Thomas Lee CFP®. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
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The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Serving Those Who Serve writers and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **
