mattee2264

Agree that equity allocations are influenced by the level of the stock market. Humans extrapolate the recent past so believe the market will continue to go up or go down and act accordingly. So rebalancing doesn't happen to the extent it should and equity allocations are therefore cyclical. Even before indexing blue chips and growth stocks were over owned during bull markets. So I don't think that distortion is anything particularly new. And the concentration risk is much lower with a broader index than it was for narrower de facto indices such as the Nifty Fifty or the narrower sector concentrations such as the tech and communications stocks during the dot com bubble. And active fund managers because of career risk tend to diversify widely and approximate indices and favour respectable and glamour stocks (which tend to be overrepresented in indices as well) so the market landscape hasn't changed that dramatically. The S&P 500 market cap weighted has a P/E of around 25 and the S&P 500 equal weighted has a P/E of around 22. Converting to earnings yields that is 4% versus 4.5%. So not much of a difference and you can make a case that the tech giants over-weighted in a market cap weighted index have excess cash, better growth prospects, more investments going through the P+L etc. There is after all an advantage to being big in a globalized economy and for tech stocks where winners tend to take all. It is difficult to comment on small caps as P/E ratios are distorted by the prevalence of loss making companies but the WSJ pegs forward P/E ratios (based on operating earnings) at 20 in line with the S&P 500. So the picture I am seeing is more one of stocks generally being historically expensive as you'd expect in a low interest rate environment. So I don't think that it is easy to outperform the index simply by stock picking unless you have superior skill which by definition the average investor doesn't have. And I don't think it is obvious to lighten up on stocks and move to cash in anticipation of cheaper markets in the future. This only makes sense if you believe you will have the opportunity to get back in at a substantially lower market level. And all the while you are fighting the upward bias to stock market prices from earnings growth and inflation which will partially offset the benefits of any eventual P/E contraction meaning time is not on your side. It seems a good bet that interest rates will go up but how fast and how much is anyone's guess and the earnings yield on the S&P 500 still offers a cushion especially when you consider that S&P 500 earnings grow over time whereas the bond coupon is fixed.

Thanks for the thoughtful response Cigarbutt. In response to your questions: Questions: -When something is true most of the times, is there a risk that you end up thinking that it is true all the time? I'd definitely agree. Just because something has always happened in the past doesn't mean it will happen in the future. Obviously value investors are on safer ground using the broad sweep of past experience rather than extrapolating current conditions as the "new normal". But things do change and the past is not necessarily prologue. -Do you imply that we have reached some kind of plateau in terms of margins, multiples and interest rates? I think plateau is the wrong word to use as the economy and markets never reach a steady state. But arguments that markets are overvalued do seem to rely a lot on the notion that margins, multiples and interest rates will revert towards historical means. Bruce Greenwald has a pretty interesting viewpoints on margins: https://www.valuewalk.com/2016/11/columbias-bruce-greenwald-corporate-profits-sustainable/ Also you have companies like Amazon and other tech companies holding off on monetizing their market dominance as they try to become even more dominant and a lot of investments are going through operating expenses which depresses margins. Regarding interest rates technology and globalization have deflationary effects so could keep inflation below historical norms justifying interest rates not much above current levels. Commodity prices may also be kept low by efficiency improvements, shale technology, a more service oriented economy etc. Also if we are in a slower growth world that will also keep interest rates low. Lower more stable growth deserves to be valued a lot more highly than higher but more cyclical growth as it makes stocks more bond-like. Buffett made the comparison between a no-growth company selling for 40 x earnings (IE US treasuries!) and the current stock market valuation. As Greenwald points out in his article services are less cyclical than manufacturing. And the equity risk premium which depresses market multiples is influenced by psychology so as long as investors are comfortable with higher multiples and willing to accept lower returns (but still favourable with bonds) they can stay high. Also with the dominance of index investing there are perhaps far fewer valuation sensitive investors out there! And technology companies make up about a quarter of the market and sell for high P/E multiples because of things like operating expenses including investments in growth and these companies generally pursuing revenue growth over earnings growth sacrificing current profitability. Of course there are counter arguments you can make. And margins, interest rates and valuations are difficult to predict for this reason. But for the same reason it is difficult to say with any real certainty whether or not the market is overvalued or not. Or that even if it is overvalued that it will crash as opposed to treading water until earnings catch up. So saying no to the S&P 500 just seems a bit risky to me.

Dollar cost averaging is going to be suboptimal simply because over most 5-10 year periods the direction of the general market is upwards so your average cost is likely to be higher than lower than a lump sum investment. Plus you are missing out on dividends. The models that show the market to be overvalued tend to be based upon the idea we have to revert to mean profit margins and interest rates and valuation multiples. But even then they do not imply negative returns or that the market is going to crash or that cash is a better option. They just simply say it is a low return environment going forward and a valuation headwind means that returns on stocks might lag the returns on underlying businesses. But if the models are wrong and there have been structural changes in the economy that mean higher profit margins and valuation multiples and lower interest rates can be maintained then markets are probably fairly valued and prospective returns are healthy enough that if you sit it out in cash you may never get the chance to re-enter at a lower market level and by dollar cost averaging you would end up paying a much higher average cost than the current market level. And if the economy really takes off and people become very optimistic then we could easily see the market go up another 50% over the next 3-5 years which will be psychologically very difficult if you have a high cash allocation. And when markets are valued based on the prevailing psychology and difficult to predict economic fundamentals there isn't really a scientific basis for trying to time the market especially considering the risks of missing the market altogether if you are wrong