Navigating the stock market in the coming years may prove challenging, primarily because markets need to adapt to higher interest rates. Whilst there are significant risks to avoid, I also believe there are promising opportunities worth considering.
Do these 3 things to successfully invest in stock markets
To maximise your investment returns in the stock market, follow these three essential steps.
Firstly, identify which markets exhibit strong potential for delivering above-average returns in the next 5 to 10 years based on their fundamentals. That is, which markets are relatively cheap by historic standards.
Secondly, only use investment products and methodologies that are low-cost and use evidence-based investment methodologies, such as index funds.
Finally, exercise patience and discipline by holding these investments for many decades to allow mean-reversion to deliver strong returns.
It’s important to note that this approach doesn’t require you to predict future trends, select individual stocks, or engage in frequent buying and selling, as these strategies have proven to be ineffective and costly. Instead, you can enhance your portfolio’s performance and reduce investment risk by focusing on where and how you invest.
Recap of past investment performance
The irrefutable law of mean reversion dictates that markets which have shown above-average returns in the past decade are likely to yield below-average returns in the next decade, as returns tend to return to their long-term averages. Therefore, when considering where to allocate capital into share markets, it is often prudent to invest less in markets and asset classes that have outperformed over the past decade.
The chart below illustrates investment performance until the end of September. You will note that bonds, real estate, emerging markets, UK market and to a lesser extent, the Australian market have all provided returns below the long-term average over the past decade. In contrast, the US market and the global index have outperformed during this period.
Disconnect between bond and share markets
In comparison to historical levels, stock market valuations in the US remain notably high. The US Cape Ratio, a valuation metric that smooths out fluctuations in company earnings, currently stands at nearly 30 times, significantly exceeding the long-term average of 17 times. This suggests that the US stock market hasn’t factored in the possibility of a US recession, presumably because it anticipates rate cuts by the central bank in the coming months.
Conversely, the bond market holds a different perspective. The US yield curve, represented by the blue line in the chart below, is relatively flat, indicating that the bond market foresees interest rates remaining elevated for a couple of years. This scenario could materialise if inflation proves more persistent than expected – a risk I’ve previously discussed here. If this prediction becomes a reality, there’s a strong likelihood that the US will slip into a recession and stock market valuations will need to correct.
Interestingly, the Australian yield curve doesn’t indicate any anticipated interest rate cuts over the next 5 years.
To sum it up, US stock market valuations assume that inflation will quickly return to normal, allowing the central bank to cut rates, averting a recession. In contrast, the bond market takes the opposite stance, anticipating persistent inflation, stable interest rates over an extended period, and the possibility of a US recession.
Not all stocks are overvalued
Currently, the combined value of the top 7 US companies makes up more than a quarter of the total value of the S&P 500 index. These 7 companies, predominantly in the technology sector, are trading at very high PE ratios, suggesting they may be overvalued. They’ve also seen substantial share price growth this year. In fact, if we were to exclude these top 7 companies, the index’s performance would have been flat.
This situation presents a significant concentration risk for the S&P 500 index, as it’s heavily weighted toward technology stocks, which tend to have high PE ratios. These stocks carry a risk because they must surpass the market’s already high growth and earnings expectations to provide investors with a return.
However, it’s important to note that not all US stocks are overvalued. For example, mid-cap and small-cap stocks, are relatively cheap compared to historical measures. Consequently, opting for an equal-weight rather than a traditional market-cap-weighted index one can help address the concentration risk while capitalising on valuation opportunities.
Projected future returns
The table provided below presents future expected returns as projected by Research Affiliates’ proprietary Asset Allocation model. This model employs peer-reviewed methodologies that offer the most reliable means of predicting future returns. Future stock market returns are influenced by three key factors: dividend yields, earnings growth, and valuation multiples.
Navigating the risk and capturing above average returns
As per Research Affiliates’ model, Japan, Australia, and emerging markets stand out as the most appealing geographical markets. However, this doesn’t imply that you should disregard other geographic markets. Quite the opposite, it’s vital to maintain a broad exposure across all markets. The significance of this data lies in the consideration of alternative methodologies beyond traditional market-cap indexing to mitigate potential underperformance. These alternative approaches could include:
- Value Approach: This involves filtering out overvalued companies.
- Quality Factor Approach: Focusing on investing in companies with high-quality attributes, such as low debt and strong cash flow.
- Equal-Weight Indexes: Providing increased exposure to mid and small-cap stocks while reducing exposure to large-cap stocks.
- Fundamental Index: Minimising unnecessary turnover due to fluctuations in stock prices. This is particularly attractive for markets that have higher industry concentrations.
Constructing a portfolio that utilises various rules-driven, evidence-based, and cost-effective indexing approaches tailored to different geographic markets can significantly decrease investment risk whilst simultaneously positioning your investment portfolio for potentially higher-than-average returns.