Are stock prices too high? This is the question on the minds of a lot of investors I talk to today. Looking at the last ten years of returns for the Vanguard S&P 500 Fund, you can see why this question is so common. The S&P 500 is up +16.2% per year through August, well above its long-term average of +10.3% since 1927. What's going on?
The short answer is: Growth stocks are doing great, and these high-priced companies make up a majority of the S&P 500 or Vanguard US Total Market Index. Companies like Apple, Microsoft, Amazon, Google, and Netflix have earned above-average profits in recent years, and their prices have soared as a result.
But this isn't the experience for all stocks. Take the DFA US Small Cap Value Fund (DFSVX), which buys the smallest 10% of stocks in the market with the lowest 30% of prices. Its returns haven't been nearly as high as the S&P 500--just +12.0% annually over the last ten years. Of course, this return isn't bad, but it's lower than the long-term average for these stocks. From June 1927 through June 2021, the Dimensional US Small Value Index earned +13.4% per year. It's hard to believe we could call a 12% annual return "below average," but it is.
Things are even worse outside the US; the DFA International Value Fund (DFIVX) has gained just 5.5% per year over the last decade. The DFA International Small Value Fund (DISVX) is only +8.0%. I don't need to tell you these results are way below the long-term historical returns on large and small international value stocks.
These returns have had a profound impact on the relative "valuations" of different stock asset classes, what is "cheap" and what is "expensive." As prices on the largest US growth stocks have gone up, they have become increasingly expensive. Other stock asset classes, specifically the lowest-priced value stocks (and international stocks), have had much more modest returns. Therefore, their values are pretty reasonable today and, even in some cases, below average.
One way to look at this is to compare the valuations of the highest-priced growth stocks and the lowest-priced value stocks worldwide. In a recent blog article, AQR's Cliff Asness did just that.
Look at the chart below. When the lines (that compare the ratio of value stock to growth stock valuations) are trending near the bottom, value stock prices are high compared to growth., When the lines are at the top, value stocks are "cheap." What do you notice about today? The chart reveals that value stocks are almost as cheap as they've ever been compared to growth stocks--in the 93rd, 94th, and 99th percentiles!
Are stocks prices too high? Some are. The growth stocks that have had tremendous recent returns are extremely rich. Value stocks, on the other hand, represent the values today that they were named for.
What has happened in prior periods when value stocks became extremely cheap compared to growth? Let's look at the two previous peaks in 1999 and 2008.
From 2000 to 2004, the S&P 500, then dominated by 1990s era tech stocks, lost -2.4% per year. The DFA US Large and Small Value Funds gained +9.1% and +19.4% per year. The DFA International Large and Small Value Funds had similar results: +8.4% and +17.0% per year returns.
From 2009 to 2013, the S&P 500 did much better, gaining +17.8% per year, but the DFA US Large and Small Value Funds did much better still, returning +21.0% and +22.9% annually. The DFA International Large and Small Value Funds had strong returns too--+13.0% and +17.1% per year--but not as high as the S&P 500 or US value stocks.
As you can see, high valuations for growth stocks don't always predict low or negative future stock returns; the S&P 500 did well from 2009-2013. But when the spread between value and growth is exceedingly wide, it has represented one of the best times to be a value investor. Value "premiums" (the gain on value stocks above the return on growth stocks) tended to be even higher than the long-term average. This is where we are today.
Practically speaking, the question of "are stocks too high to invest in today?" or "should I wait for a better time to invest?" can be answered with a resounding NO. Assuming you are broadly diversified and hold value and international stocks in your portfolio. Value and foreign stock returns have been disappointing in recent years as US large growth stocks have soared. Still, future returns over the next five to ten years may be much better in these currently unloved asset classes.
If you're not diversified today, you need to get diversified. Suppose you have held these asset classes in your portfolio for some time but have lost interest in them as their performance has underwhelmed. In that case, you need to shed your short-term-itis and rebalance back to your target weights.
If you're not sure how much you should be investing in value and international stocks? Unclear what the best funds and ETFs are to target the value and small-cap premiums? If so, don't hesitate to reach out to me for a 2nd opinion.
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Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.