Making Money When You Buy, Not When You Sell

The old saying that you make money on real estate on the purchase not the sale, applies just as much to stocks. The more expensive a stock gets, or in this case, the S&P 500 Index, the lower the future returns investors should expect. At a recent price/earnings (PE) ratio of 21.5, equity valuations are high and the implied 5-year annualized return is flat.

That’s not to say there won’t be abnormally high returns in the stock market over the next five years. As the chart above indicates, there have been periods during which returns were decent even when equity valuations are high. We also don’t see on this chart the sequence of returns of those 5 subsequent years. In other words, there could be additional upside over the next 12 months with a muted returns thereafter. Or a series of returns that are highly volatile, with high returns in one year, followed by sharp losses the next – resulting in flat returns over the entire 5 year period.

For the buy and hold investor, however, this data is telling. There is a high probability (insert % here) that the returns from your equities over the next 5 years will not be as good as they have been.

Unfortunately, there aren’t many attractive opportunities in fixed income either. So where should you put your money? Much of the high valuation of the S&P is being driven by the Top 10 companies in the index. Start there. That is, start reducing some of the exposure to these stocks. They have paid off handsomely over the last few years, but they also now carry a higher level of risk – particularly as it relates to valuation.

If you don’t know which ones they are, they are your typical household names such as Apple, Microsoft, Amazon, Facebook, Alphabet, and Tesla. They may not be the Top 10 by the time you read this, but chances are if they have generated higher returns than the market over the last 5 years, they fall into the ‘expensive’ category.