Stock valuations have climbed to levels seen only once before, in 1999, right before a bear market that lasted 546 days. There have been 10 bear markets since 1970, and history suggests investors are due for another within the next two years.
Market valuations are flashing a warning rarely seen before. These are caution flags that should remind investors to be prepared.
Valuations near a historic extreme
The Shiller price-to-earnings ratio, which adjusts market valuations for a decade of inflation-adjusted earnings, currently sits at 42. The only time it has been higher was in November 1999, when it peaked at 44 — a level that preceded a bear market lasting some 546 days. The S&P 500 itself just hit an all-time high on Aug. 7, closing at 7,757, and has hovered near that level since.
No two markets are identical, and today's setup differs from 1999's. Still, the gauge is a caution flag investors shouldn't ignore.
A market overdue by the numbers
Since 1970, there have been 10 bear markets, or one on average every six years. The most recent one hit in 2022, when the market fell about 25% from January through mid-October. That pattern implies another downturn could be due within two years, though the market has gone stretches as long as 13 years without one, from 1987 to 2000.
Past downturns show how varied they can be. The 2000 bear market ran about 540 days and dropped the market 37%, while the 2002 bear market lasted more than 275 days with a 33% decline. According to an analysis by The Hartford Funds, the 2007-2008 bear market spanned more than 400 days and cut the market 51%.
Preparing a portfolio for the next downturn
Investors can start by identifying stocks with abnormally high price-to-earnings ratios relative to their peers, since those tend to get hit hardest when a bull market turns. Trimming those positions and diversifying into value stocks, international stocks, small-caps, and dividend payers can cushion a portfolio against a steeper drop.
As a benchmark, Vanguard's current model portfolio calls for 36% U.S. stocks, 24% international stocks, and 40% bonds, split between 28% U.S. bonds and 12% international bonds. Diversified ETFs, particularly actively managed ones that can adjust holdings as conditions shift, are another option for riding out a downturn.
Source: The Motley Fool
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