It can be hard to see a bubble when you’re smack-dab in the middle of it. I think that describes our situation today.
Let’s look at a few large tech stocks’ price-to-earnings (P/E) ratios.
- Amazon: 115
- Tesla: 918
- Zoom: 522
These valuations are worrying. Yes, these companies have historically shown high growth. But at these kinds of levels, valuations are starting to get ridiculous.
P/E is a commonly used indicator of how expensive a stock is. You can think of P/E as a multiple of how expensive a company is compared to its earnings. The lower it is, the cheaper a stock generally is. And a higher P/E means it’s more expensive. There are other factors to consider, such as debt, debt load, growth rate and assets. But P/E is generally a good place to start to figure out how expensive a stock or index is.
Overall, the Nasdaq 100 currently trades at an average P/E ratio of 35.9 according to WSJ data. A year ago it was around 25. Back in 2000 it peaked at a P/E ratio of more than 100, so we’re still far from that level. However, I wouldn’t exactly call current U.S. stock valuations attractive.
When you factor in the record levels of corporate debt and a questionable economic outlook, the outlook for stocks gets even cloudier.
Bonds are Bubbly Too
When stocks are overvalued, one of the best historical strategies has been to switch into high quality bonds. Bonds tend to do well when stocks are lagging, so it’s been a winning strategy for a long time.
Many investors go with a traditional “60/40” portfolio — 60% in stocks and 40% in bonds. This portfolio structure has worked incredibly well for more than 100 years, returning 8% a year on average since 1861.
But bonds today don’t have the same appeal they once did. Most U.S. government bonds today have real yields — after inflation — of near or even below zero percent. Many high quality corporate bonds also have real yields at or near zero.
Bonds have still managed to do pretty well over recent years — despite very low yields — due to the fact that the price goes up as the yield goes down. However, it seems unlikely that bonds can continue to rise in price much more. To go significantly higher, yields will need to go negative.
The Rise of Alternatives
The combination of bubbly stocks and non-yielding bonds has created quite a predicament for investors. What has worked well for the last 150+ years seems unlikely to work as well going forward.
In fact, Morgan Stanley now forecasts a 2.8% annual return for the traditional 60/40 portfolio over the next 10 years.
“The return outlook over the next decade is sobering–investors face a lower and flatter frontier compared to prior decades…”
This is why I believe so strongly in adding alternative assets to your portfolio (and reducing exposure to bonds). You probably all know what I like by now, but just to reiterate the areas I’m focused on:
If you’re not familiar with these alternatives, I strongly suggest reading up on them.
I think these four hold the key to outperforming the overall market (and especially bonds) over the next ten years.
To be clear, I’m not recommending selling all your stocks. I look at these alternatives as something like a “new 40%” that can help diversify and hedge your portfolio better than bonds today.
It’s a new and unprecedented landscape out there today. To navigate it successfully, you’ll want to get acquainted with the world of alternative investing.