US equity valuations are high.
How high?
The CAPE Ratio on the S&P 500 just crossed above 40.
When was last time we saw a CAPE ratio above 40?
September 2000.
What happened after that?
The “lost decade” for investors. The S&P 500 declined 15% over the next 10 years, with two significant drawdowns in between. The tech-heavy Nasdaq 100 fared much worse, falling 55%.
How did that happen?
Mean reversion. By September 2010, the S&P 500’s CAPE Ratio had been cut in half, moving from 40 all the way down to 20. This multiple contraction outweighed what was still a positive period for S&P 500 earnings, which increased 35%.
Will investors in the S&P 500 today will suffer a similar fate?
It’s impossible to say, but if it happened before at the same valuation level there’s certainly a chance that it could happen again.
Is there any way an investor back in September 2000 could have avoided the “lost decade” that followed?
Yes. By maintaining a diversified portfolio that included asset classes other than U.S. large-cap growth equities.
While the S&P 500 declined 15% from September 2000 through September 2010, here’s a look at how other major asset classes performed (note: cumulative total returns):
- US Aggregate Bonds: +47% (Bloomberg Barclays US Aggregate Index)
- US Large Cap Value: +51% (Russell 1000 Value ETF, $IWD)
- US Small Caps: +62% (S&P Small-Cap ETF, $IJR)
- International Developed Market Equities: +94% (MSCI EAFE ETF, $EFA)
- US High Yield Bonds: +103% (US High Yield Master II Index)
- US Real Estate: +109% (US Real Estate ETF, $IYR)
- Emerging Market Equities: +234% (MSCI Emerging Markets Index)
Owning many of these asset classes back in 2000 was not an easy decision, as they had been underperforming the S&P 500 and Nasdaq 100 by a substantial margin.
But, there’s a cycle to everything, and having the foresight to understand that and remain diversified in the midst of a mania would prove to be invaluable in the years to come.
Today we are faced with a similar situation as 2000, where large-cap U.S. growth equities in general, and technology stocks in particular, have trounced everything else.
Diversification has once again become a four-letter word, as owning anything outside of the Nasdaq 100 tech leaders has cost investors dearly.
One consequence of this is that major indexes have become much more concentrated. The top five holdings in the S&P 500 (Apple, Microsoft, Alphabet, Amazon, and Tesla) now comprise 23.5% of the Index, the highest we’ve seen with data going back to 1980. That means passive market cap-weighted investors are increasingly betting on fewer companies to continue their outperformance.
Just as it was back in 2000, it’s hard to imagine a world in which these market leaders do not continue to dominate.
But that’s precisely what you must do as an investor if you want to be prepared for multiple possible outcomes, including the risk of another lost decade.
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.
