Stock Valuations Are Sky-High — What’s the Smart Money Doing About It?
As we kick off another year of investing, we return to a perennial question: What should we do when stock valuations are sky-high?
How high is the stock market, historically speaking?
Right now, the market is flashing some intimidatingly high valuations.
Take a look at the current CAPE ratio for the S&P 500. The CAPE ratio is a classic measure of valuations. As of the end of January 2025, it does look very high compared to history.
So, what do we know about what tends to follow high valuations?
When valuations are this high, 10-year returns have recently been dreary
This chart from JP Morgan shows a pessimistic outlook for making a decent return in the next 10 years. It shows the following 10-year returns based on different stock market valuations.
You can see our current level highlighted with the vertical bar. Take a look at the data points around that bar.
This data shows that we have seen low single-digit positive or negative returns over the 10 years following similar valuations. Woof.
Let’s compare that to another similar forecasting model, which forecasts 10-year returns based on valuation. That model is quite simple—you just calculate the 1/CAPE Ratio. It suggests a real return of about 2.5% over the next 10 years. Woof indeed.
While past performance does not guarantee future results, history has not been kind to the 10 years following today's high valuations.
The next decade could be much worse for portfolios than the previous decade.
What about the short term? Should we be bracing for a crash?
Now, look at the 1-year returns from JP Morgan’s research.
This chart could not be more different than the last one.
It shows that valuations don’t predict anything in the following year.
There have been years with high valuations where there has been a 40% return! And some with close to -30%.
The chart clearly shows that one-year returns are more often positive than negative across all valuations (the whole x-axis). We know that the stock market tends to go up. However, negative returns become more common as the valuations go up and as we move to the right on the chart.
What’s an investor to do?
The lesson from this recent JP Morgan analysis is that the stock market is unpredictable in the short term but follows long-term trends. This is consistent with everything we know about the stock market.
Historically, investors have been rewarded for staying in the market, even when conditions are similar to today because we never know when the market will turn.
We might have another blockbuster year before a downturn. It could be longer than that or could be much shorter. (Tariffs and related inflation are starting to threaten stocks.)
I have 4 recommendations for investors today.
1. Stay the Course, ignore the headlines.
Keep investing based on your financial plan and retirement timelines.
Timelines and goals should guide your strategy, not what the market does on any given day.
2. Build or update your financial plan.
If you haven’t thought about it in a while, now is probably a good time to update your financial plan. In particular, you want to ensure your portfolio has an allocation and strategy with an appropriate level of risk to match your goals and timelines.
For example, a fair amount of people have an investing plan that involves simply dumping money into an S&P500 index fund. Honestly, that’s a pretty good general-purpose strategy if your timelines are long and you have the appetite and capacity to take on risk.
But what if you are about to start a family? Or buy a house? Or do you want to retire on the earlier side? Those goals and timelines suggest a different plan. Now is a good time to figure out a plan that matches your situation.
3. Adjust Your Expectations and modeling assumptions.
Markets don’t consistently deliver double-digit growth over the medium term and are VERY unlikely to provide anything close to that when valuations are so high. Adjust your mindset and prepare yourself mentally and emotionally.
This probably won’t be the decade where you get rich.
If you are counting on 10% returns to retire 3 years from now, that’s VERY optimistic. It’s probably time to review your planning assumptions.
4. Stay diversified.
Just as we can’t predict one-year returns on the total stock market, we can’t expect to pick the winners and losers of individual stocks and sectors.
Stay broadly diversified to spread your risk. Ensure you have the right asset classes in the right proportions to match your financial plan.