Stock markets produced healthy gains in the second quarter, building on the first quarter’s strong start to the year. The S&P 500 rose 2.5% during the quarter, while international stocks again outperformed their domestic counterparts with a 4.7% advance.

Also consistent with the first quarter, defensive assets delivered a much more subdued performance than stocks. Fixed income markets inched up by 0.8%, meaning that virtually all of the return was in the form of interest payments. Broadly diversified Real Estate Investment Trusts (REIT’s) delivered a similarly mediocre return of 0.7%.

We would like to devote the next several paragraphs to what is, in our view, the most important issue confronting investors: are US stocks in particular, and growth assets in general, overvalued? Or even in a “bubble”, as some believe? Yet at the same time a number of market analysts argue that the current investment landscape actually favors maintaining an aggressive commitment to equities. Obviously both perspectives can’t be right, so who’s “reading the tea leaves” accurately? Let’s consider some of the factors cited by either side.

Factors indicating an overvalued stock market:

  • As the Federal Reserve continues to pursue its strategy of gradually raising short-term interest rates, the resulting higher yields produced by bonds will draw money away from stocks and into fixed income. This will create a “headwind” that will undermine stock market performance.
  • US stocks are now into an unprecedented ninth straight year of a bull market, with broad indexes continuing to trade at or near all-time highs. During that extended period there have been only a few pullbacks that approached a 10% “correction” … and even these pullbacks were extremely short, doing little to meaningfully lower stock valuations.
  • Compared to its historical average, the current price-to-earnings (P/E) ratio of the S&P 500 is substantially elevated. Based on reported 12-month earnings the index currently has a P/E ratio of 26, versus a historical average of roughly 15.
  • Despite having a single party in control of both Congress and the White House, political gridlock in Washington offers little encouragement that fiscal policy will be enacted that can stimulate higher economic growth.
  • Numerous geopolitical crises – North Korea and the Middle East, to name just two – pose the risk of threatening market confidence with little advance warning.

Factors supporting a robust commitment to equities:

  • There is clear evidence of an improving global economy; especially in Europe, which is much earlier in the business cycle than the US.
  • Strengthening corporate profitability for American companies will help to lower P/E ratios to more sustainable levels.
  • Despite rising interest rates, the credit markets continue to provide both investors and corporations ready access to inexpensive debt, supporting the valuation of risk assets and lowering the cost of doing business.
  • A historically low rate of inflation further reinforces a very gradual climb in interest rates and, if it persists, might even cause rates to drop.

Both sides of this debate can make a persuasive argument in support of their thesis. And the harsh reality is that we won’t know which side is right until well after the markets have delivered their verdict … not exactly a rational platform on which to base investment decisions. But while we have to acknowledge our inability (really everyone’s inability) to predict the short-term direction of the markets, the good news is that we don’t have to make that prediction.

We’re not focused on where the markets will be six months, a year, or even two years from now. Of course we hope those results will be positive, but a client’s short-term financial needs should be met with assets that aren’t exposed to market risk.

As your advisor, our job is to develop and implement a plan that offers you protection from the short-term risk of the investment markets, while maximizing the achievement of your financial goals for the rest of your life. How? First, we won’t try to “time the market”, which is more likely to impair returns than enhance them.

Second, we will always rely on an investment strategy based on broad diversification across asset classes. While the relative mix of these classes will depend on the individual client’s specific goals, risk tolerance, and timeframe, every investment portfolio incorporates an appropriate exposure to a broad array of assets. And given the currently lofty levels of US stocks, we are making sure that every client has a meaningful commitment to international stocks and an appropriate level of portfolio liquidity.

Finally, and perhaps right now most importantly, it’s critical that we base your financial plan on realistic return assumptions. We view managing investment risk as one of our most important client obligations. By relying on conservative assumptions we can reduce the risk of plan failure and increase the likelihood of a successful outcome.

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