Interest Rates & The CAPE Ratio

Earlier this month, the Federal Reserve lowered their target interest rate.

So how do stocks typically perform following a rate cut? Generally, slightly worse than usual (but still substantially positive).

Why? Because history is littered with examples of the Fed needing to cut interest rates during times of economic emergency (think 2001, 2008 or Covid). Those times obviously coincided with stock market crashes, thus lowering the average figures we’re looking at below.

Source: Charlie Bilello of Creative Planning. Past performance is no guarantee of future results.

Here is another data point that has been in the news lately; known as the "cyclically adjusted price-to-earnings” ratio.

This is a method for valuing the stock market by comparing it to the economy as a whole (which you would reasonably expect to grow in relative lock step). The goal here is to determine whether the stock market is inexpensive, fairly valued, or expensive.

Source: Charlie Bilello of Creative Planning. Past performance is no guarantee of future results.

As you can see, by this measure, the US market is potentially highly overvalued. This sentiment was echoed by Federal Reserve chairman Jerome Powell when he recently stated that US stocks were “fairly highly valued”. Warren Buffett himself has called for caution when we’ve reached these levels in the past.

This is possibly the result of optimism surrounding AI, and the hope that the technology can positively impact the bottom line of America’s companies. If that positive impact materializes, great, maybe the market is fairly valued. If it doesn’t, then we may have a problem. And that, my friends, is the very definition of a market comprised of both buyers and sellers.

To play devil’s advocate here, I remember noodling on CAPE ratio figures nearly a decade ago, which were highly elevated even back then. Taking this line of reasoning to it’s logical conclusion of reducing or eliminating your US stock exposure would have been a very costly decision considering how well the US market has performed since then.

This leads me to the paradox that is always difficult to convey to clients:

• You will likely be very well served by owning stocks over the course of decades.

• You will likely get walloped from time to time.

I wish that weren’t the case just like I wish I could eat pizza and ice cream all day and be fit, but that’s just not how the world works.

So, I think the best way to approach this can best be summed up with one of my favorite words when it comes to finances: prudence. 

• Avoid the temptation to chase what has been performing best as of late (US stocks included).

  • Those trends frequently reverse course rapidly.

• Keep your eggs in as many baskets as reasonably possible.

  • Not just by stocks, bonds and cash, but also by geography, sectors, industries, maturities, credit qualities, etc.

  • (The international stock market is far more reasonably valued according to this metric.)

• Know your time frame, and ensure that I know your time frame.

  • Someone considering retiring this year needs a very different portfolio than someone who has a 30 year career ahead of them.

• Rebalance your portfolio to keep your investments in check by taking profits on your winners before they become too concentrated of a position.

  • This is taken care of on a quarterly basis for clients.

• Perhaps most importantly, extend your perspective.

  • Even someone retiring at 65 years old needs to be prepared for the possibility of a 30 year retirement. Whatever declines occur in the near term will likely look like a small blip by the continued long-term growth and inflation protection that only the stock market has offered.

    
    

  “In the financial markets, you’ll typically pay a high price for certainty. That price is paid in lower investment returns, and sometimes also in greater financial hassles. Yet I see investors paying that price again and again.”

  – Jonathan Clements

If this is helpful and you would like a complimentary discussion of your portfolio, retirement plan, or anything else, please schedule some time together below.

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Moore Financial Management, Inc. is an Investment Adviser registered with the State of Florida. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request. Past performance is no guarantee of future results. All investing involves risk, including the loss of principal. This email is for educational purposes only and is not advice. Consult with your tax, legal, and financial advisor before engaging in any transaction.