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Is the market too expensive?

I’ve been in the financial services business for over 37 years now. In all that time, the one and only headline I’ve yet to see grace the top of any financial news section is: “the markets are too inexpensive.”

On the contrary. Year after year, day in and day out, the financial media are almost always trying to convince us that stocks are too expensive, equities are dangerously overpriced, and a crash or major correction is surely imminent.

This sky-is-falling narrative wouldn’t be so bad if we all took it with a grain of salt or applied a little historical context to balance the story. But unfortunately, many investors who hear this constant catastrophizing make the mistake of taking it to heart, and rush right out to sell off all their stocks – without realizing just how much that kind of panic selling could end up costing them in the long run.

Don’t get me wrong. I understand the fears that can drive even the smartest or most experienced investor to make a bad decision. Panic can be a tempting course of action, especially these days, after the markets have seen a spectacular run up from the depths of last spring’s coronavirus-inspired sell off.

For those who don’t remember (or would simply rather forget), in March of 2020, the average investor’s portfolio suffered the fastest 30-day decline in the last 200 years. It wasn’t the biggest decline in the history of the markets. But it was the fastest 30 per cent drop ever recorded.

Thankfully, the recovery was almost as quick. By last summer, most of those paper losses had already been regained. Then, on one particularly hot day last July, one of my clients called me to say that they wanted to lock in all those perceived gains, cash out most of their stocks, and wait for what they felt would be the inevitable pull back.

I tried to talk them out of it. But they were adamant that their strategy was the right move. After all, we’d just enjoyed one of the fastest market advances in history. Surely a correction had to be right around the corner, right?

But the “imminent correction” they were predicting didn’t happen. The markets kept on rising, while my client could only stand by and watch from the sidelines. As of the time of writing, they had missed out on what would’ve been a 30 per cent gain in their portfolio. Now, the only choice they’re faced with is whether to buy back the shares they sold a year ago at a 30 per cent premium, or continue to wait and see if the external world will eventually decide to mirror their internal dread.

The reality is, when it comes to equities, the only thing we really know for sure is that we have absolutely no idea what the short-term future will bring. A new variant of the coronavirus could shut the economy down again, and lead to another record-setting sell-off. We might get higher interest rates, or maybe that long-awaited major housing market correction. Take your pick. There’s never any shortage of things for investors to be afraid of, now more than ever.

On the other hand, we also have soaring corporate earnings, and an economy that’s roaring to come out of lockdown. Consumers in the U.S. and many other countries are in the best economic shape in recent memory. And innovation is continuing to push forward on pretty much every front imaginable.

While U.S. market valuations are indeed on the high side, those in other countries like Canada or many emerging markets are still at or below their historic average. And when we say average market valuations, those market averages happened when interest were quite different. The current yield on a 10-year U.S. Treasury bond, for example, is just under 1.3 per cent. This is compared to the long-term average of about five per cent. If anybody can find me a 10-year Treasury bond paying five per cent now, please let me know – I’ll be first in line to buy!

Given these spectacularly low interest rates, what happens if the markets adjust their valuations accordingly? How much higher will they go, while investors like my client continue to watch and wait?

Warren Buffett once wryly observed that the risk of being out of the market is much higher than the risk of being in the market. This comes from the fact that, historically speaking, the markets go up about 75 per cent of the time, and decline only around 25 per cent of the time. So if you sit out of the market for any extended period of time, odds are, you’re going to miss out on significantly more growth than you will avoid potential losses.

Staying invested is no picnic. Anyone who’s been around the markets for any length of time has had that sinking feeling as 25 per cent or more of their portfolio temporarily disappears overnight. It can be truly terrifying, and while it’s happening, the fear is often compounded by a sense that there’s no obvious solution on the horizon. When we find ourselves in that inevitable but unenviable position, what can we do about it, other than panic and run for the hills?

For people who depend on their investment portfolios for income, one strategy is to focus on dividends. These days, you can put together a solid portfolio of dividend-paying stocks that will yield anywhere from three per cent to six per cent a year in dividends. That’s a pretty good return, especially when compared to the current five-year Canadian bond rate of less than one per cent. Even better, dividends tend to be pretty sticky, so the majority of that income is likely going to continue through almost any temporary market drop.

I also advise all my clients who depend on their investments for some (or all) of their income to make sure they have a “portfolio seat belt.” The longest bear market since the Second World War lasted for 36 months. By keeping at least three years of income set aside in something guaranteed like government bonds, cash or money market funds, we can plan for the worst, while hoping we never need to use it.

And while “buy now and hold” will always sound like a misguided platitude whenever the market tanks – which it definitely will again, whether it’s tomorrow or 10 years from now – the fact remains that buying equities is almost always the right thing to do.

We can’t predict the future. But the past is clear. When I first got started in this business 37 years ago, the Dow Jones Industrial Average stood at 1,086. Today, the Dow Jones is sitting at 35,198. That’s more than 30 times higher, and that doesn’t even include all the dividends that were paid along the way.

How do we get this remarkable rate of return? By doing what can sometimes feel like the most difficult thing to do: control our fears, trust in our long-term plan – and just sit still.

This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.