Last week I was talking to two new acquaintances on different days. Both asked me what I do for a living and where I work. After telling them that I work in the investment industry, both of them asked some variation of the same question: whether they should continue investing given that the market is currently expensive?
Yes, the market is expensive compared to history. And that's worrisome for intermediate-term returns. According to data published by JPMorgan, anytime the S&P 500 as traded at a forward P/E ratio of greater than 22, the subsequent next 5 years returns have always been flat to negative. What's the S&P 500's forward P/E right now? Just above 22. Now remember, past performance is no guarantee of future returns. It's possible it's different this time. But that doesn't bode well.
I don't have a crystal ball to predict the future, but I do think a market correction (dropping 10%+) is possible in second half 2021. Returns are never guaranteed, but volatility is. In fact the NASDAQ already had a correction earlier this year when investors were rotating from Growth to Value. I don't think the market will have a bear market though in 2021 (dropping 20%+). It's possible to have a bear market without having a recession (like in 1987), but that's not common these days (speaking only about the US). Even when valuations are extreme, it usually takes a catalyst to cause a bear market.
As former Fidelity fund manager Peter Lynch says, it's not about timing the market, it's about time in the market. Although I think it's unlikely in the immediate future, it's still quite possible we see a 20% drop. In that case for every $1 invested now, you'd lose 20 cents. If you didn't invest and instead you just held the $1 in cash, those 20 cents would be your potential savings. But what if you invested the $1 now for retirement and got a 7.5% return over the next 30 years. Each dollar would turn into $8.75. In other words, by holding in cash, you may save yourself from a $0.20 loss, but give up the chance at a $7.75 gain. That does not sound like good odds to me. And I'm not joking about it being a million dollar question. Now investing $1 may not make a difference, but if you invest $130k at 7.5% over 30 years, that really is a difference of $1 million in gains.
Let's say, even if the market does stay flat over the next 5 years and then you get a 7.5% return for the remaining 25 years, you'd still end up with $6.10 for every $1 invested. Or what if you invest $1 now, it immediately drops by 20% and then you get a 7.5% return from there over the next 30 years? You still end up with $7.00. So whether you end up with $8.75 if things turn out smoothly or end up with $6.10 - $7.00 if you start out with a rocky beginning, it's still way better than keeping it in cash. If you hold cash, chances are you're not going to be able to time the market and buy in after the drop. You'll just lose to inflation anyways as you hold cash. And if you hold the cash in your bank account rather than your investment account, you are more likely to just end up spending the cash. Saving the money is better than spending it. But investing the money is better than just saving. That is why investing is key to taking your money to the next level.
So what I told both acquaintances - if it's money you're investing for your retirement, yeah, the market is expensive but it's probably best to keep on investing for the long-term.