Imagine a world with two investment options, apples, and oranges. Investors are best served to reduce their holdings of apples and to replace them with oranges when demand for apples drives the price too high. The simple logic in this example is applicable across the full spectrum of economics, and it holds every bit as true in today’s complex world of investing. The question every investor should have is, “When does the price of “apples” make “oranges” the preferred holding”? Most of the time, answering that question is not easy. Occasionally, however, the evidence becomes too obvious to ignore.
Replace apples and oranges with stocks and bonds and you have defined the majority of investors’ asset allocation schematic. Unlike our fruit example, the allocation decision between stocks and bonds is based on many factors other than the price of those two assets relative to each other. Among them, recent performance and momentum tend to be a big influence in both raging bull markets and gut-wrenching bear markets. In both extremes, valuations tend to take a back seat despite historical data providing ample evidence that equity valuations alone should drive allocation decision.
Current equity valuations and nearly 150 years of data leave no doubt that investors are best served to ignore yesterday’s stock market momentum and gains and should be shifting to bonds, as we will demonstrate.
Valuations
How often do you hear someone touting a stock because its share price is low, or advising you to sell because the price is too high? This nonsense does not come from just Uber drivers and novice investors; it is the primary programming line-up of the mainstream business media. The share price on its own is meaningless. However, the stock price times the number of shares outstanding provides the market capitalization (market cap) or the dollar value of the company. Inexplicably, market cap is a number you rarely hear from those giving stock tips.
