As price/earnings ratios suggest, stocks are currently expensive relative to their earnings. But outside of that, the situation is clearly different from 2007. Back then the S&P 500 was reaching all-time highs in the face of deteriorating fundamentals—now the index is reaching new all-time highs but fundamentals are mostly improving. Remarkably high and rising profit margins may even be able to support elevated valuations, while low interest rates (the ten-year Treasury is currently yielding about half of what it did a decade ago) make bonds a less than stellar alternative to stocks.
Of course, we do not know exactly what the future holds. There may certainly be painful price corrections from time to time, especially as the likelihood of market-friendly tax cuts continues to ebb and flow. And stretched equity valuations put a damper on intermediate-term expectations. But with fundamentals on the upswing, rather than a 2007-08 type crash we may see valuations take their sweet time to revert to long-term averages via an extended period of subpar price returns. That does not sound like much fun, but it is a different scenario than a collapse.
While valuations are worrisome, it seems unlikely the next several months will turn out the same as they did back in 2007. And a different set of macro symptoms calls for a different prescription. Rather than taking growth-oriented assets completely off the table (would have been ideal in 2007), in 2017’s environment of high valuations it may make more sense to rotate amongst alternative solutions for generating appropriate returns. That includes increasing allocations to geographies with more reasonable valuations, as well as considering alpha-oriented strategies which rely on manager skill rather than market beta.
It is hard to argue that economic fundamentals and corporate earnings are not in much better shape than they were a decade ago. In 2007, a precarious economy in conjunction with elevated valuations put nearly all risk asset classes (overseas stocks, high yield stocks, real estate, energy, hedge funds) on the precipice of a steep decline. This time around, with fundamentals clearly in a more advantageous spot, markets will likely follow different path. Investors should as well.
