As U.S. equity valuations hover near historical highs, it’s a good time for investors to evaluate the sustainability of stock gains and to revisit the fundamental benefits of portfolio diversification.
Asset prices are “elevated by many metrics right now,” Federal Reserve Chair Jerome Powell said at a 29 January policy press conference. Two days earlier, a front-page story in The Wall Street Journal, titled “Premium for Owning Stocks Vs. Bonds Disappears,” noted that the equity risk premium – defined as the gap between the S&P 500’s earnings yield and the 10-year Treasury yield – had turned negative for the first time since 2002.
Another common equity gauge, the cyclically adjusted price-to-earnings (CAPE) ratio, has climbed to levels previously seen only twice in the past three decades: during the dot-com bubble and the post-pandemic recovery (see Figure 1). Those prior CAPE peaks occurred when Fed projections and consensus market forecasts called for U.S. growth of 3.5% to 4.7% annually. Today, however, growth is forecast to be only about 2% for 2025.
Figure 1: CAPE ratio is near peak levels
It seems especially concerning that valuations are so stretched when uncertainty is so high (see Figure 2), with U.S. tariff policies set to reshape the global economic landscape (for more, see our latest Cyclical Outlook, “Uncertainty Is Certain”).
Figure 2: Trade policy uncertainty has surged
The case for continued U.S. stock market gains appears to rely on two key assumptions: that “this time is different,” and that U.S. economic exceptionalism – outperformance versus the rest of the world – will endure. These assumptions were tested in late January when fears about the durability of artificial intelligence investments, amid rising competition from China, sparked a sell-off. Such volatility could become more common, and a negative equity risk premium may not provide adequate compensation.
Diversification is essential
Investors should revisit a time-tested strategy: diversification. The equity risk premium has turned negative partly because bond yields have reached the most attractive levels in years (see Figure 3).
Figure 3: Bond yields have risen above S&P earnings yield
The recent reemergence of the traditional negative correlation between stocks and bonds further enhances bonds as a counterbalance to equity exposure (for more, see our November 2024 publication, “Negative Correlations, Positive Allocations”).
Over the long term, U.S. equities are essential components of any investment portfolio. Equity investments have helped power the growth of the U.S. economy while creating wealth and retirement security for millions of investors. However, periods of elevated valuations have tended to heighten shorter-term risks to the equity outlook.
As Fed Chair Powell also noted on 29 January, it’s human nature to underestimate tail risks. Following outsize stock market gains in recent years, which may have tilted portfolio allocations even further toward equities, investors should evaluate the risks related to valuations and remember the importance of bonds in a balanced portfolio. Given the historical tendency for valuations to revert to the mean, it could be a mistake to assume that today’s exceptional conditions will last indefinitely.
Disclosures
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.
Diversification does not ensure against loss.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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