“It’s very difficult for any particular segment of the stock market to sustain superior performance. The watchword for our financial markets is “reversion to the mean,” i.e., what goes up must come down, and it’s true more often than you can imagine,” John Bogle said.
What does that have to do with an overvalued stock market? Well, even if the market is overvalued, Bogle believed it was futile to try to time tops and bottoms, making it unwise to attempt to jump ship. Instead, he advised staying the course and holding on to investments “forever.”
But how can investors tell if the market is overvalued in the first place? Bogle's methodology for assessing valuation could provide some clues.
Who was Bogle?
Bogle, the founder of Vanguard Group, is often considered the father of index investing and is credited with popularizing low-cost index funds for average investors. Index funds allow you to invest in the overall stock market at minimal fees by tracking a broad market benchmark like the S&P 500 ETF TRUST ETF (SPY, Financial). They provide instant diversification and are a prudent way for most individual investors to participate in equities without trying to pick individual stocks or beat the market.
The investor was a major proponent of buying index funds on a regular basis, such as monthly, and holding them for the long term rather than trying to time the market. However, he also developed a methodology using dividend yields, earnings growth estimates and price-earnings ratios to evaluate whether the overall stock market was significantly overvalued or undervalued. This estimate of potential market returns over the next five to 10 years could provide useful context for index fund investors in determining reasonable return expectations.
How exactly do index funds work?
Index funds provide investors with an easy, low-cost way to invest in the stock market as a whole. An index fund simply buys all the stocks in a market index, like the Vanguard S&P 500 ETF (VOO, Financial), replicating the index by investing in the exact same companies in the same proportions. This provides instant diversification across 500 large U.S. companies spanning all sectors and industries.
The main advantage of index funds is their ultra-low fees and expenses. Actively managed mutual funds employ stock pickers, analysts and researchers trying to beat the market by selectively picking stocks. This results in much higher expense ratios, often 1% or more per year. Index funds skip the stock picking and simply track the underlying index, keeping management fees minimal at around 0.05% 5o 0.10% on average.
When you buy shares in a Vanguard S&P 500 exchange-traded fund, you essentially buy the entire U.S. stock market in one simple purchase. The built-in diversification and low costs make index funds an excellent way for the average individual investor to participate in equities without needing to become a stock-picking expert.
Specific strategies for investing in index funds
Bogle preached that trying to time the market is futile and likely destructive for most individual investors. Therefore, the best course of action is to steadily invest fixed amounts into index funds month after month, buying through ups and downs. Some specific tips include:
- Invest regular amounts consistently: Make continuous monthly investments in your chosen index fund(s), even if only small amounts like $100 to 500 per month. This discipline lets compounding go to work over time.
- Ignore short-term volatility: Do not panic sell out of index funds during periodic market swings or corrections. Have courage and stay disciplined, keeping your monthly contribution schedule through bull and bear markets.
- Hold for the long term: Think in terms of decades, not months or days. Give your investments sufficient time to compound higher returns over long periods.
- Reinvest dividends: Ensure your account is set to automatically reinvest dividends back into the fund to continually compound gains.
Bogle's methodology for assessing valuation
While Bogle firmly advocated buying and holding index funds forever, he also developed a straightforward methodology to evaluate whether the overall stock market was significantly overpriced or underpriced at a given time. In a 2017 interview, here is how Bogle assessed valuation and estimated future 10-year returns:
First, he looked at the current dividend yield. Higher dividend yields suggest stocks are cheaper and imply higher future returns. The S&P 500 ETF Trust's dividend yield was around 2% in 2017.
Second, he looked at expected earnings growth. The S&P 500 ETF Trust's earnings growth has averaged about 5%. Bogle's estimated continuation of 5% to 6% long-term earnings growth was reasonable.
The price-earnings ratio also comes into play. Higher ratios indicate overvaluation. The Shiller CAPE price-earnings ratio was over 30 in 2017 compared to a historical median of 16.
Finally, combining the dividend yield, earnings growth and price-earnings adjustment, Bogle forecasted about 4% annual returns for the S&P 500 ETF Trust over the next decade starting in 2017. This was far below the historical norm of around 10%.
What Bogle advised to do in an overvalued market
Importantly, Bogle cautioned against market timing, even in periods that appeared significantly overvalued by historical standards. His advice for navigating high-valuation markets included:
- Maintain index fund investing discipline through ups and downs.
- Adjust return expectations downward for the next five to 10 years.
- Reduce equity allocation percentage if risk tolerance necessitates.
- Never exit equities entirely or engage in market timing.
Getting out of the market completely and trying to time re-entry is one of the biggest and most common investing mistakes, according to Bogle. Even in overvalued markets, he firmly advocated maintaining discipline, focusing on savings rates and costs and continuing to buy and hold index funds for the long run.
Bogle's enduring core investment philosophy
While Bogle periodically provided estimates of market valuation, his underlying philosophy for most investors remained fixed throughout his career:
- Buy broad stock index funds: The most reliable way to participate in equities for the average person.
- Hold forever: Resist the temptation of market timing and stick to a long-term buy-and-hold approach.
- Reinvest dividends: Continuously plow dividends back into the fund to compound gains.
- Invest regularly: Make continuous, consistent and uninterrupted contributions to index funds regardless of market gyrations.
- Ignore volatility: Do not panic sell in periodic downturns. Stay calm and stick to the plan.
Current market context
Bogle's estimate of 4% annual returns for the S&P 500 ETF Trust was made six years ago in 2017, looking out over the next decade. We are now in 2023, approximately halfway through that 10-year timeframe. The Covid-19 crisis and associated bear market and recovery confounded many predictions and assumptions.
Looking at 2023, valuations remain elevated by historical standards, with the Shiller price-earnings ratio (price divided by the 10-year earnings average adjusted for inflation) hovering around 30. However, other factors like rising interest rates, high inflation, geopolitical tensions and the potential for an economic slowdown or recession create uncertainty. This complex economic and market backdrop makes forecasts even more difficult than usual.
