In case you’re still hiding under your pandemic rock, it’s time to come out and consider, among other things, that the stock market is currently expensive, overpriced, and overvalued.  All these terms mean essentially the same thing: share prices of companies are high relative to basic measures of their current or future value.  For example, this Marketwatch article by Mark Hulbert reviews several different stock valuation metrics including:

• The ratio of S&P 500 price over earnings, sales, or book value for the previous year (P/E Ratio, P/S Ratio, and P/B Ratio, respectively).
• The Cyclically-Adjusted Price/Earnings Ratio (CAPE Ratio) of the S&P 500 uses the average of the past 10 years of earnings.
• The Total Return (TR) CAPE Ratio of the S&P 500 is similar to CAPE but includes dividends in the calculation.
• The total dividends of the S&P 500 as a percent of index price (Dividend Yield).
• The total market cap of all publicly traded U.S. companies divided by the replacement cost of corporate assets (Q-Ratio) or the latest government estimate of GDP (Market Cap/GDP Ratio aka the Buffett Indicator).

You can read the Hulbert article yourself for details, but the bottom line is that all these measures suggest that the U.S. stock market is at nose-bleed valuation levels.  As an example, here is a graph from a website called Current Market Valuation¹ that shows the Market Cap/GDP Ratio (Buffett Indicator) since 1990.

Basically, the U.S. stock market has reached its most expensive level since this metric has been in use.

So What?

This is typically where most articles on stock valuations tend to end.  Perhaps, the author adds a few words of caution or suggestions to “take money off the table”.  Of course, for mindful investors, these platitudes are useless, because we know that timing the market is impossible, and the most productive way to invest is to buy and hold low-cost stock index funds for the long-term regardless of whether the stock market is expensive, cheap, or anything in between.

The other conclusion you’ll often see is that although suggestive, these high valuation indicators aren’t necessarily predictive of poor future returns.  Continuing with the initial example, Current Market Valuation provides this graph of how the Market Cap/GDP Ratio has performed in the past as a predictor of the next five years of cumulative returns for the S&P 500.

The overall R-squared level of this relationship is just 0.18, which suggests the Buffett Indicator is not a great predictor of future returns.  Nonetheless, there is some predictability here.  And staring at the chart, I can’t help but notice several sub-patterns in the dots that might be teased apart to generate even better predictions.

Regardless, I like a metaphor from Hulbert’s article, where he compares the market to a leaf in the wind.  You can’t predict exactly where the leaf will be an hour from now, but it will almost always be somewhere downwind of its current location.

Current high market valuations are the main reason why most professionals are predicting that the next decade of nominal stock returns will be around 5%, well below the historical average of 9%.  If you like to engage in crystal ball gazing, I summarize and annually update future stock (and bond) return predictions here.

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Three years ago I had this idea to show how hard it is to successfully pick individual stocks by having a contest between investing “experts” and a stock-picking monkey.  The monkey was represented by a random selection of stocks from the S&P 500.  I expected that the random monkey portfolio would perform as well or better than the portfolios recommended by some of the world’s stock “experts” back in May of 2018.

But the stock market has a funny way of making us look like fools.  (If the stock market hasn’t yet fooled you one way or another, then it’s likely only a matter of time before that story changes.)  After an explosive start out of the gate, the monkey portfolio was significantly lagging the expert’s picks by the two-year mark of the contest.

At that time, I decided that my contest would never definitely prove that stock picking is a loser’s game.  That’s because if you compare almost any two stock portfolios, their relative performance will usually ebb and flow over time.  Examples include the varying relative performance among stock sectors, geographic areas, and investing factors like size, quality, and value.

So, it’s not surprising that my monkey looked like a winner in the first year, then a loser in the second year.  I almost decided to stop the contest entirely.  But after looking at the third year’s results, I noticed that they illustrate how the fickle market gods will always test, sometimes mightily, our convictions about any particular stock portfolio.

Contest Results – Year Three

But before I get too philosophical, I should present the contest results as of the third-year mark, which was the end of May 2021.  If you want more details about the contest and the stocks that make up each portfolio, you can read the original post.  In summary, the contestants include three portfolios selected in May 2018:

• 30 stocks recommended by Morgan Stanley
• 20 stocks favored by several hedge funds.
• 10 S&P 500 stocks randomly selected by my monkey.

And for added context, I’ve also compared the results to simply holding a low-cost index fund of the S&P 500.

Here’s a bar graph showing the annualized returns (Compound Annual Growth Rate; CAGR) for these four portfolios since the start of June 2018.

While the monkey portfolio is again the clear laggard, its nearly 16% annualized return seems pretty good for a monkey.

The Monkey Portfolio in Perspective

The decent performance of the monkey portfolio made me wonder how it compared to other popular investing themes.  I ran the same numbers for the same period for different sizes of stocks, value stocks, and the old faithful portfolio consisting of 60% stocks (U.S. large caps) and 40% bonds (U.S. 10-Year Treasury Bond).  I was particularly interested in the size and value factors because I’ve seen quite a few articles recently trumpeting the comeback of these factors after many years of poor performance.  Here’s the graph of the results.

Note that many of these portfolios (except the 60/40) aren’t realistic because they’re 100% concentrated in one or two factors.  In reality, most factor investors hold portfolios that “tilt” towards these factors, where size or value-focused funds represent less than half of the entire portfolio.  However, looking at these extreme portfolios helps illustrate whether such factor bets would help or hinder a larger portfolio with substantial allocations to more traditional stock or bond funds.

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In my last post, I showed that U.S. stocks (the S&P 500) have offered positive inflation-adjusted returns 87% of the time and positive nominal returns 94% of the time for investors with a 10-year timeframe.  (By “positive return”, I mean that the investor made a profit, while a “negative return” means losing some money over the specified timeframe.)  And even over a one-year timeframe, U.S. stocks have provided positive returns 68% to 73% of the time, inflation-adjusted and nominal respectively.  Despite these facts, stocks have a “scary” reputation for being crash-prone and highly risky as compared to “safe” government bonds.

Data Limitations

However, a regular reader by the name of Mathew made this insightful comment about these statistics:

• This is interesting although it’s just for the S&P 500 in a period where the US had a great 100 years.

He went on to note that, for example, the prices of Japan’s stock market (as represented by the Nikkei 225) have gone essentially nowhere since 1990, as shown in this chart from Macrotrends.

 

Mathew makes a good point.  At the absolute most, there are only 150 years of reliable U.S. stock market data, and probably only the last 100 years are relevant to our modern economy and markets.  I’ve used Mathew’s same point myself to criticize factor researchers for relying too much on this rather limited dataset to find all sorts of weird anomalies that have outperformed the broader stock market in the past but aren’t guaranteed to outperform in the future.

So, am I making the same sort of mistake when I calculate positive return statistics based on just 100 years of U.S. stock data?  Will the next 100 years of U.S. stock market returns mimic, or even resemble, the last 100 years?  Perhaps the future of U.S. stocks will be scarier than its past.  And perhaps, stocks from other countries have been and will be scarier than U.S. stocks.

Beyond the United States

As Mathew’s observation suggests, comparing historical stock returns across many countries might provide:

1. A measure of how exceptional or unusual the last 100 years of U.S. stock returns have been.
2. A better sense of the risks involved with stock investing in general, as indicated by many different geographic and economic conditions.

Further, I’ve argued that it’s mindful to consider geographic diversification of stock portfolios.  For such geographically diversified investors, an analysis confined solely to U.S. stocks could be misleading.

Consistent with the idea of maximizing datasets, I searched for the longest annual return records for different countries and found that the MSCI dataset for Developed Market countries goes back to 1970 for 17 countries and nearly that far for 5 other countries.  The MSCI Developed Market dataset spans only about half the available period for the U.S. dataset.  But the 50 years from 1970 to 2020 include some pretty turbulent times such as the stagflation and the global oil crisis of the 1970s, the rise/fall of the dot-com bubble in the 1990s and early 2000s, and the global financial crisis of late the 2000s.

Using these data, I conducted a similar analysis to my last post, where I calculated the percent positive returns for various investor timeframes.  Specifically, I calculated the percent positive returns since 1970 for the 22 MSCI Developed Market countries on an annual, rolling 5-year, and rolling 10-year basis.  And as an overall comparison, I included the MSCI Developed Market Index that covers all these countries.  This index is tracked by many low-cost mutual and exchange-traded funds¹.

Also, all these returns are calculated in U.S. dollar terms.  So, this analysis reflects someone in the U.S. investing in index funds that include stocks from one or more of these foreign countries.  For this same reason, inflation-adjustments are calculated using U.S. inflation data.

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Even a quick perusal of a few investing references or media articles will leave you with the clear impression that stocks are “scary” and bonds are “safe”.  That seems to be the conventional wisdom.

But the conventional wisdom is predicated on the misleading idea that routine volatility equals risk.  And because stocks have higher routine volatility than bonds, stocks must be scary.  However, it turns out that routine volatility tells us remarkably little about our likely long-term outcomes when investing in these two assets.

For example, in my early February post, I wrote about the chances of losing inflation-adjusted money over various time periods, when invested in stocks (as represented by the S&P 500) versus bonds (as represented by the U.S. 10-Year Treasury Bond).  These two graphs tell the tale using Aswath Damodaran data going back to 1928.

By this measure, over almost any period of time, you have a greater chance of losing real money with bonds than with stocks.  That’s why some long-term investors, like me, view investing in bonds as the scarier choice.

Stocks Crash and Bonds Don’t?

Outside of technical measures like routine volatility, there’s also the general perception that stocks tend to “crash” a lot, while bonds don’t.  This view is understandable for anybody who’s been investing for the last 20 years because of the huge stock crashes of 2000, 2008, and smaller examples like the relatively brief crash of March 2020.  But even that view is a bit myopic.

For example, these two graphs show the nominal annual total returns of stocks and bonds sorted from lowest to highest using the same Aswath Damodaran data.

Stocks have gone up¹ in 73% of the years since 1928, while bonds have gone up in 82% of those years.  The difference amounts to just 8 more down years for stocks over 93 years.  Given the stock market’s scary reputation, you’d expect stocks to go down more often, but that’s not what history shows.

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The pages of Mindfully Investing make it clear that I’m fascinated with the whole topic of investing.  But the details of investment taxes exhaust me, mainly because the U.S. income tax system is so incredibly byzantine and tedious.

But boring things can sometimes be important.  Unfortunately, minimizing taxes is one of the few aspects of investing that we have some control over.  And seemingly trivial annual taxes (and other costs) can make a massive difference in the compounding of investments over time.  Each wave that crashes against a cliff may only move a few pebbles, but enough waves over time can cause a mighty edifice to crash into the sea.

Some Simple Tax Rules for Investing

Given my distaste for learning about taxes, I’m no tax expert.  And I’m certainly not providing any tax “advice” here at Mindfully Investing.  But personally, I follow a few simple rules that help minimize investment taxes including:

• Max out tax-advantaged retirement contributions first, and then invest any remaining savings in taxable accounts.
• Among tax-advantaged accounts, contribute first to any available employer retirement plan (like a 401K) up to the match level.
• Evaluate whether you will pay more in total taxes by contributing to tax-deferred accounts like Individual Retirement Accounts (IRAs) or after-tax “Roth” accounts.
• Consider how early withdrawal penalties and Required Minimum Distributions (RMDs) might impact the availability and taxation of your money as you age.

And here are a few more rules for investments in taxable accounts:

• Exchange-Traded Funds (ETFs) are generally more tax-efficient than mutual funds.
• Stock funds are generally more tax-efficient than bond funds.
• Stock index funds are generally more tax-efficient than actively managed funds.
• Minimize capital gains by limiting unnecessary sell events, for example when rebalancing.
• Stock funds that pay higher dividends usually produce slightly worse income tax outcomes.
• Avoid wash sales and short-term stock trading in general, which are taxed at higher rates.

As a non-expert with no appetite for tax details, I freely admit that my simple tax rules may be deficient in many respects.

International Stock Dividends

However, this year, as my tax statements were rolling in, I noticed one new detail.  Specifically, my U.S. stock funds produced mostly “qualified dividends”, while my Developed Market (excluding the U.S.) and Emerging-Market stock funds produced a lot of  “non-qualified” dividends.

Why do I care?  Qualified dividends are taxed at a lower rate than non-qualified dividends.  So, by investing in international stock funds in a taxable account, a larger portion of my annual dividends are taxed.  (Note that this whole dividend tax issue does not apply to tax-advantaged accounts where dividends aren’t taxed as they accrue.)

I’ve argued back and forth in past posts about the merits of investing in international stocks versus U.S. stocks only.  Over the years, I’ve concluded that diversifying a stock portfolio with international stocks is a good idea.  But you can certainly argue, as Warren Buffett and John Bogle have, that holding only U.S. stocks provides sufficient diversification.

So, I started to wonder whether the cost of the higher dividend taxes might outweigh the diversification benefits of holding international stock funds.  And that’s the question I want to address in the remainder of today’s post.

Dividend Tax Brackets

First, non-qualified dividends are taxed as ordinary income.  So, the amount of additional taxes you pay on non-qualified dividends depends on your income bracket.

This table shows the married joint-filing ordinary income brackets as compared to dividend tax brackets.  I used approximate income thresholds here to help match up the income and dividend brackets, which are slightly different¹.

Joint Filing Approximate¹ Tax Brackets	Non-Qualified Dividend Tax Rate (or Ordinary Income Rate)	Qualified Dividend Tax Rate	Difference in Tax Rates
$20K – $80K	12%	0%	12%
$80K – $171K	22%	15%	7%
$171K – $327K	24%	15%	9%
$327K – $415K	32%	15%	17%

The brackets go higher than $415,000, but these brackets are likely to be relevant to a majority of investors.  And I suspect most readers of this blog are in brackets less than $327,000, where you pay around 10% more in taxes on any non-qualified dividends (as shown by the range of 7% to 12% in the right-most column).

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