Overvalued Markets and What You Can Do About Them

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) is essentially flat over the last 12 years, but that doesn't mean it's due for big returns anytime soon. Valuations are what set up high future returns, and -- depending on how you measure them -- stock valuations aren't cheap these days.

And don't expect anything from bonds. Interest rates are practically guaranteeing negative future returns after inflation.

So what's an investor to do?

Last week, I sat down with Robert Arnott, CEO of Research Affiliates and one of the most influential investors of the last decade. In his mind, markets are priced to deliver "anemic" returns for the foreseeable future.

Given those expectations, here's how Arnott thinks average investors should navigate today's financial markets (transcript follows):

Morgan Housel: So, given those low levels of future returns, would you say that the S&P 500 is overvalued today?

Robert Arnott: Relative to bonds, the S&P is not overvalued. Relative to expectations, it is, and so which prevails? Which is going to drive the pricing? My personal view is moderately bearish on stocks. I think they are moderately overvalued, but not all over the world. Emerging markets, I think, are reasonably priced.

Morgan Housel: Do you think from the stock market we will have essentially a flatline 1% real return, or do you think it'll be a boom-bust cycle of roaring bull markets followed by crushing bear markets that, over the long run, evens out to a lower run?

Robert Arnott: It'll be the latter. The notion of a lower return -- a lower normal return for stocks -- doesn't mean that the bull and bear market cycle stops and the market goes on a straight line; it never has, it never will. But if you have 20% bull markets and 15% bear markets, you're going to have 1% average returns. If you have 30% bull markets and 10% bear markets, you're going to have high single digits. It's that simple.

Morgan Housel: So what should the average investor at home be doing to navigate around these markets?

Robert Arnott: The first and most important thing that people urgently need to do is ignore the fact that yields are low and that the government wants us to save nothing and spend everything; do the opposite. Cut your spending, increase your savings and investments, because you need it in order to make your future dreams come true. People can't earn money on assets that they haven't first saved. You have to save first and then invest. That is a given. The mainstream markets that most people rely on -- what we would call a two-pillar approach to investing mainstream stocks and bonds -- they're priced to give us really anemic returns. A balanced classic 60-40 portfolio is priced to give us maybe 1% above the rate of inflation; net of taxes, you're down to zero.

So if you're looking at mainstream markets that are priced to give us horrible rates of return, isn't it time to broaden our horizons and look elsewhere?

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