As we prepare to turn the calendar to 2025, equity investors have good reason to feel rather euphoric. The S&P 500 Index has returned almost 29% year-to-date, on a total return basis, as of December 10. Moreover, this result follows a 26% return in 2023. During the past five years, the market returned 15.85% on an annualized basis; over 10 years, the compounded annual return has been 13.4%; and the annualized figure for 15 years is 14.2%.

Before uncorking the champagne, let’s stay sober for a moment and consider some of the portfolio implications of such a dizzying rise in large-cap US stocks. On a valuation basis, the S&P 500 Index has only rarely been less attractive in its entire history. Goldman Sachs Research reports that, in trading at a forward P/E multiple of 22 times earnings, the market is more expensive than during 95% of its history; on a price-to-book-value or cash-flow-yield basis, it’s even more expensive.

Based on these lofty starting valuations, David Kostin, chief US equity strategist at Goldman Sachs Research, projects that the annualized index return over the next decade may be only approximately 3% (the historic average annual return is nearly 11%). He notes that the return could be as high as 7% if you exclude the variable of stratospheric market concentration—the top 10 stocks account for a record concentration level of 36% of stock market capitalization (in other words, an equal-weighted S&P index investment should outperform a market-weighted one over the coming decade).

The magnificent 10 are outstanding, highly profitable companies, but they are, in aggregate, priced at about 31 times earnings, a level that is unlikely to be realistic for some of them. As Kostin explains, “History shows that the number of companies that can actually deliver 20% growth year after year after year after year fades dramatically and almost no companies can continue to do that over a decade.”

We’re not predicting a crash, recession or lost decade (or predicting anything really)--and we’re certainly not advocating market timing. But based simply on current market valuations (and we would include high-yield bonds in this discussion since their spread-to-worst as of November 30 was just 3.1% vs. a long-run average of 5.6%, according to JP Morgan), we do think it makes sense to seek more diversification in the portfolio, including with an allocation to alternative asset classes.

The Lost Decade

Since most of us, as investors, are afflicted by recency bias—the tendency to favor recent events over prior ones and to extrapolate the recent past into the future—it makes sense to step back and ponder some market history. For example, if investors simply decide that stocks are worth only 16.8 times forward earnings projections—the 30-year average multiple, according to JP Morgan’s research—that would imply a decline of nearly 25% in stock prices. Frothy valuations may not be too useful as a timing tool for tactical trading in the market, but over extended periods of, say, 5-10 years their usefulness as a metric grows.

In addition, most of us are old enough to have experienced a “lost decade” for stocks. During the 10 years ending on December 31, 2009, clobbered by the puncturing of the tech bubble and the crash amid the Global Financial Crisis, the S&P 500 Index’s return on a cumulative basis for stocks was minus 9% and only 9% over the same decade when including reinvested dividends. The performance of the tech-laden NASDAQ Composite was much worse: It declined by 44% during the “lost decade” of 2000 to 2009.

There are a variety of alternative asset strategies available to investors, of course, but one worth considering is a long-short fund, in which a portfolio manager can sell short stocks that he or she perceives are overvalued and buy and hold long positions in stocks the manager feels are undervalued. Handled skillfully, a long-short portfolio is a type of absolute return strategy that both dampens market volatility and dramatically cuts downside risk during the inevitable bear market bouts.

For example, let’s examine the performance of long-short hedge funds during the same 10 years that was a “lost decade” experience for long-only investors in large-cap US stocks. The Eurekahedge Long Short Equities Hedge Fund Index, an equally weighted index of 1,134 constituent funds, nearly tripled in value during a period when the S&P 500 Index’s cumulative return was just 9% on a total return basis.

Hedge funds, of course, have certain drawbacks such as high investment minimums, lack of liquidity (e.g., long lock-up periods), and relatively low levels of transparency and disclosure. Fortunately, today there are regulated 40 Act funds available for retail investors with daily liquidity and low investment minimums. Long Short Advisors (symbol LSOFX) is one such fund with a strong, consistent track record, a seasoned investment team and low investment minimums.