The Greater Fool Theory says it’s okay to pay inflated, or even outrageous, prices for assets because while it may be unwise, a “greater fool” will come along and buy them from you at even higher prices. The problem is, being the greater fool can be one of the costliest mistakes investors can make, and it’s impossible to know who will be the last to the trough.
It is understandable why younger investors, or anyone looking to put fresh capital to work, might feel hopeless in their efforts to avoid being the fool. Three out of five young Americans don’t think they’ll ever be able to own a home.¹ The median price of a house sold in the United States ballooned to $420,400 in the third quarter, nearly 50% higher than just a decade ago.²
At these inflated levels, home ownership may not turn out to be the powerful engine of wealth creation it’s historically been. As Ben Graham liked to say, “price determines returns.” And with house prices now at a 42% premium to their 20-year average, it’s hard to imagine our homes producing the type of returns we’ve come to enjoy in the past. And that’s to say nothing of the monthly carrying costs.
Housing isn’t the only market potentially too ritzy for new money. Large growth stocks (which include the so-called Magnificent Seven tech names) currently sport a price/earnings ratio of 28. This valuation is 46% higher than the 20-year average — an even higher premium than homes.
So, with no house or blue chip stocks scratch two of the most common routes previous generations used for wealth creation.
Is it any surprise that young investors have flocked to some alternative asset classes, like crypto currencies or private equity? If you’ve made some quick crypto cash, good for you. As for private equity, you may have already started to learn more about the impact of “cost of capital” than when you initially invested. You’ll likely learn more about “liquidity” at some point as well.
How Can Youngsters Get into the Fight?
First, reflect on the weapons at your disposal. The most powerful is likely time — time to allow an investment to unfold and work through any short- to medium-term turbulence.
Second, many beneficiaries of the astounding growth we’ve seen will want to have their cake and eat it too. However, desire to avoid the taxman will prevent some who have benefitted from inflated valuations from ever realizing the growth. They will hold onto overvalued shares simply because they don’t want to pay taxes on the gains. The good news for new investors is that you’re not in this trap. You can simply go where the opportunities are most attractive.
Last, your willingness to rebel against common wisdom is an asset. Markets, like fashion, tend to work in cycles (the rumor is that skinny jeans are toast). It’s young people who usually start the trends in fashion. In the markets, however, a lack of familiarity can prevent a similar dynamic from taking shape. While your parents and grandparents are adamantly hanging onto the skinny jeans of the stock market, chances are you’ve already reloaded much of your wardrobe. We believe that’s the way you should approach the market as well.
So Where to Go?
Look at the charts below, which were produced by The Leuthold Group. The first chart highlights the S&P 500. Each dot shows the intersection of the price/earnings ratio (bottom) and the future 5-year returns (left side) from that price. At a starting price/earnings ratio of 28.4, which is where things stand today, the median 5-year forward annual returns for large stocks has been less than 4% (see dotted arrow) — predicting a not so bright future for the “skinny jeans” of the market.
Source: @2024 The Leuthold Group. Data from 1995 to 2024. The data in this chart represents the S&P 500 median normalized P/E ratio vs. 5 year forward returns for the S&P 500 Equal Weighted Index 5 year annual price return. The S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. The S&P 500 Equal Weight Index (EWI) is the equal-weight version of the widely used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight - or 0.2% of the index total at each quarterly rebalance. All indices are unmanaged. It is not possible to invest directly in an index. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
By contrast, let’s look at the same data for mid-cap and small stocks. At a slightly lower multiple of 26.1 times earnings, history would indicate that mid-cap stocks can expect a forward annual return of just under 8% over the next five years (see dotted arrow). And below that, you can see small stocks, trading at an even lower multiple of 24.1, have historically produced annual returns of more than 10% at these levels.
Source: @2024 The Leuthold Group. Data from 1995 to 2024. The data in this chart represents the S&P MidCap 400 median normalized P/E ratio vs. 5 year forward returns for S&P MidCap 400 Equal Weighted Index 5 year forward annual price returns. The S&P MidCap 400 Index is a group of 400 domestic stocks chosen for their market size, liquidity and industry group representation. The S&P MidCap 400® Equal Weight Index (EWI) is the equal-weight version of the S&P MidCap 400. The index has the same constituents as the market capitalization weighted S&P MidCap 400, but each company in the S&P MidCap 400 EWI is allocated a fixed weight. All indices are unmanaged. It is not possible to invest directly in an index. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
Source: @2024 The Leuthold Group. Data from 1995 to 2024. The data in this chart represents the S&P SmallCap 600 median normalized P/E ratio vs. 5 year forward returns for S&P SmallCap 600 Equal Weighted Index 5 year forward annual price returns. The S&P SmallCap 600 Index is a group of 600 U.S. stocks chosen for their market size, liquidity and industry group representation. The S&P SmallCap 600® Equal Weight Index (EWI) is the equal-weight version of the S&P SmallCap 600. The index has the same constituents as the capitalization weighted S&P SmallCap 600, but each company in the S&P SmallCap 600 EWI is allocated a fixed weight. All indices are unmanaged. It is not possible to invest directly in an index. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
This shouldn’t come as a big surprise: The valuation for mid value is only 8% higher than its 20-year average, which pales in comparison to the premium at which large-growth stocks are trading. Prices of small value stocks seem to be cheaper still, at a 3% premium to their 20-year average.
Small- and mid-cap stocks — particularly value— seem to represent the valuation salvation that new investors should covet. Add in the fact that their parents have shunned this part of the market for some time, and you have an enticing combination.
The Greater Fool Theory asks you to stomach frothy prices counting on someone to make a worse decision than you when you sell. Perhaps it’s time to be the Greater Sage and seek out attractively priced assets with the potential to outperform over the long term.
1 “60% of Gen Z Adults Worry They Might Never Own a Home,” New York Post, July 10, 2024.
2 Median Sales Price of Houses Sold for the United States, Federal Reserve Economic Data, St. Louis Fed.