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For investors, there's a hurricane coming. What you should do now

A law enforcement officer directs traffic at a checkpoint, preventing residents of the Florida Keys from returning to their homes following Hurricane Irma on September 11, 2017 in Homestead, Florida.

GASTON DE CARDENAS/AFP/Getty Images

Hurricane Irma demonstrated a surprising feature of human nature: Even with potential calamity bearing down on them, a significant number of people refused to budge.

Put up your hand if you spot a parallel with today's stock markets. To be sure, there's nothing as cataclysmic as a Category 5 hurricane bearing down on our portfolios. But we live in perilous times, with many prominent voices warning of trouble ahead.

"Prices are elevated, prospective returns are low, risks are high," Howard Marks of Oaktree Capital Management wrote a few days ago. Mr. Marks, a widely followed investor, is not urging investors to run, but he is suggesting that "people should be taking less risk today than they did three, five or seven years ago."

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Read more: Hurricanes will buffet U.S. economy for months to come

You could populate a small phone directory with all the other notables making similar cases. It's easy to see why. The most reliable market yardsticks, such as those that gauge stock prices against their replacement value (the q ratio) or measure them against their past decade of earnings (the cyclically adjusted price-to-earnings ratio), indicate shares are very expensive.

What makes the current landscape especially frustrating is that everything looks overpriced. Unlike the dot-com era, when many assets were still reasonably valued despite the insanity in the tech sector, no investment looks obviously cheap today.

Elevated prices leave even top-notch money managers with few alternatives. Seth Klarman, one of the most successful value investors of recent decades, intends to return capital to his investors this year because of a lack of opportunities. GMO, an influential money manager in Boston, predicts every major asset class, outside of emerging markets, will lose money in real terms over the next seven years.

So why are so many investors still sticking around? Hurricane Irma demonstrates just how difficult it can be for people to respond to dangers, especially when there's no clearly preferable alternative.

Many residents who refused to leave Miami said they had been through similar storms in the past. They pointed out that fleeing involved its own dangers, from being caught on the road to coming back to a looted home.

Those are valid points, especially to those who have seen past storms blow past. "We are raised not to take them seriously," wrote Jennine Capo Crucet, a Miami-bred novelist, in a New York Times article urging people to flee. The problem, she said, was that every Miamian grows up with a list of comforting rationalizations about hurricanes: "It will turn at the last minute, there's no reason to cancel school, this is just a way for supermarkets to make money."

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Today's investors are striking a similar attitude. They've heard warnings about this bull market for years and many have prospered by ignoring the alarms. With bond yields at such miserly levels, there's no obviously better alternative to stocks. And with the global economy on the upswing, an immediate correction seems unlikely. The result is widespread complacency.

The confidence indexes compiled by the Yale School of Management demonstrate this odd psychology. Roughly three-quarters of individual investors expect stocks to go up over the next year. However, only 37 per cent of individual investors believe the market is reasonably priced, the lowest figure since the days of the dot-com bubble.

To put it bluntly, many people think the market is frothy, but are counting on stock prices to rise anyway.

The high hopes strike observers such as Mr. Marks as nonsensical. "It would be sheer folly to expect to earn traditional returns today from investing like you've done traditionally," he warns.

He lays out some possible paths for investors to take. One is to gamble on special niches where you feel that you, or your chosen manager, have an edge. Another is to reduce risk – and potential returns – or even go to cash. Yet another is to stick to what you've been doing and simply accept that lower returns will be the rule going ahead.

None of these options is obviously attractive. But they do point to the need for investors to consider potential storms ahead.

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One excellent question to ask is what would happen if your current assumptions prove to be wrong. With luck, a burst of growth will ease this expensive market back into more reasonable territory. But if there is a tempest ahead, it's important to know your financial plan is strong enough, and your expectations conservative enough, to withstand it.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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