Image Source: Dimitris Kalogeropoylos
By Brian Nelson, CFA
Since joining the workforce after undergraduate studies, those that will be turning 30 years’ old during 2017 will have never witnessed a meaningful bear market, large down year, or even a substantial “correction” in the stock market during their working lives. That’s right — many workers that were born in the mid-1980s when Ronald Reagan was President are probably starting to believe that they’ve found the secret to investing success and that broader US markets only go up (or down just a little at times, but they always recover and go higher). No matter if this assessment of their opinion of the markets is true or not may not matter.
At the very least, it may be appropriate to say that this group of savers has yet to truly discover their risk tolerances, which in my opinion, can only be tested under adverse market conditions, and it’s also quite feasible that they may have unrealistic portfolio return expectations in light of the trajectory of the markets during the past several years. I ponder what might happen if the stock market gives back only a portion of the gains it has reaped in recent years. The S&P 500 (SPY) has more-than-tripled since the March 2009 panic bottom, amounting to a 200%+ cumulative return for the entire S&P 500 in just ~8 years. But what happens if the market starts to disappoint? Will there then be a stampede towards the exit? Are the markets today just building up for the next “crash” as investor expectations are reset? Possibly.
But many may say — markets always go up in the long run, right? Well, so far, but it’s not that easy. Indexers often champion their cause when the going is good (right now), as returns during the immediate 8-year look-back period have certainly been fantastic. It’s worth noting, however, that at the beginning of 2009, we were just starting to emerge from the worst financial catastrophe since the Great Depression, hardly a fair starting point to measure returns. In my view, the last 8 years reveal more about the benefits of timing the market, than time in the market, the latter many indexers hold dear. By my calculations, S&P 500 index returns haven’t been all that great if we look back just a bit further than the recent past. Since July 2000, for example, near the peak of the dot-com bubble, the S&P 500 has notched just a ~2.4% compound annual return since then, during the past 16-17 years (according to YahooFinance data that adjusts for dividends). That’s about what the riskless 10-year Treasury yields today, after years and years of expansionary monetary policy that has just begun to reverse. In case you missed it, the Fed plans to tighten three more times during 2017.
How wonderful one must think the stock market is if he or she launched their 401(k) in March 2009. On the other hand, how disappointed investors must be, by comparison, if an indexer had accumulated most of their savings by the dot-com peak. Timing is everything. Please forgive me, but I’m not going to refer to 200-year charts that show how the stock market has provided a mid-single digit annual return over the past two centuries (has it?), as I just don’t think this line of thinking is helpful. I used to love reading about historical returns, too (thanks Jeremy Siegel), but we need to get serious because this is your money — stock market returns prior to the invention of the computer, television, automobile, prior to the American Civil War? I think the financial industry is getting a bit ridiculous with their multi-century, backward-looking studies that always seem to somehow support their agenda, to keep your money with them over long periods of time. Don’t get me wrong — of course these studies are interesting and informative, and they may even be accurate (I haven’t audited them), but what I do know is that they’re not practical — and what’s worse, new regulations appear to be forcing financial advisors to put more and more investors into index funds. Frankly, it has me scared.
Someone said rushing in as an indexer in today’s market is like rushing into the elevator with everyone else just to go down. You see–indexing is not investing. Indexing is speculating on a basket of stocks, buying and holding them at any price regardless of what their intrinsic value is. Indexing is like driving a car with your hands off the wheel looking only at the rear-view mirror to gauge your future direction. As an indexer, you’re not in control, and you are using the past (what’s behind you) to determine what may be ahead, as indexers use historical returns as justification (evidence) behind the “prudence” of a strategy. To me, driving blind will always be a recipe for disaster–and I’m worried investors may be spending more time thinking about how much they pay for groceries, or at the gas pump, or for that new refrigerator than they do reasoning through what they are doing with their savings. To me, indexing, which amounts to buying “everything” in the index at “any price” and holding it “regardless of what happens” is just not prudent. It’s just a form of speculation. Maybe the worst kind?
No matter what you may have heard or believe, timing is so important when it comes to investing–and while “everybody” says you can’t time the market, I believe that reasonable investors can and have. During the Financial Crisis, it was pretty clear that the stocks of great companies were beaten down unfairly. During the housing bubble, it was pretty clear that with all the “liar loans” everybody knew about, housing prices were way too high. During the dot-com bubble, Internet stock prices were getting way out of whack–and now today, the forward price-to-earnings ratio on the S&P 500 is 17+ times, well in excess of its 10-year average of ~14.4 times. Yet, hordes of pundits will tell you to leave your money alone no matter what, for what might be the beginning of another 16-17 year period where returns are ~2.5% like those starting from the dot-com peak? Is this what prudent pundits are now advocating? Without a doubt, how to allocate one’s capital is as difficult a decision today as it has ever been.
Complicating matters is that we have a President-elect Donald Trump that may make it his personal agenda to drive the market ever higher in any way he can during his administration. He is a competitive spirit, and he doesn’t like losing. His rhetoric is working thus far–and if the incoming administration is successful in cutting the corporate tax rate, the “bubble” that we are currently experiencing could continue to inflate, arguably through much of the Trump administration. If you may recall, Alan Greenspan in a televised speech on December 5, 1996, coined the term “irrational exuberance,” but it would be another 3+ years of strong stock market returns before that “bubble” finally burst at the beginning of this century, the starting point of the period of meager ~2.4% compound annual returns (2000-2016).
What I’m trying to say is that the market is overheated today, but it could continue to get even more overheated in coming years–and with political influence and potential changes in tax and accounting treatments on the horizon, “Utilities and Telecoms to Benefit the Most from Corporate Tax Reduction,” it’s even becoming more and more difficult for analysts to predict corporate earnings without tying probabilities to them influenced by an assessment of whether political initiatives and changes to the tax code will come to fruition. Stock analysts have become political analysts more so today than perhaps in any other time in history. This can’t be a good thing, and I don’t think what we’re witnessing in terms of valuations across market sectors in the context of contractionary monetary policy is sustainable.
At some point, contractionary monetary policy will come home to roost in the form of higher discount rates applied to stock valuations. Right now, stock prices and interest rates are moving in the same direction, which simply doesn’t hold water. I’m also starting to believe that the labor force is getting a bit tapped out in light of some statistics I’ve come across. I read that more than half of US companies “state that they have few or no qualified applicants for their openings,” coincidentally at a 17-year high. It seems very likely that the Trump administration may still help to fuel US GDP growth through infrastructure investments, benefiting “old economy” companies, but he has also thrown out some rather harsh rhetoric toward defense spending, pointing at Boeing’s (BA) Air Force One and Lockheed Martin’s (LMT) F-35, in particular. Please be sure to examine how sector returns have shaken out during the past few weeks, “Returns Following the Trump Victory,” if only to get a feel for the change in sector leadership, now financials and energy–two sectors that were responsible for a lot of pain during 2008-2009 and 2015, respectively. With now everything having rallied considerably, is this the beginning of the end for this now-7+ year bull market?
You may not believe this, but we really don’t care what the answer to that question is, as it neither changes our game plan nor the Best Ideas Newsletter portfolio’s path to long-term success. We’re going to continue to highlight undervalued, strong companies for consideration, and add the very best to the Best Ideas Newsletter portfolio when we think the time is ripe. The latest additions to the Best Ideas Newsletter portfolio, General Motors (GM), Berkshire Hathaway (BRK.B), and the SPDR S&P Dividend ETF (SDY), have been solid performers, and we plan to continue to add opportunistic ideas, but only at the right price. That being said, we’re also letting a lot of our winners run in the spirit of the Valuentum methodology, but we’re watching those same companies, too, and view them as a source of cash should their equities get too “extended.” These are exuberant times, in my opinion. I hope that you enjoy this December edition of the Best Ideas Newsletter.
[The December edition of the Best Ideas Newsletter was released December 15.]
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Podcast: FALLACY of Index Funds!
The Valuentum Analyst team digs deep into the logical fallacy that paved the way for index funds, and the very real risks investors take while driving with their hands off the wheel looking only through the rear-view mirror.