This essay’s title was inspired by – and is paraphrasing – a question emailed to me by a client last weekend. Given the current obsession the media and investors seem to have with forecasting and sidestepping the next big correction (which cannot be forecast with any consistency, much less timed), it is indeed, time to protect investor portfolios from the next big decline. Remember, the financial media is not merely incapable of providing prudent financial guidance to investors -- it has NO interest in doing so, as its sole objective is to encourage more viewership and clicks on its stories to maximize advertising revenues. Fewer outlets do more than the media to destroy investors and their plans.
“If I’d only followed CNBC’s advice, I’d have a million dollars today…Provided I’d started with a hundred million!”Jon Stewart
The first layer of portfolio protection should begin with revisiting Fusion’s credo for long-term success: All successful investments are goal-focused and planning-driven, such that all successful investors are continuously -- ALWAYS -- ACTING on a plan. All failed investments are market-focused and performance-driven, such that all failed investors are continually – episodically – REACTING – to current events, financial media and short-term forecasts/market moves.
The second layer of protection is to revisit some facts about corrections (declines of at least 10% from a previous high), bear markets (declines of at least 20%) and recessions (two consecutive quarters of economic decline):
- Since 1980, there has been an average peak-to trough correction of nearly 15%, annually.
- Since the end of WWII in 1946, we have had about 60 corrections (1 every 13 months) and 14 bear markets (with declines averaging 30%) with one occurring every 5-6 years.
- During these 74+ years when stocks were correcting 60 times and experiencing 14 bear markets, the S & P 500 soared from 15 to 4400, an increase of about 300 times (the dividend went from 70 cents to $60, up about 85 times). A $1million investment in stocks went from paying a dividend of $47,000 to paying one of $3.9 million now and the value of the $1 million today is $300 million!
- During these 74+ years while the economy was experiencing 12 recessions (we experience one about every 6 years), real – inflation-adjusted -- GDP (total value of US economic output) went from $2 trillion to about $23 trillion. That is a multiple of more than 11 times in a country whose population has grown less than 3 times, so real GDP growth per person has been extraordinary.
- Bear markets tend to be short-lived. The average bear since 1929 has lasted less than 10 months and declined about 35%.
- Since WWII, the average time from a peak in the market, to a trough and back has been about 3 years. Last year’s round trip (decline began in February and new highs were again reached in August) was exceptionally short – about 6 months.
- In the past 20 years, 60% of the market’s strongest gains took place in bear markets. Another 32% of the strongest gains happened in first two months of the new bull – before we knew the bull had begun.
“When an investor focuses on short-term investments, he or she is observing the variability of the portfolio, not the returns – In short, being fooled by randomness.”Nassim Nicholas Talib
Author The Black Swan
The third layer of protection is understanding that the only way one has ever experienced a permanent loss in the stock market (i.e., S & P 500) is when one has humanly manufactured a permanent loss by selling into a temporary decline (the only kind ever experienced). The stock market, near all-time highs, has never caused the loss -- the investor’s behavior always has.
No one should be faulted for feeling a very human impulse to try and get out before something bad happens, as that impulse is innate in all of us. But it’s just that: an impulse, because getting out is at best half a strategy. In the absence of a strategy for re-entry, one will just wait until they feel the impulse to get back in. The odds that these two impulses, acting in sequence, will yield results better than the market return are prohibitive to the point of impossibility. Human nature cannot absorb this and so it will repeat these mistakes always and often in the absence of an empathetic, but tough-loving behavioral investment counselor – please pardon the shameless plug!
What is the Cost of Trying to Exist Stocks Before Corrections/Bear Markets/Recessions?
According a 2021 Dalbar study, global stock portfolio returns averaged 8.29% annually over the 20 years ending 12/31/20 while the average individual fund investor -- largely due to trying to time the market and other bad investment behaviors – earned only 5.96%. Over 30 years, the period of time an average couple will spend retired, these behaviors could cost investors over $5 million (for every $1 million invested) in wealth. The cost is far greater when considering the premature taxable gains generated and the interrupted dividend growth. That outcome is catastrophic to almost anybody’s financial future.
In sum, if one can’t stoically watch their stock portfolio appear to disappear to the tune of 15% each year and about 30% every 5-6 years, one cannot be a successful equity investor.
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”Peter Lynch
Storied Manager - Fidelity Magellan Fund
What if we experience an unprecedented event causing a big drop?
The word unprecedented is defined as something that has never happened or existed before. Notwithstanding this definition, The American investor thinks it means something that poses an insoluble problem that will permanently impair the value of their investments and lead to financial ruin. Among the many unprecedented events in modern history are WWI, Atomic bombing of Hiroshima and Nagasaki, Cuban Missile Crisis, 1973 oil crisis, largest one day market drop in 1987, Y2k, 9/11, the first ever downgrade of US Sovereign debt from AAA to AA in August 2011, Brexit, and most recently the Coronavirus and associated shut down of the entire US economy. The reality is that things that have never happened before happen all the time and our entire history is devoid of one example of what investors fear most – the inability to “survive” such events and subsequent personal financial destruction --- having ever happened. The fear du jour relates to the willingness/timing of raising the US debt limit and avoiding a “fiscal cliff.” (2012 redux….)
Successful investing is a tug of war between our fear of the future and our faith in it. This war is often only won when a behavioral investment counselor is tugging on the investor’s behalf at anchor. Success is 99 parts temperament (what we do) and 1 part intellect (what we know). Most investors and advisors think it is the opposite. Regardless of how much one knew, if they sold out some or all of their stock portfolio in response to any of the above-mentioned events, they failed. We can invest to satisfy our emotional wants (very little portfolio volatility) or our financial needs (having a high probability that our money will outlive us and not the opposite) but we cannot do both. One must decide on which end of their financial life they are willing to accept insecurity so that they may have security on the other end!
“Don’t bet on the end of the world ‘cause that only happens once and something that happens once in infinity is a long shot.”Art Cashin
UBS, Director NYSE Floor Operations
Debunking the Myth that the Market is Too High – A Rational Perspective
There are many misleading narratives created by the investment industry and the financial media that supports it. For example, TINA – meaning stocks are up only because bonds offer no yield, so There Is No Alternative; stocks are artificially being propped up by all the money the fed has pumped into the system; PE ratios are 21, which is too high and indicates stocks are too expensive, the political climate is too risky, etc... If true, how did stocks rise from 15 in 1946 to 4450 today, in the absence of these conditions over much of the history?
As it relates to the health of companies, according to Factset, the percentage of S & P companies beating earnings-per-share estimates in the most recent quarter (87%) is a record high – the highest since Factset began tracking this metric in 2008! Similarly, the blended earnings growth rate of 90.9% is the highest year-over-year earnings growth rate reported by the index since 2009’s 4th quarter.
As for the consumer, US Household net worth, topping a record $136.9 trillion, is at record highs – nearly doubling from a decade ago -- and a recent measure of consumer debt as a percentage of disposable income is at record lows not seen for 40 years. The American consumer is the wealthiest and most liquid it has been in 4 decades. In an overwhelmingly consumer-driven economy, this is extremely positive.
With respect to the US economy, the current value of all goods and services produced (GDP) is not only above pre-covid levels, but at an all-time record high near $23 trillion. Moreover, largely due to extreme underinvestment in housing since the 2008-2009 financial crisis, the National Association of Realtors reported a study by Rosen Consulting Group showing a 5.5 million-unit housing shortage that will require building approximately 2 million more units a year, for 10 years, to fill the gap. This might create 2.8 million new jobs, and generate more than $400 billion in economic activity. While it is possible that this major economic tailwind is already in the price of everything, my suspicion is that little if any of it is currently reflected.
Corporate, consumer and economic prosperity have rarely, simultaneously been this strong. If this backdrop paired with record low investor sentiment readings and near record cash levels of $20 trillion on the sidelines is not a recipe for much higher stock prices for the better part of this decade, I don’t know what is!
As it relates to the current market valuation levels, the first thing to note is that neither valuation, nor any other variable is an effective market timing tool. At 4,450, the forward price-to-earnings (PE) ratio is 21.5X while the 25-year historical average PE is about 16.5. But, when we consider that the 10-year treasury yield is 1.4% and it’s 25-year historical average is 4.5%, stocks look undervalued.
The earnings yield (Earnings/Price – today, we buy $200 in earnings for 4,400 in current price) of the S & P 500 – an easy way to compare stocks to bonds in yield terms -- is currently 4.5%. This tells us that for each $1,000 invested in the S & P 500, we get earnings of $45, getting $1,000 back in 22 years. A $1,000 investment in the 10-year Treasury generates $15 income. Therefore, it takes almost 70 years to get $1,000 back and somehow investors fear that stocks are the overvalued asset class! The 10-year treasury has historically sold for 23X earnings and currently sells for close to 70X.
The long-term average S & P 500 earnings yield is 4.75%. Today’s 3% excess earnings yield (4.5% for the S & P vs. 1.5% for the Treasury) over the 10-year treasury yield implies stocks represent a very good relative value. Historically, the gap between the earnings yield and treasury yield has been very narrow.
Is the market really too high – a contextual framework?
Investors, having seen the market (S & P 500) grow from 700 in March 2009 to 4,450 today, believe the market must pull back due to that recent 12-year plus run (over 16% annually). But what if we choose to consider another clip of time? Let’s call it the 21st century, so far, from January 2000 through June 2021.
From January 2000 to March 2009, the market averaged negative five percent (-5%), annually. So, the return for the entire century, so far, has been 7% annually as compared to the Ibbotson 1926-2020 reported average of 10%, annually. Looked at it this way, the market is still playing catch-up – progressing towards its nearly 100-year average. It likely has a long way to go! This is what the market does, it runs below trend for many years and above trend for many years. Those who focus on the sharp up and down movements around the permanent uptrend line, miss the permanent long-term returns, as they get fooled by the temporary variability.
What about investor sentiment and the secular bull?
We are still, as Fusion has counseled since 2015, in the midst of the third and greatest secular bull market in history. The first one began in 1948 and ended in 1968 in anticipation – and ultimate bursting of -- the “nifty fifty” stock bubble. The second began in 1982 and ended in response to the technology, telecom, dotcom bubble in 2000. This one began in March 2009 and will only end as the others have – when all investors are consumed with the fear of missing out (FOMO) on the next equivalent of the dotcom bubble. The most recent CNN Business Fear & Greed index showed a reading in the 20s (indicating extreme fear). Until investor fear turns decidedly to FOMO, this bull has a long way to go -- it will likely continue for the better part of this decade and several thousand more S & P 500 points (north of 7,000 on the S & P). We will experience many more corrections and perhaps another cyclical (short-term) bear market along the way, but another 2000-2002 or 2008-2009 bear is likely far off in the future.
Google searches for “stock market bubble” reached an all-time high in January. When such searches approach zero, we can begin to expect that we are in a bubble about to burst, but until then, please buckle up and enjoy the ride.
A game can be played to win or played not to lose. The game of investing is almost always -- and only -- lost when played not to lose. Left to its own devices, human nature always plays not to lose and is always a failed investor.
Fusion will keep coaching and playing to win for our clients – Wishing everyone a wonderful Fall season!