In a bull market, many investors come to believe that risk is synonymous with reward. “You’ve got to be in it to win it” or “If you don’t take chances, your wallet will forever remain empty.”
In a bear market, the truth about risk is revealed. Specifically, steep financial losses are neither rewarding nor easily recovered. The average descent? 30%. And the average time to recover? Approximately three-and-one-quarter years.
So, if an average bearish downtrend occurred right now, the S&P 500 would trade in and around the 1670 level; the Dow would trade near 14,700. (Note: The last two bear markets produced 50% price declines. If recent history came to pass, the S&P 500 would trade near 1200 and the Dow would trade near 10,500.)
All things considered, watching one’s portfolio revert to a value last seen in October of 2013 might not be so bad. The buy-n-holder with $500,000 who insisted he/she would keep the all-stock portfolio through thin and thick would still have $350,000. And, based on the averages, it would only take until June of 2020 to get back to the $500,000 break even point.
On the flip side, might there be a different approach to managing the real risk of financial loss during one of the most overvalued stock markets ever? If one avoids over-committing to stocks when the asset class resides at exorbitant valuations as well as all-time price peaks, either by trimming positions to raise cash or pocketing cash from outside resources, might one be better situated for buying bargains? Indeed, where one begins his/her ownership journey ultimately determines the total return outcome.
For example, based on the cyclically-adjusted P/E ratio (a.k.a. “PE10” or “CAPE”), forward 20-year annual stock returns are odious. Robert Shiller’s data dating back to 1870 find that buying and holding for the next 20 years might only offer 0%-1% annualized gains.
Keep in mind, these sub-par results are nominal. There are zero instances where investors experienced inflation-adjusted gains over 20 years (going back to 1870) when the PE10 surpassed 22. We are currently sitting at a PE10 of 29.
Shiller’s PE10 (CAPE) has its detractors. Yet, 12-14 other widely regarded valuation measures regard current stock prices as the 1st, 2nd or 3rd most elevated in history. Only the infamous crash in 1929 and dot-com mania in 2000 serve as competition.
Valuation naysayers are doing everything in their power to explain why this time is different. Even Warren Buffett downplayed his comments from 2001 on the importance of market-cap-to-GDP as a valuation methodology. (Note: Market capitalization-to-GDP, often called the “Buffett Indicator,” places February of 2017 as the 2nd priciest on record.) What’s more, the Oracle of Omaha recently claimed that ultra-low interest rates put 2017 stocks on the “cheaper side.”
I wish this were true. In the two-decade span between 1935 and 1954, however, investors enjoyed similar ultra-low interest rates. Yet valuations were one quarter to one half more reasonable in those two decades than they are here in 2017. Additionally, between 1935 and 1954, stocks still experienced four bear markets – 1937-1938 (-49%), 1938-1939 (-23%), 1939-1942 (-40%), 1946-1947 (-23%).
Yet this time is different, right?
Maybe not. The current equity risk premium (ERP) – the excess return for investing in stocks over risk-free ultra-low yielding treasuries – is a frighteningly skimpy 1.55%. (This takes into account the GAAP E/P at 4.0% and the 10-year yield at 2.45%.) Stocks tend to perform far better in periods when the ERP is greater than 3.0%. By way of comparison, an investor’s equity risk premium for choosing stocks over the risk-free rate of 10-year U.S. treasuries was closer to 4.5% in 2010.
Entering 2000, the financial media, analysts and gurus completely disregarded traditional valuation measures for stocks because we were living in a “New Economy.” Internet stocks were unique and the investing public needed to value them differently in the 21st century. That proved to be a monstrous mistake for hold-n-hopers of NASDAQ darlings. Entering 2008, the financial media, analysts and gurus showed disgust for traditional real estate valuation because the asset class had never gone down in value on a national basis. That too proved to be a monumental misstep with respect to understanding bubbles.
Here in 2017, the rationale for buying more stocks right now goes something like this: (1) Stable, low interest rates cannot be beat, (2) Even if rates should gradually move higher, President Trump’s fiscal stimulus (e.g., tax cuts, defense spending, infrastructure improvement, etc.) will make up for any borrowing cost challenges, (3) Even if Trump’s plans fall short, the Federal Reserve will do whatever is necessary to support stock prices, preserve the wealth effect, and guard against a severe sell-off.
So, then, what could possibly go wrong?
For starters, ultra-cheap borrowing costs that do not continuously move lower eventually meet the law of diminishing returns. According to the National Association of Realtors, record high home prices and slightly higher mortgage rates here in 2017 are keeping potential home buyers on the sidelines, as pending home sales dropped to the lowest level in a year (down 2.8%). Equally worthy of note, the S&P 500 made no progress for nearly two years between mid-December of 2014 (when the Fed’s last asset purchase from “QE3” settled) and early November of 2016. Borrowing costs remained subdued throughout the period with the 10-year yield between 1.5%-2.5%, yet the mere possibility of Federal Reserve tightening gave investors fits and starts.
Perhaps obviously, stable interest rates, even those that remain historically low, had been meeting resistance. Then came the wild card, President Trump. From the first day of trading after the election to the last day of trading in February, the S&P 500 has closed every session above its 50-day moving average. The 14%-plus surge has been utterly jaw-dropping.
Fortunately or unfortunately, presidents have far less control over an economy than people think. The power to spend? Congress. The power to cut taxes? Congress. The notion that Republicans in Congress will agree with one another across the board, let alone agree with President Trump on everything from a debt ceiling increase by mid-March to a domestic infrastructure overhaul to a comprehensive tax revamping, is far-fetched.
Should an investor simply rely on faith? Even when interest rate stimulus meets the law of diminishing returns? Even when expectations for massive fiscal stimulus from Congress/Trump is overdone? Historically, faith in ever-increasing asset prices (e.g., stocks, real estate, etc.) during periods of valuation extremes has been misguided as well as financially devastating.
Bulls are betting that any and all pullbacks will continue to be buying opportunities. They’re betting on the Federal Reserve to act as a backstop should Congress/Trump fail to launch an economic mega-boom. Indeed, if the Fed aborts its pledge to hike overnight lending rates three times in 2017, “buy the dip” may work swimmingly.
On the flip side, there’s no way around nearly 150 years of data. Extreme stock valuations imply paltry forward returns. While the Fed could create more electronic money to buy bonds and other assets – revise quantitative easing activity to preserve the wealth effect that the institution stoked – central bank voting members are unlikely to act aggressively in the absence of a bearish (20%) downturn.
It follows that exercising some restraint in the face of injudicious exhilaration is warranted. Even with the Federal Reserve acting as a “backstop,” extraordinary confidence in Congress/Trump could shift unexpectedly, particularly when asset valuations push extremes. I continue to hold as much as 25% of my moderate growth-and income client portfolios in cash equivalents.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.