Signal versus noise
We’re usually reticent to provide running stock market commentary – it’s a fool’s errand, and mostly it’s just noise anyway.
However, we do believe investors should be wary of the current market signal.
Ben Graham famously outlined the difference between investing and speculating thus:
Graham didn’t rule out speculating altogether, provided there was some logic behind it.
Unfortunately we’re not seeing much logic at the moment!
Managing exposure
Contrary to how many folks interpret Graham, he spoke extensively about stock market aggregates, what a sensible valuation for the market looked like, and whether it was a good time to invest (see The Rediscovered Benjamin Graham by Janet Lowe).
Both Graham and later John Templeton advocated adjusting your exposure to stocks as markets become too expensive.
They did this by noting what was a reasonable approximation of ‘value’ given the future stream of cashflows (dividends) to investors.
So low market valuations and prices generally lead to future high expected returns, and vice versa.
This is what the CAPE ratio shows in many developed markets today – low expected returns.
But, as we often say, it’s not a short-term market timing tool.
Long term focus
Investors are increasingly focused on chasing the capital gains, with much talk about whether the market will go higher, what the 2020 year-end price will be, expected 12-month returns, and so on.
These one-year projections are pure speculation based upon momentum and recency bias.
They add zero value in terms of helping to build your long term wealth.
The CAPE ratio and Graham’s use of earnings yield do a much better job for the investor (not the speculator), as we’re interested in maximising wealth over the long term, not cashing in tomorrow or next week.
It’s anyone’s guess where the market finishes next week or next year, and as Howard Marks pointed out in his most recent memo, Thinking in Bets, don’t confuse skill with luck.
Just because you make a few bucks doesn’t mean you’re a genius.
It’s the process that counts and its why we focus on our timeless investment principles, not only strategy and tactics.
Managing risk
This leads us to today and our concern for investors, especially those who are young and haven’t yet experienced a serious market decline.
The financial industry operates on selling investment products and generating fees – we don’t criticise that, but simply note where their motivations lie.
Your dollars are their fees and income, so don’t ask the barber if you need a haircut!
What we are critical of is the constant refrain of the finance industry that you must be fully invested at all times, or else this will somehow be detrimental to your returns.
It’s a fallacy – see again our posts on the sequence of returns and geometric averages.
Even asking the simple question ‘what are the expected returns?’ should lead you to the straightforward conclusion that there are both good and bad times to be fully invested.
Please note, we’re not saying it’s all or nothing; it’s more nuanced than that.
Long term versus short term
Many industry folks rightly highlight the importance of dividends as a large part of the success of a portfolio over the long term.
But it’s also important to recognise the relationship between price and value.
As Buffett said, price is what you pay, and value is what you get.
Here’s the maths.
If you pay a dollar for a stock paying a 5 cent annual dividend then the dividend yield is 5%.
If you were to pay 50 cents for the same stock (great!) then the yield is much higher at 10%.
But if you do something silly and pay 3 dollars for that same stock, then the yield is woeful at just 1.7%.
Of course, you do want the dividends to be increasing over time, not just to be chasing a high percentage yield for its own sake.
If you pay too much for the stock then not only is the dividend yield equivalently lower, the risk of a capital drawdown is higher.
Too many folks are flatly ignoring this and are speculating based on the promised future capital gain.
In our experience, overpaying is the cardinal sin and leads to lower future returns.
We adjust Buffett’s saying to ‘the higher the price you pay, the less value you get.
Investing when the market is high leads to lower dividend income, and a potentially large capital drawdown.
We know this because that is simply how markets operate.
It’s not different this time
There’s no ‘it’s different this time’ – it never is, and this time won’t be either.
At the moment almost all of the markets talk is about capital gains rather than income, and not enough attention is being paid to risk.
According to the most reliable market valuations the S&P 500 is at a level never previously sustained (the CAPE ratio now sits above 31.5) and the dividend yield is atrocious at about 1.7% (not relatively, but historically).
We have available figures going back to 1871, and the dividend yield has actually been lower once before, from 1997 forth during the infamous tech bubble.
With a yield of 1.7%, real returns can only be achieved by speculating on capital growth.
You’re missing nothing by not investing at these prices, unless it’s ‘different this time’.
Ben Graham lamented those periods when investors shifted from a focus on earnings (income and investing) to expansion (capital gains and speculation), and this is exactly what’s been going on recently.
Like property flipping, speculation can be lucrative, but it’s also very high risk if you get caught in a drawdown with low liquidity and high volatility.
The low yield is a warning sign of capital losses to come, backed up by the fact that the long-term CAPE average ratio for the US in 16.7 (while the long-term median is 15.8).
The CAPE ratio has exceeded 30 twice before: on Black Tuesday in 1929 (the Wall St. Crash and Great Depression), and in 1999 (the tech wreck).
The market’s dividend yield is well below it’s long term average and so this should be a warning sign to be careful about capital losses, since you are potentially paying too much for very little return.
And the risk of a capital loss is high given what we know about the correlation between long term valuation indicators such as the CAPE ratio and future returns.
In Australia, banks and REITS are fairly expensive, but industrials are a nascent speculative bubble.
Remember that global markets are now more correlated – if the largest market goes down, we all go down.
Don’t pay too much
Think about the following paragraph.
If dividends are important to your long term returns, then the low yields are a warning sign, and the exposure to expensive equities should be reduced until better opportunities come around.
Think about it.
If dividends are important to your future returns, then you shouldn’t pay too much for those precious income streams.
The level of dividends tells you much of what you need to know about the market level and valuation.
And it’s not a pretty sight.
Those saying ‘well, yes, but there’s no alternative because bonds are worse’ fail to recognise that investing isn’t a game of moving to where the action is.
Sure, the returns on cash and bonds may be low, but investing also isn’t a game of baseball, and you don’t have to swing at every pitch.
Collecting nickels in front of steamrollers
Besides, there are plenty of opportunities for those that seek out steady returns, instead of wanting to boast they made a tiny capital gain but with a huge amount of risk.
Like Buffett, the focus of your portfolio should be growing your capital base over time, and so staying fully invested when the market is so expensive (and potentially volatile) is not the right recipe.
Focus on steadily building your wealth by being patient, and avoid looking for a quick and dirty 10-20% because inevitably you won’t be able to get out in time.
If you truly are a long term investor, then many indicators are currently flashing red, so be careful out there!
In a forthcoming post we’ll look at how you can also use our 8 timeless investment principles to successfully and safely invest for income in the low interest rate environment.
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