With all the current talk about fake news since the election it sure seems like the fake news was the market was going to tank if Trump won. As we mentioned in an earlier video we sent through email we expected this time to be turbulent and take a while to settle out and get over the euphoria. It sure has!
Should the Trump presidency be a cause of all the increased business optimism and quick market advance since Election Day? We can understand where businesses are more optimistic now that they might get some relief from regulation but it remains to be seen whether the broad market will continue at this pace! The advance has been mostly in a couple sectors, mainly the banking sector whose profits could benefit from less stringent regulation. But any company or sector that could benefit from a $1 trillion infrastructure stimulus package stands to have improved results. I read recently that 5 stocks out of 30 in the Dow Jones average have been 50% of the total advance. That’s not a broad advance.
Just for perspective: when President Reagan was elected in 1980 the market went up 6% in one month because he was thought to be a game-changer for the economy like some say of Trump. Unfortunately from there the stock market proceeded to go down about 27% over the next 20 months. It finally got to its low in August 1982 when his tax cuts were finally passed. This was the start of the great bull market from 1982 to 2000. Some would say that was a much different time and may have little bearing or resemblance to current market conditions. However, we think it points out one of the conundrums we currently face in the markets and by understanding it you can continue to be a better investor.
That great bull market from 1982 to 2000 started after stock prices were extremely low and beat up. Doesn’t it make sense that the best returns would happen from low prices? Keep in mind the widely-used Shiller P/E ratio was 7 at the bottom in 1982 for the S&P 500. That means investors were paying 7 times in price for an investments earnings/profits, or $700 for a company earning $100. The Shiller P/E ratio today for the S&P 500 is 26, meaning investors are paying 26 times in price for an investments earnings/profits or $2600 for a company earning that same $100.
Price to earnings ratios, or P/E ratios (the price divided by the earnings/profits from the investment) are one way to gauge if stock prices are high or low compared to historical averages. Currently they are high and by some measures have only been higher twice: in 1929 and 2000 right before two large market drawdowns. So, current P/E ratios being high could mean forward returns could be lower and risks could be high. But, these conditions can last for a while as they have already by investor optimism or euphoria.
As you may remember from other elections there has always been a honeymoon/euphoria period but then the actual passage of legislation tends to be slower and the euphoria can fade. The most important thing to remember is a solid market is not based on euphoria. Eventually it has to be based on profits, sales growth, and a solid economy.
This was the case during the tech bubble and the real estate bubble and will ultimately be the case again. For now, it seems that the market advance will continue for a while but with the Fed tightening and raising interest rates we still need to be alert to the fact that markets can change quickly. When the Fed raised rates modestly in December 2015 the market went down about 13% before the Fed moderated on further rate increases and went a whole year without raising rates instead of the two or three they projected would happen during that time.
Business cycles and stock market cycles don’t last forever. Will there be a recession in 2017 as many predict or will disappointing economic data bottom out and start to improve maybe because of Trump’s changes? Either can happen. Usually when the Fed tightens and raises rates, like they are now, recessions are more likely.
A business recession that lowers earnings can really throw that P/E ratio into trouble and can cause markets to correct.
We have been telling a story in our workshops lately about the four seasons – what farmers know that investors forget. Farmers plant in the spring, grow during the summer, and harvest their crops in the fall. They know if they leave their crops out during winter they will be destroyed. Investing is like that except it is not exactly every twelve months. Investors tend to forget it’s a cycle and think it will always continue in the direction its going now. Like a connecting-the-dots puzzle, humans tend to project conditions to continue as they are going. It’s a well-known, undisputed fact that investors buy more at the top of a market and sell more at a bottom. Again, thinking it will continue in the direction it is going.
Here is the hard and critical part: knowing where each market, investment or strategy is at right now in the season’s cycle! (There is no perfect way to know because even though P/E ratios can be warning of risk, investor optimism and euphoria can keep markets rising-like now.) Did some investment just go through its winter and is about to turn up? Think energy about 12 months ago, it was a disaster and the news was awful but guess what the best broad sector was in 2016? Yes energy. What about the leading tech stocks we have discussed before that accounted for much of the markets advance? Are they in their spring poised for a great run through summer or in their fall right before a winter like 2000?
This is where we think additional, below the surface information is crucial. Price to earnings ratios as we discussed before can give us a clue. When P/E ratios are low on a stock or sector they tend to “revert to average” and bounce up when investors see they are “cheap”. When P/E ratios get high, you can have the opposite “reversion to average” and stocks/sectors etc. struggle as many see them as overvalued.
Let us give you an example. In the early 70’s McDonalds was a tremendous growth stock. It was projected to grow earnings at 25% per year as they expanded. Its P/E ratio got as high as 75 in 1973.² Investors gladly paid 75 times what McDonalds was earning at the time. McDonalds lived up to all its hype and projections. It did grow its earnings that fast, 400% from 1973 to 1980, but its stock price fell 50% until it was at an 8 P/E ratio in 1980.
The biggest single mistake we see investors make is comparing what is happening with only the past return of an investment to what something else is doing right now without knowing what is going on below the surface with P/E ratios or other less widely available metrics. For example, investors could not get enough of McDonald’s stock in the euphoric price run up and hype leading up to 1973. Think about it, how would the price get so high without euphoric demand? Very few investors were buying McDonalds stock when the price dropped in half in 1980 but the P/E ratio had dropped from 75 to 8. The price decline just looked too ugly to buy. Think about it again, would the price get that low if there was any buying demand.
Remembering that markets, sectors or stocks are cyclical, knowing that trends can reverse, having a plan for harvesting in the fall if necessary and planting in the spring pays off in the long run. But just like McDonalds in the early 70’s when that euphoria, hype and crowd behavior was at its peak it can feel awful to think you are missing out on something. But think about this. Investors probably felt good buying McDonalds when the news and increased price looked so good. But how did they do as an investor the next 7 years? Do you think everyone held on forever as the price fell 50%?
Here is a simple rule. Whatever is the most repeated story in the news at any given time is either because something is really looking good (had good returns) or really looking bad (had bad returns). When that popularity and euphoria (or fear for bad news), is at its peak, many times it is a turning point to go the other direction. Think about it. Who is going to keep buying at higher prices when peak popularity has been reached and everyone knows about it? Conversely, who is left to sell when a stock, sector or market has dropped and everyone knows it is an awful story. Only that below the surface information we talk about can help to know if summer (the best) is over or winter (the worst) is over.
The most popular story right now is to buy the index, typically the S&P 500 cap weighted index (it’s not even the best performing S&P 500 index fund), save as much in fees as possible, ride out any market downturns and everything will be great! It’s the most popular option now because it is back at a high point now. It is the story.
Just some quick facts. This index has averaged about 4.5% per year for the last 16+ years since March 2000. It has suffered two declines of 46% and 51% along the way and for 13 + years it was at or lower then it was in March 2000. Take a second and just reread that sentence to understand the gravity of what we’re talking about. To us that is a lot of suffering for a 4.5% return.
One of Vanguards founders and originator of index funds, Jack Bogle was quoted in April 2013 saying “prepare for at least two declines of 25-30 percent, maybe even 50 percent, in the coming decade”. “Why it doesn’t bother me is if you hang on through the cycle, that’s the only way to invest. Trying to guess when it’s going to go way up or way down is simply not a productive way to put your money to work.”¹
That is a valid strategy of course and if you are okay with the inefficiency and emotional roller coaster he says will come, great. To us though it’s not just the decline but the time it takes to recover that is the major problem. It has averaged over 6 years since 2000 to recover your losses and get back to where you started before a market decline, it has averaged 5 years to recover losses in the market since 1929.
Here is one example of a way to run a portfolio based on an index that could prove to be advantageous to you. It also demonstrates how striving to protect against downside losses can help returns and lower risk.
In our review, the S&P 500 Index that many commentators suggest you use might not even be the best S&P 500 index for you. Let’s look at the results of four ways to index and use those same five hundred stocks:
S&P 500 Cap Weighted Index—Bigger companies have more weight; just as bigger states get more congressmen and women in the House of Representatives.
S&P 500 Equal Weight Index—All five hundred companies have equal weight, just as each state gets two senators.
S&P 500 Dividend Aristocrats Index—Out of the five hundred companies, this index owns the ones that have raised their dividend for the last twenty-five years.
W. E. Donohue’s Power Dividend Total Return Index—Buys the five highest dividend paying stocks in the ten broadest industry sectors of the S&P 500 once per year. It will sell all stocks and go to money market based on a risk overlay.
Here is a ten-year comparison of the four different indexes.
Ten-year return as Largest loss of value Time to get back
of Jan. 3, 2017** during ten years to previous high
S&P 500 Cap Weighted Index SPX 7.05% -56% 65 months
S&P 500 Equal Weight Index SPW 8.53% -60% 54 months
S&P 500 Dividend Aristocrats Index 9.76% -51% 47 months
W. E. Donohue’s Power Dividend TR Index* 13.48% -12% 15 months
** All data was found at spindices.com on Jan 3, 2017. Index returns do not represent the performance of Shepherd Wealth Group or any of its advisory clients.
The first three indices stay invested in their stocks all the time—no matter what the current market conditions are—based on their respective ways of using those five hundred stocks. The last index, W. E. Donohue’s Power Dividend TR Index, is an example of using simple technology improvements, sorting for dividends annually, and using a moving average signal to go to safety. It strives to reduce risk during market downswings, to shorten the time it takes to bounce back to previous levels and to be invested in rising markets. The idea is a strategy that can adjust to market conditions as they happen instead of managing for the average market risk over the last twenty to thirty years.
Here is the transformation we are striving to help investors with so they don’t go through another painful 5 or 6 years again.
1. Stop chasing performance euphoria and hype. We just read another study that showed investors almost cut their returns in half when they sell low and buy high, but it is the most common investor behavior.
2. Remember everything is cyclical like the seasons. Buying the most popular story with no plan for fall and winter has never worked out well. Examples, McDonalds, the Nifty 50, tech stocks, oil stocks, real estate, gold, and on and on. It is a very common reoccurring event.
3. Great lasting bull markets have never started with P/E ratios this high. Could it be different this time? Logically of course, yes anything can happen. But remember the four words that have cost the most money for investors over time are “this time IS different”. There is a big difference between could and “IS”.
4. There will be many great investment opportunities in the future. We, like almost everyone else, are hoping for an improving economy, great job opportunities and a growing stock market. But, we think it is most prudent to remember the lessons of the past and know that striving to prevent large losses should always be part of the plan. Large losses diminish the ability to take advantage of future opportunities if you are waiting 5 or 6 years just to recover your losses to get back to where you were.
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¹JACK BOGLE WARNS: Prepare For Two Massive Market Declines In The Next Decade – Business Insider.com Apr. 1, 2013, 5:38 PM
²Securities Research Corporations: Blue Book Jan. 1982 edition