Surrendering Before the Battle Begins

“In any sort of contest – financial, mental or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try”  – Warren Buffet

Spring has arrived, and 2017 has continued with the positive sentiment that closed 2016.  U.S. stocks have done very well with the S&P 500 index up over 6% year-to-date.  This positive movement is largely the result of continued expectations that the new President will implement business-friendly tax and trade policies that will further boost corporate earnings.

In the December quarter, 65% of companies in the S&P 500 beat their earnings targets and had an average earnings growth rate of 4.9%[1].  This is the first time the index has seen a year-over-year growth in earnings for two consecutive quarters since March 2015.  More good news is expected in the coming quarters, but investors are now increasingly beginning to wonder if the stock market is “overvalued” and “are we due” for a correction or crash?

The Price-to-Earnings (P/E) Ratio[2] for the S&P 500 is currently 21.8x, which is higher than the 5-year average of 17.1x and the 10-year average of 16.6x.

S&P500 Valuation

These ratios would imply that the market is roughly 25 – 30% overvalued.  So a pull-back in the market would be a healthy development, but this revelation is no reason to run for the hills. We are in a bull market that began at the depths of the 2008 Financial Crisis and not every company is overvalued. Corporate profits could continue their current growth track and new tax and trade policies could further boost earnings.  Lower taxes would increase profits for corporations and create a “wealth effect” for consumers. Consumers who feel wealthy want to spend and this spending then boosts corporate earnings.  The momentum from all of this could bring earnings valuations more in line with historical averages (or push us into bubble territory).  But for now, the market appears to be trading primarily off of inflated expectations for future progress.

The question of “are we due” is not really the right question. Bull markets do not end because “we are due”.  But rather they end when driven by developments in the economy or consumer thinking that changes behavior and spreads into a malaise or panic.  These developments put investors on the defensive and they begin to hide their cash under mattresses.  Historically, we have seen causes that include a broad realization that technology companies should earn profits. Or that home valuations don’t always go up, and your new neighbor probably can’t afford that fancy home given their current occupation.  Other triggers can develop quickly through incidents such as pending wars, revelations of massive fraud, or a presidential impeachment, perhaps?

These developments create a tipping point in the business cycle, investors panic and withdraw assets; banks stop lending to both businesses and consumers, and stock prices drop until valuations find their way back below historical averages.  The panic recedes, investors pull their money from mattresses and put them back into the markets and we start the cycle all over again.  But bull markets can last much longer than expected:

Bull Market Ending crop


My own assessment of current conditions is that we are more than likely mid-way through the business cycle with no immediate signs of a bubble or pending recession. More importantly, the world economy is doing well: South Korea has seen export growth of over 20% and the previously faltering economies of Russia and Brazil have stabilized. So there appear to be no immediate signs of a pause in our bull market.  Of course, I could be wrong, but you can’t predict these things.  There are often warning signs, but the truth is only clear in hindsight.

And while you can’t really predict the end of a market cycle, you can predict that during bull markets there are increasing signs of ebullience among the investment community.  During these periods, investors begin to cling to themes that rationalize herd behavior.  Most recently, this narrative seems to be that “Passive Investing” is the only avenue for the astute investor. Passive investing aims to maximize returns over the long run by reducing the number of trades and eliminating fees by investing in low-fee indexes where you own all of the companies in the market rather than actively selecting the best investment opportunities.  In bull markets, all boats rise and so there is no need to concern yourself with business fundamentals or valuation. “Just buy the entire market and hold.” “No one can beat the market anyway.” I agree completely with the notions of reducing fees and reducing the number of trades.  But I am a firm believer that the market is inefficient and, through thorough stock selection, you can outperform the market average over time.  This statement shouldn’t be a surprise as our firm’s whole reason for existence is predicated upon this assumption.  Our aim is to outperform the indexes for our clients.

The stock market is not a casino or a lottery game where some lucky investors make all of the profits. At Richie Capital Group, we conduct thorough research and invest in real companies.  We believe that it is possible to determine which companies will perform better over time. And it’s never a bad thing when other investors decide that it’s not even worth trying to separate the good investments from the bad. On the surface, it makes logical sense that investments in great companies purchased at attractive valuations will outperform the broader market.  If I were to ask you which business will perform better over the next 10 years Sears, Target, or Amazon? Most would say Amazon. And I would agree with you. But if you know this fact intuitively (or after conducting your research), then why do you need to own all three companies?  Why not just own Amazon instead of the others?  With a passive indexing strategy, you will own all three even though at least one may no longer exist 10 years from now…

As we dig deeper into the concept of passive investing, what does passive truly mean? To me, passive investing means finding a low cost Exchange Traded Fund (ETF) that mimics the S&P 500 (or other broad market index) and leaving your investment for 10-20 years without touching it. By definition, you should achieve average returns before expenses. But for the average (and often institutional) investor, things get a little more complicated.  Investing in a single index is BORING! And who wants to do boring?[3]  And so they quickly delve beyond the single index into one of the almost 4,800 ETFs[4] available. What about international exposure? I’m sophisticated, and so certainly I should own some international indexes. Or maybe I should focus on a specific country? Japan ETF. Germany ETF. Check and check. And what about this Short-term Inflation Protected Securities ETF? Everyone knows inflation is bad and protection is good, right? And maybe round it all out with a dividend fund. With all of these choices, the investor has unwittingly averted his decision to become a “passive” investor by now making “active” choices between various funds among the various brokerages that offer them.  And with these active-decisions, the investor has lost the ability to achieve even average returns. Any outperformance from a single ETF index gets consumed by sub-par performance from the additional sector, country, or other investment. The investor has surrendered while believing they are still fighting.

[1] Data provided by FactSet.
[2] The P/E Ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings. If a company’s shares are trading at $100 and its annual earnings per share was $5.00, the trailing P/E would be 20x.
[3] Coincidentally, the answer to that question is: “Those who want to make money.”
[4] And that’s not to mention the 9,520 mutual funds in the U.S. (Statista, statistics portal)

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