It’s time to be cautious
“Be fearful when others are greedy and greedy when others are fearful” – Warren Buffet
Whether you realize it or not, you are a long-term investor. The 35-year-old certainly has a longer life expectancy, but even a 70-year-old is likely to need their assets for decades to come. As a long-term investor what you should care about is what happens over a long period of time.
For reference, here is a price chart of the S&P 500 going back 70 years. The trend is up.
In fact, if you had invested $1,000 and reinvested all dividends over the last 70 years, your investment would have become more than $1,600,000. Yes, our math is correct, $1.6M. So, investing for the long-term is the prudent thing to do when you are building assets for a lifetime (which we already agreed is most of your assets).
So why begin the article with a cautionary quote?
Here is why. People are out of their minds right now and we are concerned that you may be getting caught up in it too. Anecdotes abound to support this point – traditionally conservative individuals are now interested in highly speculative investments (e.g. bitcoin), the number of second home purchases is climbing rapidly, and we’re hearing of more and more day trading going on (thank you Robinhood). Each of these in isolation would not be a concern but the confluence of all of them is setting off alarm bells. More importantly, the data is starting to confirm the anecdotes.
To tell this story well, we need to go back to Finance 101 and rediscover why anyone would own a stock. When you buy a stock, you are buying the rights to future profits. You are an owner. In many cases, those profits are returned to you as a shareholder via a dividend. There are some companies (usually high growth ones) that do not distribute a dividend at all. In this case, you are hoping that the company distributes a dividend in the future or that the price of the stock goes up so you can sell it at a profit to someone else.
If we were to set aside stocks and just think about purchasing behavior broadly. The decision about whether to buy is undoubtedly driven by two factors – the price you pay and the value you derive.
Let’s pull on this thread a bit more.
Imagine your favorite food. Imagine how good it smells, looks, and tastes. Now imagine that the price has gone up exponentially because everyone else has decided it is also their favorite food. At some point, it would become so expensive that you would stop purchasing no matter how much you loved it.
A stock should not be any different.
The only reason the price of a stock should go up exponentially is because the future profits are expected to match that trajectory. While profits are recovering and expanding, stock prices appear to be expanding at a faster rate driving up a common measure of value in the market place – the price to earnings ratios (P/E). See insert below for detail on P/E ratios or feel free to skip below:
Let us dive into one of the most often cited financial metrics of market value – price to earnings (or P/E). This ratio takes the (P) price you pay per share and divides it by the (E) earnings per share (Remember earnings equals profit). If the ratio goes up, then the price is climbing faster than earnings and you are paying more for the same value that you derive (profits which translate to cash to you as an owner).
This metric is not perfect, none are, but for illustrative purposes we like it. So, what has happened to P/E ratios in the last few years? Well, they have gone up. A lot.
Let’s dive deeper using a twist on the traditional P/E ratio. The cyclically adjusted price to earnings (CAPE) ratio was developed by Nobel Prize winning Yale economist Dr. Robert Shiller as a way to better normalize the noise that you get when using a standard P/E ratio. A large cadre of people believe the CAPE ratio is more nuanced and accurate at forecasting future stock returns than the basic P/E ratio. What is important to understand is that the CAPE ratio and standard P/E ratio are both measures of relative value in the stock market.
For reference, the CAPE ratio of the S&P 500 now sits above 37 (see chart below). The only other time in history it was this high was during the peak of the dot-com bubble when it nearly hit 45.
Our conclusion is this; beware of market eurphoria. Now before you hit the “sell” button on your equities, remember what we stated above. Long-term investors play the long-term trends, and this is what we recommend you do too.
This is a time of caution, a time to stay the course. Not a time to ratchet up risk even if everyone else is doing so with reckless abandon. Thank you, Warren, for the reminder.
Note: If you want to check out Dr. Shiller’s work you can find it HERE, including the data that sits behind the CAPE ratio chart above.