Are The Investing Storm Clouds Gathering?


It’s times like these that the markets make me nervous.  This week, the Dow, S&P 500, and Nasdaq reached new all-time highs.  It’s safe to say that most investors in today’s markets are “eager participants”.  Shares have now been bid up to a point where earnings yields are minimal.

This is not when I want to be investing.  A quick look over at multpl.com provides the Shiller PE ratio of 30.26.  That’s a tiny earnings yield of 3.3%.

Honestly, the economy seems to be doing very well.  U.S. consumer confidence is at very high levels and everyone seems flush with cash.  GDP is rising (albeit very slowly).

When times are good, investing seems easy.  Consumers act accordingly — they buy new cars, trade-up for larger houses, spend on fancy vacations, buy on credit, and just generally live it up.

The economic mood is positive.  We have now had 8 years of uninterrupted economic expansion.

shiller pe ratio
Anybody nervous yet?

 

Human Behavior

This week I was reading through a presentation by Howard Marks, (the founder of Oaktree Capital) and stumbled across some interesting ideas.  You can find his presentation “The Truth About Investing” here.

One of those slides struck me as being exceptionally insightful about human behavior:

“Most investors behave pro-cyclically, to their own detriment. When economic indicators, corporate earnings and asset prices have been rising, people become more optimistic and buy at cyclical highs. Likewise, their pessimism grows when the reverse is true, causing them to sell (and certainly to not buy) at cyclical lows. It’s essential to act counter-cyclically.”

Marks is dead right — humans do act pro-cyclically.  When times are good, they spend more freely (on both consumption and investing).  When the mood turns pessimistic (and times aren’t so good) they hoard resources like cash, food, and shiny bits of metal.

This behavior has been with humans since the earliest caveman days — it’s probably burned directly into our human DNA.  It’s a survival mechanism you can find mirrored all over the natural world.

Unfortunately this survival mechanism doesn’t serve investors well because it forces us to spend at the wrong times and conserve cash when we should be investing heavily.  (Mother Nature isn’t helping you get rich folks)

 

Invest Counter-Cyclically

It’s an elementary investing fact — if you invest when share prices are low you’ll realize better returns.  Quite simply, earnings yields will be higher when prices are lowest.

To get the best long term returns, an intelligent investor must invest counter-cyclically.  This means fewer dollars invested near the top of the market and many more invested near the bottom.

Easy right?  As an investor that’s been through a few of these cycles, I can tell you it’s anything but easy.  The investing environment is constantly changing — interest rates change, economic growth rates change, inflation rates change.  It’s impossible to predict what’s going to happen next.

So how does an intelligent investor know when to stop buying and start hoarding cash?

That’s a great question… and one I happen to blog about fairly frequently.  I guess beating this dead horse a little more won’t hurt….

 

Measuring Your Equity Bonds

One of my favorites ways to think about valuations is this idea of the “equity bond“.  Essentially, think of your stocks as if they were bonds — the yield on this hypothetical bond will be the earnings yield of the stock.  We can then compare the earnings yield of this “equity bond” to the risk-free rate.

(While many investors use different risk-free rates.  To keep things simple I’ll use a 30 year treasury.)

Currently the earnings yield of the S&P500 is 3.82%, while the 30 year U.S. treasury yield is a mere 2.83%.  For investors, that’s a 0.99% premium for taking on considerable risk.  Meanwhile, the real GDP growth rate is about 2%.

Back in 2008, (just before the Great Recession) these numbers looked very similar — a 0.33% premium for investing in equities and a real GDP growth rate of 2.73%.

In both situations it seems clear — investors are taking on a whole lot of risk for not a lot of growth.

Back in the late 1990’s (during the DotCom bubble) the situation was even worse — earnings yields on stocks were less than the risk free rate. Investors were banking on significant growth.  These were heady times of course — everybody thought the internet was going to change the world.  (It’s also worth noting that economic growth rates in the 90’s were considerably higher at 4-5%).

Today, we have no such illusions about high growth rates.  Productivity growth has actually cratered in recent years according to the Department of Labor.  Birth rates have also dropped below population replacement rates.

Simply put, this doesn’t bode well for investors expecting large growth rates.  I think the economic storm clouds are gathering.

 

Building Arks

All this economic barometer reading doesn’t amount to much when we have no idea when the storm will hit.  It could be next week, or it could be next year… nobody knows.

So what should investors do during times like these?  Invest very carefully, and prepare for the bad times.

“Predicting rain doesn’t count; building arks does.” — Warren Buffett

At some point, the intelligent investor has to start building that ark to carry him (and his family) through the rough times.  This could mean piles of cold hard cash.  It might also mean adding to a bond position, or purchase more preferred shares.

Yes, this also means your returns will lag behind the market averages as you invest more defensively.  A counter-cyclical investor has to be willing to look away from the overheated returns of a frothy market.  He (or she) must be willing to forge their own investing path and ignore the wild party going on in the other room.

In my own portfolio we’ve stopped investing in broad market investments — No new index fund investments, and we’re carry a ton of cash right now.  (Over $400k)

Yes, this means my cash is sitting around earning very little while the S&P 500 racks up double digit returns.  Meanwhile, I’m hunting around for good investments, but find very little that interests me.

champagne
The party has now lasted for 8 years uninterrupted.  Will you be ready when it ends, and everyone wakes up with a nasty hangover?  This is what it means to be a counter-cyclical investor.

I won’t kid you — Having this level of conviction is difficult.  It’s not easy to turn your back on those easy profits when the champagne is flowing and the market party is in full swing.

I’m reminded of another Buffett quote I find strangely appropriate:

“We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”  ―Warren Buffett

For the early retiree, this conservative manner of thinking is important.  We must ask ourselves, “How will I pay the bills when party ends?”

 

What About Those Still Saving?

If you’re one of those folks still saving to reach FI, you probably have nothing to worry about.  While a few years of recession might hurt that 401k balance, you still have a job.  There will still be decades of saving ahead, and the growth that follows will quietly heal those economic wounds.

What’s important is to keep saving, and to maintain a safety-net in the event of a job loss (these things do happen).

However, if you’re closer to financial independence, you might not have have the luxury of an extra decade before you pull the plug.  In this case, I recommend caution.  In fact, I wrote a post about this very topic — When Is The Best Time To Quit Working?

For the already financially independent (those who’ve already pulled the plug on a job), I’ve always advocated for living off dividends instead of capital gains.  Even then, in tough recessions dividends can still get cut.  I’ve had it happen.

(The longest dividend cut I’ve ever endured was 4 years.  Thankfully it was a cumulative preferred and all money was eventually paid.)

Yes, eventually good companies do resume paying dividends, but it can take years.  In the meantime, how do you plan to pay the bills?

 

[Image Credit: Flickr1, Flickr2]


35 thoughts on “Are The Investing Storm Clouds Gathering?

  • July 22, 2017 at 3:42 AM
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    I hear you. I see a lot of blog questions about “should I be 90% or 100% equity right now….” Yikes. I remember 1987, 2000, 2008 and have read about prior crashes. Recently I read a book about the great depression. Wow do we take a lot for granted. I’m currently 40:40:20 (stocks:bonds:other). I will raise the equity percent after any big crash or decline. I’m not good at predicting the exact top. I had a lot of bonds in 1999 and missed some gains, but I didn’t lose in 2000.

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  • July 22, 2017 at 3:50 AM
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    You make a ton of great points Mr. Tako!

    As someone who hopes to follow your path and reach financial independence and early retirement within four years, a big downturn in the market is the most obvious thing that can sidetrack my plans. Like you, I am holding more cash than normal to potentially take advantage of things and invest counter cyclically when it happens. Even so, a 20%+ decline in the broader market will delay my FIRE date by years.

    For the long run, getting the next market correction out of the way before I retire is probably a good thing, but it’s not going to make it any less frustrating to potentially have to wait longer before I can afford it!

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  • July 22, 2017 at 4:00 AM
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    I knew her birth rates were lower in recent years, I didn’t realize how low and have the productivity growth had dropped off as well…yikes! Being quite a few years from FI, we are still heavily invested in equity and are working to build cash savings as well. Thank you for the great post!
    Mrs. Adventure Rich recently posted…Adventure Challenge #2: Walk It!

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  • July 22, 2017 at 4:12 AM
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    I’m always impressed with how you and your wife made great investment when the market was down, which enabled you to reach the millionaire status faster. I think when the economy is good, people spread themselves too thin: they are too highly leveraged.

    For example, a real estate investor may take out big mortgages to expand his portfolio and are forced to sell his properties under the market price when time is tough. It’s not because he wants to. He has to do that to keep himself afloat. That’s why I’m very conservative when it comes to investment. I want to have more choices over what I do.

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    • July 24, 2017 at 2:37 PM
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      I’ve always thought there was a sliding scale between investing for big profits and safety. You can move the slider to the extremes on either end, but both extremes have issues.

      There’s nothing that says we have to keep that slider in one place either. I’m just dialing it back a bit right now.

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  • July 22, 2017 at 5:13 AM
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    I’m a firm believer in stay the course and dca. It’s a hard thing to do in a down market. However in a up market I still believe timing the top is a losing game. In the dotcom bubble we were above our current level for years and in inflation adjusted price the crash stayed above that point, even if earnings adjusted. Missing out on years of dividend growth is also painful.
    FullTimeFinance recently posted…Root Cause and Lessons Learned

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    • July 24, 2017 at 2:40 PM
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      But what if you stay the course and DCA, and then the market never returns? I frequently bring up Japan as a perfect example of this happening in the real world.

      Tulips never regained their atmospheric prices after the tulip mania popped either. There are countless examples.

      DCA won’t save investors when the winds of change truly blow… there I go with the weather metaphors again!

      Reply
  • July 22, 2017 at 5:24 AM
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    Great analysis. It is definitely an interesting time to be an investor. It seems that everyone who has been an investor for 20 years or longer are waiting for the market to tank. Keeping cash on hand sounds like a smart move. If the market does have a major correction, you will be able to make some value buys.

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  • July 22, 2017 at 5:32 AM
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    Yep. Waiting for the inevitable fall coming soon. Right now I’m probably 30% Stock/30% Bonds/30% Cash/10% Alternatives. I’ve picked up a few dividend growth stocks this year but still have a lot of cash sitting on the sidelines. I might even sell some index ETFs this week…

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  • July 22, 2017 at 6:55 AM
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    There are still investment opportunities left and right. One or two good ideas in a year is all you need. Personally I find the current circumstances much more interesting. It’s in times like these that you find out if you actually have some skill as an investor and aren’t just lucky … Reminds me of another Buffett quote: “only when the tide goes out do you discover who’s been swimming naked”

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    • July 24, 2017 at 2:44 PM
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      I agree, one or two ideas a year is plenty. I already found my idea for this year, but still the search continues! 😉

      Reply
  • July 22, 2017 at 11:03 AM
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    Awesome perspective, Mr. Tako! I’m not stacked with as much cash as you are, but we’ve been doing the same thing and just waiting for the tides to turn. We’ve been cutting back on buying quite a bit as well lately and just keep socking it away for the cycle to change.

    I’m actually hoping for a downturn sooner than later… everything’s too darn expensive right now!

    — Jim
    Jim @ Route To Retire recently posted…What I’m Doing With My Money Right Now

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  • July 22, 2017 at 11:13 AM
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    Great post Tako, we just wrote about that too but we are not worried since we are in our accumulation phase, the best thing that can happen for us is a recession.

    Buying in a crash lets you enjoy a huge discount on high-quality investments. When others are fleeing, you can accumulate highly diversified investments such as index funds and stay put for the ride up!
    Xyz from Ourfinancialpath recently posted…When it Will Fall

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  • July 22, 2017 at 12:54 PM
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    Put me in the camp that believes the party is going to end soon. That said, I am early enough in my investing career that I am not changing my strategy at all. I am building a slightly higher cash reserve than usual, but my same automatic investment transfers are going every two weeks. As you said, I will still have a job and a paycheck to keep investing during the down market.

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  • July 22, 2017 at 1:57 PM
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    Yup absolutely right. People tend to buy at highs and sell at lows, even though they should be doing the opposite. It’s human nature. That’s why we don’t bother trying to predict the future and just rebalance back to our allocation whenever things get mis-aligned. That way we buy low sell high, without needing to predict the future and getting caught up in FOMO.

    I also agree with you on the cash cushion. Risk takers will poo poo it, saying we’re losing money by not investing it, but when shit hits the fan, we’ll be the ones who are able to sleep at night.

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    • July 24, 2017 at 2:47 PM
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      Rebalancing is definitely a great way to do it!

      In a way, you could say this is exactly what I’m doing right now.

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  • July 22, 2017 at 5:54 PM
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    Unless you are buying the indexes there is always a sale going on in the market. I wish I have more money to buy (ve been doing this for 30 years).

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    • July 22, 2017 at 8:57 PM
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      Oh do share where you believe this ‘sale’ is.

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      • July 23, 2017 at 6:00 AM
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        I have been picking up shares of US midstream companies which are currently out of favor and have good margin of safety.

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  • July 22, 2017 at 10:29 PM
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    Excellent post, Mr. Tako. You quantify a lot of what my gut feeling has been telling me about the current market. I’d love to know where savvy investors are parking their excess cash currently.

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  • July 23, 2017 at 9:18 AM
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    Great post.

    Value vs price paid is everything. So we have the obligation to be careful.
    Cash & bonds is the obvious answer.

    In Europe the only problem is, that bonds still yield effectively 0%. So there´s not plenty of options apart from the stock market or real estate, if you are still out there to accumulate.
    The guys who are already retired can relax and shift more into cash, but then inflation comes into play (the real life inflation, not the number these bankers and politicians want us to believe….)

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    • July 24, 2017 at 2:30 PM
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      I know it ads currency risk, but you might want to think about investing overseas if your risk free rate is 0%.

      Question: Is it possible to borrow at that rate?

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  • July 23, 2017 at 4:51 PM
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    I’m super nervous about this impending doom and gloom, but I’m also kind of hoping it happens sooner rather than later. Like, now would be great.

    I’m aiming to FIRE in just over 8 years, so the sooner that crash happens the better for me.
    LadyFIRE recently posted…July Highlights – Best Posts in the Blogosphere

    Reply
  • July 24, 2017 at 12:58 AM
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    Great thoughts. I’m not sure how what you’re advocating here is fundamentally different from timing the market though. What will be interesting of course will be in a few years, after that storm has come and passed, for you to compare how much you lost in “opportunity” by having $400k out of the market for several months/years versus how much you did not lose when the market went down.

    There are multiple studies that show that if you miss out on just a handful of good days in the market (which could very well happen towards the end), you are significantly losing. So, at the end of the day, with your 400k out, you are attempting to time the market.

    Maybe the difference for you is that this cash you have is not necessary as part of your growth plans since you’re already FI?

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    • July 24, 2017 at 7:18 AM
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      No, I’m not “timing” anything. I’m simply choosing NOT to make BAD investments. I don’t call that “market timing”

      I’m perfectly willing to spent that 400k should a good investment come along.

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  • July 24, 2017 at 3:34 AM
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    Nice thoughts. Macro-economically, things are quite overvalued but when you drill down you will see that there are a handful of high flyers (AMZN, TSLA, FB, NFLX) that have large market caps. There are very high long running growth expectations built into them so it’s likely that they will underperform in the next decade.

    Anything with the word “retail” in it that’s not AMZN is trading at a discount, and valuation expectations are dragged down. If only a few of these end up doing not so badly, then it will be great for investors buying in at these levels. So it’s up to each of us to do our own valuation equations and decide what is best for us. Yes, I’m the guy who loaded up on MCD at $92 per share, but also the same person who bought KMI at $32 per share… winners and losers and all that.

    Take care,

    -Mike

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    • July 24, 2017 at 7:28 AM
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      I’m searching for retail names that have a moat, but few convince me. Some, (like Home Depot) fill real economic niches but are quite expensive.

      Frankly, I think there isn’t enough fear in this market yet.

      Reply
  • July 24, 2017 at 7:35 AM
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    I don’t know if the party is going to end soon, but it’s a good idea to have some reserve. $400k in cash is a lot of money to be sitting around, though.
    Right now, we have 80/20 stock/bond split. I’m thinking about going to 70/30 soon. I also moved some of our US index investment over to international index funds. More cash would probably be good too. I’m pretty sure we’ll be able to weather a financial storm for a few years. Good luck to both of us!

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    • July 24, 2017 at 7:42 AM
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      Yeah, I have no idea when the party will end either, but it’s definitely getting harder to find intelligent investments.

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  • July 25, 2017 at 12:17 PM
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    The cost of hedging a SPY position by purchasing at-the-money (247 strike) put options is currently 5.2% per year (360 days actually).

    You can therefore stay invested for another year and your max capital loss is the 5.2% you paid for the option – and that worst-case scenario only occurs if the price a year from now is at or below what it is today – a historical rarity. If markets are 40% lower in a year, you only lose 5.2%. If instead it goes up another 10%, you’d earn 10%-5.2%=4.8%.

    Now add the 1.87% dividend, and your worst case scenario is -5.2% + 1.87% = -3.33% (assuming no dividend cuts within the year and no large asteroid strikes earth). Your upside is unlimited.

    You might find even better deals than SPY if you shop around. If you’d be satisfied with limited upside, you could sell calls to offset some of the cost of buying the puts.8

    Bottom line, there’s no excuse to be scared into cash/CDs/treasuries for fear of a potential loss of 3.33%. This irrational market may have another 3 years to run for all we know, and the price of guaranteed solvency is cheap right now. However, like plywood in hurricane country, the price goes up after the storm appears.

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  • July 27, 2017 at 7:55 PM
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    I don’t disagree with the sentiment. In fact, I am waiting for the next shoe to drop, but having living through 2 of these downturns in my investing lifetime I am not necessarily all that worried. Yes my investments might go down by 30% or even more, but I think we are a long way from being Japan and one of Japan’s problems is its lack of immigration and political environment. Is it possible we will be Japan? Sure it is, but I have a good job that is basically secure (tenured professor). I am just staying the course. Maybe too much stock exposure, but I have about 7-10 years to FI and I don’t think I will be RE. You have a great plan though.

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  • July 28, 2017 at 7:38 AM
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    You are a long time and long term investor so I’m wondering where your cash pile came from… have you been selling stocks recently to raise cash, or has it just been slowly accumulating from uninvested earnings?

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    • July 28, 2017 at 8:55 AM
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      I haven’t been selling any stock lately, but the exact answer is “a bit of both”.

      There was a forced sale earlier in the year when Endurance Re. was purchased, but other than that, no selling.

      Other than that forced sale, it’s mostly dividends accumulating.

      Reply

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