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.
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)
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.
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.
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?