Holy Tentacles! Have you looked at the stock market recently? In the span of two weeks my portfolio shot-up by 10%. That’s incredible!
The stock market is having a holiday party, and we’re all invited! But what exactly is moving this crazy market? Is it tax changes? Is it politics? Should we even care?
Tax Cuts & Stock Prices
Usually I try to avoid discussing current politics on this blog, but there’s just soooo many news articles attributing recent market gains to upcoming tax legislation. It’s really hard to ignore.
In United States, major corporations (those that actually pay taxes) typically pay a 35% corporate tax rate. A proposed change to tax laws would lower that corporate tax rate to 20%.
If the media is right about this tax legislation, then companies paying the highest corporate tax rates should have seen larger stock gains last week. Conversely, tax avoiders would have seen little-to-no stock market gains.
Stock prices could rise around 10 to 15% and still be valued at ‘normal’ levels. Is it actually happening?
Actually, yes! Tax paying companies, like Southwest Airlines (one of my favorite individual stock holdings) have risen nearly 10% in the last week. Meanwhile tax avoiders like Microsoft or Facebook haven’t seen similar market gains:
It’s not just tech companies or airlines effected either — Industrial stalwarts like GE and PSX saw very similar price behavior:
GE is a notorious tax avoider, often paying no corporate taxes. Meanwhile, PSX pays a 32% corporate tax rate. As you might expect, PSX’s stock rose last week.
I made these same comparisons using dozens of stocks, and saw very similar results — Taxpayers rose, and “non-payers” didn’t.
While it’s extremely interesting, none of it matters! Trying to make stock bets based on proposed political changes is just gambling.
It’s very possible stock prices will fall again next week if the tax changes don’t happen. Does it worry me? Nope!
Do I stress know the value of my portfolio value could change +10% or -10% on the whim of a politician?
Not one bit…
Keep Calm And Eat Well
In the face of such investing uncertainty, I always try to remember a few simple investing tips to keep my head in the right place…
Important Tip #1: Eat something incredibly delicious, and forget about the stock market nonsense.
Not everyone has this relaxed view of the markets however… Some people actually care what the stock market does day-to-day.
These same people probably believe the market is efficient and they should keep pumping in cash at any price.
Yeesh… if I believed that nonsense, I’m almost certain my business school professors would demand my hard-earned diploma back!
The Equity Bond
Another good trick I use to keep myself divorced from the emotional swings of the market is Important Tip #2: Remember The Equity Bond.
Equity what hu-ha-ha? Don’t worry, it’s not all that complicated.
The idea of The Equity Bond is simple — Instead of believing stocks are little pieces of paper that swing wildly in price day-to-day, imagine your stocks are really just perpetual bonds without a maturity.
Like traditional bonds that pay-out coupons, equity bonds also pay a stream of coupons. These coupons are the businesses’ earnings. Those earnings either get paid as dividends, or get reinvested for future earnings growth. If corporate earnings rise, then so will those equity ‘coupons’.
Make sense? It might be easier to wrap your head around the equity bond concept after a few drinks. Go ahead, I’ll wait…
Bond owners sleep well at night mainly because they’re in it for the coupons (aka dividends). They also hold those bonds for an extremely long time.
Investors in stocks or index funds would do well to adopt this relaxed attitude by remembering we aren’t investing in stocks because we desire the market value to rise. Nope! We’re in it for the growing earnings stream from the business (aka the coupons).
This is exactly why I talk about earnings yield so often — If we intend to hold stocks or index funds until death, we never need to sell. We simply live off the endless stream of ‘coupons’ from our equity bonds.
Don’t Forget Mr. Market
This brings me to the next helpful tip — Important Tip #3: Mr. Market is just a crazy neighbor.
Mr. Market is probably one of greatest investing ideas ever created. It originates from a book called The Intelligent Investor. (Great book BTW!)
I’ve written about Mr. Market before, but the importance of this idea bares repeating.
Imagine you own a farm. You grow vegetables on the farm, and the earnings pay for your livelihood. It keeps you well fed, and it’s a pretty good life.
Next door is another farm owned by your neighbor named Mr. Market. This neighbor is a little crazy.
Every day Mr. Market walks over and offers to buy your farm. The price he offers varies wildly from day to day — Some days the price is fair, other days it’s ridiculously cheap or expensive.
Here’s the thing — Most of the time you can safely ignore any price Mr. Market has to offer.
You’re a farmer, not a hunter. The only reason why you would possibly want to sell to Mr. Market is if…
- He’s offering a price so outlandishly high you’ll never need to farm again.
- You desire to trade your current farm for a better farm.
Investing in the stock market is really no different from owning that farm. Instead of owning ‘farms’ of course, we own small bits of very big businesses.
Mr. Market (aka the stock market) is going to offer us prices for our businesses, but the vast majority of the time we should simply ignore him.
Valuations and FI
If you’ve already FIREd, ignoring the gyrations of the market is an important skill for long term success. Don’t let crazy Mr. Market convince you to make stupid moves. Remember, you’re in this game for the long-term earnings stream.
But what if you’re not already financially independent? What if you need to invest new dollars into the stock market today?
If that’s the case, then I recommend caution. These price levels are pretty high.
Why? Think back to that earnings stream. If you plan to live-off the 4% rule, the 3.95% earnings yield of the S&P 500 might be cause for concern. There’s very little room for error if earnings don’t grow rapidly.
Are earnings growing rapidly? You should probably decide for yourself.
This is why I think everyone should think twice about the 4% rule. Earnings don’t always go up year after year. There’s always blips. Recessions do happen. Why would you want to cut things this close?
Sequence of returns risk is a real issue for the financially independent — If you ‘retire’ at the wrong time, you could end-up eating into precious capital.
Like a good surfer, I recommend catching the wave at the right time to avoid these problems. If you time things right, you’ll end-up spending far less than your ‘farm’ produces.
That’s a recipe for success!