Escaping The Madness Of Crowds
As I write this, the S&P 500 just set another new all-time high. A new record itself isn’t unusual (The S&P 500 has been setting new records for decades), but to do so in the middle of one of the world’s worst recessions AND during the middle of a pandemic is strange. Okay, it sounds more than just strange, it sounds downright crazy.
Year to date, the S&P 500 is up about 5% … yet nobody I know is willing to say the world is in a better place than it was a year ago.
Right now, big-tech and electric car companies seem to be the most “in-fashion” stocks. Tesla (Symbol: TSLA) for example, has gained 390% this year. That’s wild! Electric truck maker Nikola (Symbol: NKLA), is up 16% even though the company hasn’t shipped a single truck yet. Apple (another Wall Street darling in 2020) is up 69% YTD.
Whatever happened to markets being rational?
The truth is, the stock market can be anything but rational at times. There’s even entire books written about how irrational markets can get. The best one is called “Mania’s, Panics, and Crashes: A History of Financial Crises“. It’s one of my favorites.
Today’s market sounds like madness, but this is exactly what happens when a whole bunch of investors crowd into just a few “popular” stocks. At some point the madness becomes self-perpetuating — Investors crowd into a few popular stocks, causing them to go up. This positive momentum attracts more investors, causing the shares to go up even further. This attracts even more investors looking for “big gains” and the cycle just repeats itself… until it finally breaks.
It’s almost like the 2001 Dot-Com Boom all over again!
The Dot Com Crash
Back in the Dot-Com era, I was something of a momentum investor too. It was the year 2000, internet stocks were hot, and I was young and stupid. Those were the days!
Like many, I was attracted to the fast rising share prices of internet stocks. I confessed that I invested around $10,000 into several “internet funds”. It seemed like a sound investing strategy at the time — Capture the winds of change and set sail for a future full of wonderful gains.
Unfortunately, that strategy didn’t work out so well. All those hot internet stocks were eventually crushed in the dot-com crash, when the bubble finally popped. The internet funds I owned essentially went to zero during that crash.
Luckily the amounts of money I invested back then were quite small, and easily rebuilt. More importantly, the dot com era taught me some very important lessons about investing. I no longer chase popular stocks or those with “momentum”.
With around $3 million in assets, I try to avoid making speculative investments these days. Sure, if I catch a wave by accident I’ll ride it, but I don’t go chasing after the big waves now.
Big waves can be dangerous for investors, just like they are for surfers. Little waves are good enough for me now.
How I Avoid the Madness Of Crowds
These days I actively try to avoid the popular “momentum” stocks. The madness of crowds is no longer a game I want to play. My investments don’t need to change the world, and I’m much happier without the big wild swings from irrational markets.
How do I do this?:
* By not overpaying for growth. Growth is an important component of total return, but it’s also very possible to overpay for it. I’ve written about this extensively in the past.
* By avoiding the big names in the news every day. These are the Amazon’s, the Tesla’s, and the Facebook’s of the world. There are plenty of very good businesses to invest in that get almost no press.
* By actively investing in areas of the market where investors are rational, or even undervaluing assets.
Many investors avoid the so-called “no name” stocks under the assumption that they’ll see smaller returns than the big names. This certainly has been true in 2020, but it’s important to remember that a investing return is more than just market appreciation.
It was John Bogle (founder of Vanguard) that first wrote about the different components of stock returns in his book Common Sense on Mutual Funds.
He said total return is built from the following components:
1. Dividends.
2. Share buybacks.**
3. Business earnings growth.
4. PE expansion/”Market Multiple”.
(** In his book, Bogle included share buybacks in earnings growth, but I’m breaking it out separately here for completeness sake)
For example – Imagine we have a stock that pays 2% in dividends, buys back 3% of it’s shares annually, and is expected to grow its business earnings by 7% this year. Assuming a rational market, (and a “Market Multiple” that remains the same) you would expect this stock to provide a total return of 12%.
That all sounds very sane and mathematical, but we know this is NOT the way the stock market works. The “Market Multiple”, or how much or how little the market values a stock, can vary wildly. Take a look at how PE’s have fluctuated over the last 140 years:
Over this a very long time horizon, PE’s have averaged about 15. In 2020, the S&P 500 PE ratio sits at about 29.
Obviously this is a very big price swing. If you were good at predicting the future, you might have been able to profit from the big swing by investing all your money at the low in 2012 and then riding it up to today’s high.
Unfortunately I’m terrible at predicting the future – I have absolutely no idea what multiple the market is going to be next year, 5 years from now, or 50 years from now. It could return to its long-term average OR it might remain in the high 20’s. I just have no way of knowing.
These days I try to stick to what is knowable and mostly predictable — Earnings growth, stock buybacks, and dividends… AND I try to pay a reasonable multiple for each of those components.
It’s a strategy that works — most of the time. In one of John Bogle’s later books Don’t Count on It, he sought to show how each of the return components contributed to total return over the last 10 decades. He provided this table of returns:
Study that table well. We can clearly see that Dividends and Earnings growth typically provided a return of around 8-10%, but market swings were so powerful they occasionally created a decade of negative returns.
Dividends also tended to be much larger in previous decades. These days more cash is funneled into share buybacks, which fuels higher earnings per share growth. As you might expect, the 8-10% combined return from dividends and earnings growth has roughly stayed the same throughout.
So what effect has a rising market multiple had on stocks?
Well, if we average the annual stock market returns over those 12 decades, it works out to be an average return of 9.57%. This implies that over a long enough investing time horizon, market multiple swings don’t actually matter.
This says that long-term investors needn’t concern themselves with emotional swings of the market, only with dividends and earnings growth.
Final Thoughts
While many of the happy investors in Tesla or Apple are going to disagree with this post, I think it’s important to remember that much of this market mania we’re experiencing is most likely fueled by excess liquidity — low interest rates, and government stimulus money. NOT rising earnings growth, dividends, or share buybacks.
At some point, all that excess liquidity is going to dry-up and come to an end. Interest rates might even begin rising again.
Where does this leave stocks?
It’s not a happy place, that’s for sure. Under the most common scenarios it may mean a “multiple contraction” for the stocks seeing the most extreme and excessive gains. That’s not a place I want to be when the winds finally change.
But to each his (or her) own. It takes all kinds of investors to make a market… even those that believe that earnings, share buybacks, and dividends don’t matter. History disagrees, but I offer them “Good Luck” anyway.
[Image Credit: Flickr1, Flickr2]
This just goes to show that it’s never wise to try to time the market or predict. In March if you told “experts” that we’d still be in the pandemic in late August and asked them where they thought the market would be, I guarantee none of them would have said at all time highs.
I’m just going to keep doing what I always do – dollar cost averaging by still contributing to my 401k, but besides that absolutely nothing. Watching from the sidelines is weird enough.
This is why Personal Capital manages a good sized chunk of my portfolio. They do not market weight their stock picks, my money is not concentrated in a few stocks like an S&P index fund is. It is also why I have large bond and money market holdings. I have no idea what this market will do but I do know it can’t hurt me much no matter what it does.
A well refined strategy Steveark! Congrats!
Yep, weird it is! Thanks for the comment Dave!
Agree completely with this post. It is a rather uncertain time to be invested. We have one major “growth” investment in PINS. When I purchased it, I don’t think we overpaid assuming the company can reach our growth target in a few years. After one good quarter, the stock price shot up 40% in one day! But generally I don’t like investing in these types of companies. If and when there is a correction, I believe tech will be impacted the most. However, there is accelerated creative destruction in place with the pandemic. It’s really hard to measure the impact, because of all the competing variables. Therefore we balance our portfolio between some growth, some value and a foundation of companies who will be extremely difficult displace, like MKC and BF.B. With the pandemic though, most of our value stocks did terribly, mostly due to further declines in commodity prices in beat down industries.
I’m a longtime admirer of MKC. Great company, and the perfect example of a slow growth compounder!
It’s the price that always gets me though!
Hope your stocks do better in the second half of the year!
Perpetually overpriced. We purchased MKC and BF.B years ago and hold on. Wish I could find one of these that nobody heard of.
I think that the index weighting explains pretty well why the market seems so divorced from the economy (“reality”) these days.
Looking at the top S&P500 stocks, good old FAANG stocks are heavily weighted. There’s a lot of tech in there. And those remote work related tech companies are doing great with everyone at home, they’re often seeing record usage.
The rest of the economy is in the toilet but it just doesn’t hold a candle to big tech’s size and investor representation.
So far as crowds and madness… we’ll suppose that’s the point of index funds and DCAing though I suppose that’s kind of a big crowd unto itself. 🙂
Yep, 22.4% of the S&P500 index is just 5 stocks (apple, amazon, microsoft, google, and facebook). That’s very heavily weighted into tech in my opinion.
Be careful out there!
Yeah, these are wild times. You could make a ton of money timing the market with a time machine, but that’s about it. In fact, seriously daydreaming about time machines and stock picks is one of my internal checkpoints that the market has gotten a bit frothy 🙂
If you happen to go out and pick up a time machine, be sure to pick one up for me too! Thanks Paul! 😉
Sometimes being on the bandwagon is unintentional. For instance, over the past several years Apple and Amazon have pretty much eaten my Fidelity portfolio allocation. These two holdings have soared, now representIng about 46% of my total portfolio. I’ve held them both for years. This even includes past attempts at rebalancing, taking some capital gains and always using Apple dividends and share sales to fund my entire 4% withdrawal rate since 2015. I recently read that Apple had even grown to 43% of Warren Buffets portfolio! All of my other holdings are index funds and I have separated Apple and Amazon out so I can get a more accurate picture of my retirement portfolio allocation. Any ideas on how to handle this type of windfall would be appreciated. Rebalancing is difficult in a taxable account with unrealized gains at over 4800% according to Fidelity.
Crazy isn’t it how that happens. Usually I’m of the opinion “let your winners run”, so I don’t usually recommend selling the winners off entirely.
Instead, you might try setting a regular sale schedule. Say for example, selling 0.5% of your holdings in those stocks every month (yes, fractional shares can be traded) for a total sale of 6% of your holdings in that stock every year.
If the stock continues to rise faster than 6% a year, it’ll hold it’s relative weighting in your portfolio. But, should the stock begin to falter, you’ll begin trimming the weighting of those holdings in your portfolio.
This slower selling might also have the benefit of NOT pushing you into a higher tax bracket, but that depends upon your personal income situation of course.
What are your thoughts about getting a total market index fund instead of an S&P 500 fund? I’ve listened to some podcasts and read some articles about what could happen if people pull money out of index funds en masse, I.e. indiscriminate selling at any price. I’m thinking total stock market index vs SP500 has a better chance of surviving. Any other ideas about how to invest and survive such a scenario?
The total market index fund is good, OR you could try what’s called an “equal weight” index fund.
I don’t have any particular fund to recommend, but the idea is that every stock in the equal weight index fund holds an equal weighting. Should things crash, you’ll have a much better chance of maintaining value by having heavier weighting to the 495 stocks instead of just the top 5.
I think everyone is jumping on the tech bandwagon , particularly the FAANG stocks and especially after this Covid19 crisis. Many people stuck at home using tech.
I personally own no individual stocks that don’t pay dividends as I am a dividend growth investor.
For tech growth I have QQQ which I think is safer than picking individual tech stocks. But I am just amazed on how tech all around is just skyrocketing now.
Another thing is probably the current record low interest rates pushing more money into the market.
I think you hit the nail on the head ezdividends, but don’t forget even in funds like QQQ you hold 55% in just 10 stocks…. entirely tech stocks.
This market feels like the dot com bubble, but more complicated. Back then, everything was inflated. The businesses wasn’t matured yet. Now, the big tech companies are raking a lot of profit. It’s probably like MSFT/INTC in the 90s. The price got inflated too much and their stock was depressed for a long time. I guess we’ll see how it goes.
Yep, I guess we will! Thanks for the comment Joe!
The market doesn’t make any sense. Tesla is making going up every day and it’s barely making any profits. Not to mention we’re in the midst of a global pandemic but the stock market seems to be going up and up. It sure doesn’t make much sense right now…
Yup, Tesla may be up 400% this year, but they certainly haven’t shipped 4x as many cars or somehow figured out how to be 4x as profitable.
I just look at the valuation next to Toyota (the largest an most profitable car manufacturer in the world) and just shake my head.
It’s going to be a rough ride for sure. You would think that the bear market we just got out of would be wake-up call to those relying on that money in short term, but as the market’s back to hitting highs, it doesn’t seem like it.
I don’t have a lot of money in individual stocks anymore with the exception of a couple that I kept for fun (Google and Amazon). But as the prices continue to rise, I’m even selling a little of that off because it’s becoming too large a part of my portfolio. I bought 13 shares of AMZN at $67 (one of my few wins) but I sold a share at around $2k last year and 2 shares recently for just over $3k each. I’d love to think it’ll keep going up, but there’s got to be a limit somewhere.
More and more people are buying these tech stocks (including me to a limited degree). The split, I believe, for both AAPL and TSLA will allow the price to go up further as it’ll allow younger investors to purchase whole shares. As with all stocks, what goes up will eventually come down; take some profits if you’re able to and move on.
The problem is we’re faced with the choice to either sit in cash (why not? bonds yield nothing) for potentially several years waiting for rational valuations OR we can try our hand at market musical chairs.
Which is the rational way to FIRE? The cash/bonds route yields nothing, and so probably has a low probability of success. The market bubble, however, could continue inflating for another 2-3 years. If you jump out in time, you’re a millionaire. So what’s the rational choice, the option with little chance of success or the option with potential to retire in the next couple of years?
Also, if Amazon, Salesforce, and Tesla crash, the rest of the market will go down with it. Paying a PE of 15 for a stock seems reasonable until it goes to 10.