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:
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.
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.