The Least Important Questions
There are no guarantees. There is no free lunch. These are some of the most basic tenants of business and markets that all investors must learn. In the world in which we live, the lack of certainty seems to grow more and more as each day passes. Be that as it may, if there is one lesson that we can learn from studying financial history it is that markets are cyclical. They go up and then they go down. We never know exactly when that inflection point will be, or how long prices will move in the same direction, but we can be reasonably assured that at some point the direction will change. History has proven such as surely as night follows day. The upward moves within a cycle are referred to as bull markets (20% + gain in the index) and the downward moves are known as bear markets (20% + loss in the index).
Some would argue that we are in the early stages of a new bull market cycle as the global economy begins to recover from the pandemic. We disagree with that assessment. While it is true that the S&P 500 fell over 33% in March of 2020, only to quickly recover and finish the calendar year with a positive return of 16%, we do not believe that 2020 provided a reset of a new cycle. Our primary rationale is that in a typical down cycle, falling stock prices and slower economic activity are accompanied by a cleansing of the system. In that environment, bank credit tightens, investor behavior becomes more conservative and many weaker companies go out of business and declare bankruptcy. However, the normal process of a business cycle was not allowed to play out in 2020 as the Federal Reserve and Congress came to the rescue with over $5 trillion freshly minted stimulus and liquidity. Instead of a period of tightening credit and cautious behavior, we had an explosion of easy money and reckless speculation. Therefore, for all intents and purposes, we believe that we are still in the same bull market that began on March 9, 2009 at the nadir of the Great Financial Crisis. At 157 months long and counting, the current bull market is almost 3x as long as the average cycle over the last 90 years which lasted 56 months. The reason as to why this cycle has lasted so long is up for debate, but we believe the vast amount of Federal Reserve stimulus may have something to do with it.
For all that we do not know, we can be reasonably sure that, after 13+ years of going up, the market will eventually go down. When will that happen? How far will the market fall? How long will it last? Those are questions that we will not attempt to hazard a guess at. However, something we are
more confident in, again drawing on market history, is that when the tide does change and stocks clearly enter a new phase, all investors, big and small, retail and institutional will want to know why. Was it the spike in oil prices? Did the geopolitical tensions and war in Europe cause the market to drop? Did the Federal Reserve raise interest rates too quickly or maybe not enough? These questions have already been fiercely debated on the financial news programs as the market has gotten off to a bumpy start in 2022. With all of the ups and downs of the last 3 months, the S&P 500 is only down about 6% YTD. Can you imagine how much more intense these discussions will become if the market drops by 15 – 20% or more? Everyone will demand to know who caused it? Who is to blame? We would submit that, while all of the negative catalysts mentioned above are important and significant in their own way, they are not what investors should be focusing on. As John Kenneth Galbraith states in his book, A Short History of Financial Euphoria, “the least important questions are the ones most emphasized.” Put another way, it is not the event(s) that prick the bubble and cause the market to drop that matters. Rather, it’s an understanding of the series of actions and behavior that got us to this point where the market has the potential to suffer a serious decline.
One of our primary concerns relates to current stock valuations. Those concerns would likely be denounced as unsophisticated and irrelevant in the Twittersphere. The talking heads on financial news shows tell us almost daily that valuation has no direct correlation to what a stock or stock market will return over the next year. That may be true. However, to quote Howard Marks in Mastering the Market Cycle, “we may never know where we’re going, but we’d better have a good idea where we are.” People always say that you cannot time the market, and we would absolutely agree. You cannot time the market, but you can price the market. You can buy and be aggressive when prices are low, and you can sell and be more cautious when prices are high. Sounds easy, right? Unfortunately, investors of all shapes and sizes typically do the exact opposite. While valuations may have no predictive value over the next 12 months, they are very meaningful in predicting returns over the next 5 to 10 years.
Many market pundits tell us that stocks are not expensive at current levels. Assuming a level of 4,500 on the S&P 500 and estimated earnings per share for 2022 of $225.37, the price to earnings
ratio is only 19.96x. That compares to a 20-year average for the S&P 500 of 17x. A simple way to think about the price-to-earnings (P/E) ratio is to look at it in terms of how much you have to pay to buy $1 of earnings. A 20-year average P/E of 17x tells us that historically you have had to pay $17 on average to buy $1 of earnings in the stock market. Today the price is slightly higher at $19.96 for $1 of earnings. Many pundits will tell you that a slightly higher P/E is nothing to worry about, especially since we are in the early innings of a recovery as we come out of the pandemic. We believe that narrative is worth a deeper dive.
A strange thing occurred with regard to business earnings over the last 2 years. Prior to the pandemic, earnings for the companies in the S&P 500 grew at an average rate of 6.17% from 2011 to 2019. Based on the estimated earnings for 2022 of $225.37, earnings growth since the beginning of the pandemic will double the pre-pandemic rate at 12.3%. That includes a 14.12% drop in earnings in 2020 and a massive recovery in 2021 with a 50.28% year-over-year growth rate. We are left with a situation where we are supposed to believe that somehow the economy is much better off (earnings growth at twice the rate) than if the pandemic had never occurred at all. S&P earnings of $225 per share in 2022 is significantly higher than any analyst predicted back in December of 2019. It does not make any sense on the surface, unless you account for the $5 trillion of combined monetary and fiscal stimulus that was pumped into the system, $850 billion of which was sent in the form of checks to households. Many companies, from Dick’s Sporting Goods (DKS) to Apple (AAPL) and everything in between, saw a massive explosion in sales and earnings in 2021 that was unlike anything they have ever seen before. The market expects earnings to continue on in an upward fashion. Our concern is that when the sugar rush of $5 trillion wears off, earnings per share will likely fall back to the trajectory it was on pre-pandemic, and maybe even fall below that level as there has been massive demand pull forward resulting from the stimulus packages.
Ben Graham once said “that the primary cause of failure for investors is that they pay too much attention to what the stock market is doing currently”. For this reason, many of the greatest investors of all time have paid less attention to current earnings, and put much more emphasis on the trend over the last 5 to 10 years, and, most importantly, what they believe the world might look like 10 years from now. Below is a chart of the Shiller CAPE (cyclically adjusted price-to-earnings) Ratio that assists with a longer-term view.
The Shiller CAPE Ratio, created by Yale economics professor, Robert Shiller, compares the current price of the stock market to an inflation-adjusted average of the last 10 years of earnings. By averaging earnings over a 10-year period, the CAPE Ratio completely eliminates any abnormalities that can and do arise from one year to the next, especially when massive government intervention is involved. Based on this analysis, stocks are 79% above their 50-year average (37.79 vs. 21.09 average). That presents a much more concerning valuation picture than the current 12-month P/E being 17% higher than average.
If the least important questions are the ones most emphasized, we would consider an assessment of current valuation as one of the most important questions that nobody talks about. If they do talk about it, they simply pay lip service to it in order to move on to more exciting discussions such as world changing technology. It is no difficult task to find market pundits who talk like fundamental investors but act like speculators. The actions that we witness in the market today are no different than they have ever been. In the forward to the 1993 edition to his book, A Short History of Financial Euphoria, John Kenneth Galbraith described it the following way.
In the first Foreword to this volume, I told of my hope that business executives, the inhabitants of the financial world and the citizens of speculative mood, tendency or temptation might be reminded of the way that not only fools but quite a lot of other people are recurrently separated from their money in the moment of speculative euphoria. I am less certain than when I then wrote of the social and personal value of such a warning. Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system. Perhaps it is better that this be recognized and accepted.
At JPS Financial, we believe an important part of our job is to assist clients in filtering through the unlimited supply of financial news and information and focus on the most important questions as opposed to the ones most emphasized.
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