October 2014: Ignore History or Learn From It

 


“Those who cannot remember the past are condemned to repeat it.” – GEORGE SANTAYANA, The Life of Reason

 

The lessons of financial history are, and will always be, relevant.  In the midst of a surging stock market and widespread complacency, like now, it’s easy for investors to ignore the lessons of stock market history.  It is also an unaffordable luxury.

In today’s investment marketplace, we can make no stronger statement of greater relevance than valuations matter. Paying too much for an investment leads to poor returns.  It’s that simple.

Look at this using a simple illustration. If you paid $100 for an investment that provides $10 of annual profit, the annual percentage return is 10%.  However, if you paid $200 for the exact same investment, $10 of annual profit provides only a 5% annual return.  It’s the same investment, but with different rates of return depending on how much you paid for the investment.  Buy it cheaply and you’ll enjoy a much better return than if you overpay for it.

Today’s stock market is like the $200 valuation example, while the $100 price is more representative of historically average valuations in the stock market.

If you buy an investment at the upper end of its historical valuation, which is characteristic of current stock market valuations, the “downside risk” (potential for meager returns or losses) is high, and the profit potential is low.  On the other hand, when you buy an investment at a reasonable price, such as the historical average, the downside risk is considerably less and the profit potential is reasonable.  And, in the best scenario, if you buy stocks priced below historical valuations, not only is the potential downside risk low, but the upside potential for profit is quite high.

There are two reliable barometers of valuations that are useful in determining future returns:

1. The Shiller Cyclically Adjusted Price Earnings Ratios, or “CAPE” (see our April 2014 Commentary), and

2. The ratio of Stock Market Capitalization to Gross Domestic Production, i.e., the total value of the stock market in comparison to economic output (see our July 2014 Commentary).

The utility of these metrics is that their readings are highly correlated with future returns.  When valuations are high, future returns are poor.  Conversely, when valuations are low, future returns are high. Both metrics are currently at lofty levels, indicating valuations are exceptionally high.  Both metrics point to low stock market returns in the coming years.

 

 “That men do not learn very much from the lessons of history is the most important of all the lessons of history.”                                                                                                                                                  – ALDOUS HUXLEY

 

Studying history, learning from history, and acting on what we learn are extremely important. We find it amusing and alarming when pundits assert that the stock market is cheap at current valuations.  Using the Shiller methodology, which has shown consistent reliability in foretelling future returns, today’s stock market is presently among the four most overvalued stock markets in the past 130 years.  The other three times were 1929, 2000 and 2007 --- and we know how those periods ended.  In each instance there was a specious hypothesis of why “this time is different” and why extraordinarily high valuations were justifiable. None of them held true. Why, other than for the comfort of delusion, would anyone think that this time will be different?

 

“The four most dangerous words in investing are, ‘this time is different.’” – Sir JOHN TEMPLETON


Statistics 101: Two Types of Errors

In statistics there are two types of errors.  A Type 1 error (false positive) is when you heed the warning of lower stock prices and reduce exposure to stocks, but should not have. The consequence of a Type 1 error is missed profits.  A Type 2 error (false negative) is when you ignore the warning (stay fully invested in the stock market) but should not have.  The consequence of a Type 2 error is a loss of capital.  Of course, neither you nor we want to make either type of error.  But, which type of error would be worse for a prudent investor? We can tolerate a Type 1 error of foregone opportunity, but a Type 2 error could be catastrophic to your and our portfolios.  Knowing what we know, and acting on the lessons of history, our choices are clear and necessary.

Using and Profiting from this Information

It is unfortunate that the lessons of financial history are commonly ignored.  But, each investor has a choice to either ignore those lessons or heed those lessons.  We choose to heed the lessons of history, seeking a steadier, more prudent path.  In light of the lessons of history, along with high valuations, how could anyone other than a speculator choose differently? The investment consequences of extreme overvaluation have all ended the same way… badly.  Perhaps not immediately, but eventually the excesses will be corrected.

Investing Today

Our managed portfolios have lower than normal amounts dedicated to stock investments.  In lieu of higher stock allocations, our portfolios hold above-average allocations of cash and bonds. We believe this will help us to better weather the adverse consequences of an overvalued stock market.

What if the stock market continues to rise, becoming even more overvalued?  Of course, that’s always a possibility.  With that said, we believe the peak in this stock market cycle was reached last month (S&P 500 at 2,011).  If we are wrong, we will continue to participate in market gains, although to a lesser extent than if we held a larger portion of your portfolio in stocks.  On the other hand, what if the stock market retreats and returns to average valuations or lower?  We would participate in that decline, too, but to a much lesser extent.  Given today’s lofty stock market valuations, we believe this is an appropriate trade-off for investors seeking both profits and the protection of their capital.

Prices will eventually become more reasonable and offer the potential for high returns with reduced risk.  We would like that to occur sooner than later, but neither we nor anyone else has control over that.  Our plan is to add to your stock holdings when valuations are lower and the prospect emerges for capturing greater returns with reduced risk. We believe this is not a matter of “if,” it is a matter of “when.” Patience is essential for investors who want to preserve their capital and capture solid gains without taking undue risk.

Conclusion

It would be wonderful if we could pinpoint the exact turning points of stock market cycles, but it doesn’t work that way.  What we can do, however, is study and learn the lessons of financial history and act on them, as we have done and will continue to do.

As your investment managers, we are obligated to “call ‘em like we see ‘em.” We take no pleasure in pointing out today’s lofty valuations and the negative implications of these valuations if unheeded. We wish we could say that today’s stock market offers good value and the potential for high profits.  We cannot.

We can’t change the investment environment; we can only adjust portfolios in light of the environment.  Investing is not a sprint; it’s a long distance marathon.  In that, our clients can be assured of our steadfast commitment to guide and defend them and their capital. ***

                                                                        --- Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2014