It's portfolio review meeting (PRM) recap time.
As a reminder, the PRM—an integral part of our investment process—happens at least monthly, in which our entire Investment Committee collaborates to discuss our holdings. We review the past performance of assets in our portfolios, examine the current market and economic landscape, and touch on our short- and long-term investment forecasts.
Our May 2021 PRM came at an odd time—interest rates are low, stock valuations are high, and the stock market is regularly closing at new record highs. Amid the uncertainty, I want to discuss the importance of having a process when seeking new investment opportunities.
[1:26] If you regularly listen to the Mind of a Millionaire (MOAM), then you've undoubtedly heard us discuss diversification. Diversification is a fancy word for "don't put all of your eggs in one basket." Diversification can look different in any investor's portfolio depending on their financial needs and investment objectives, ultimately aimed at capturing upside potential while protecting against various risks. If you have questions regarding diversification in your account, don't hesitate to call our office at (303) 261-8015 to schedule a meeting with one of our advisors.
While diversification should certainly be an element in your investment process, I won't say much else on the topic. Instead, I want to discuss the three-legged stool to evaluating market health. Although Eventide Funds first coined the idea, I believe it can help most investors elevate their process.
The stool's three legs are sentiment, valuation, and leading indicators.
[2:48] Market sentiment is as it sounds: the general attitude of investors toward the market. In May 2021, there is extreme bullishness in the market—more and more investors are pouring money into stocks, which is justifiable considering bonds' low interest rates.
Historically, investors have looked at the bond and stock markets as inversely correlated. In other words, as stock prices rose, bond prices fell and vice versa. However, fast-forward to the modern era, and that's not necessarily the case—investors aren't paying as much attention to the bond market overall when evaluating stocks.
Instead, investors are turning their attention to various stock indexes. For example, the Dow Jones Industrial Average (DJIA) comprises 30 of the largest U.S. companies. These companies generally have a strong track record of performance and reliable dividend distribution. They tend to hold their value over time, providing solid investment options for less risk-seeking investors. However, they may not be a suitable fit for investors seeking opportunities for rapid capital appreciation.
More aggressive investors are interested in the tech-heavy Nasdaq Composite. Tech is widely regarded as the poster child for growth companies, whose main objective is just that, growth. Rather than paying dividends to shareholders, growth companies reinvest their earnings in themselves to help facilitate development. Thus, shareholders of tech companies (and similar growth companies) are more interested in the long-term growth potential rather than regular interest payments.
What we see now is as the DJIA goes up, the Nasdaq goes down. As the Nasdaq goes up—you guessed it—the DJIA goes down. As noted above, less-risky investors who once sought shelter in bonds are turning their attention to reliable stocks, such as those included in the Dow Jones, to address income needs.
Right now, market sentiment is extremely bullish, which can be a negative indication. As buyers flood the stock market, the risk of a correction increases. On the other hand—think March 2020—when investors are extremely bearish, it may be an excellent opportunity to buy in.
In the wise words of Warren Buffett, "Be fearful when others are greedy; be greedy when others are fearful."
[5:51] How much are we actually paying for the S&P 500?
Quick Definition Alert: Price-to-Earnings (P/E) Ratio. The P/E tells you how much an investor is willing to pay for that company's earnings. For example, if XYZ Corp. has a P/E of 20, that means investors are willing to pay $20 for every $1 of XYZ's current earnings.
Trailing P/E divides the current market value of XYZ by their earnings-per-share over the last 12 months. Forward P/E estimates XYZ's earnings for the next 12 months.1
Alright, back to the good stuff.
Newspapers and financial media outlets are littered with talk of an overpriced market, which does have some merit. Right now, the S&P 500's trailing P/E is 71% above the historical average (since 1960). It's high, sure, but looking back at the past 12 months, our economy was plagued by closures—businesses couldn't generate high earnings.
The forward P/E, however, is still 46% above the average. So, investors are still paying a massive premium compared to historical data.
You may be wondering, if stocks are so expensive right now, then why don't investors look to bonds? For that, we look to the equity-risk premium. The equity-risk premium essentially tells investors how much we're receiving to take on additional risk in the stock market rather than playing it safe by investing in bonds (specifically, government bonds). That number is also well above the historical average.
Between the extremely bullish market sentiment and high valuations, some stocks are not looking attractive right now. BUT, I haven't gotten to the best part. I've been saving the best for last.
[7:41] Leading indicators simply tell us how the economy is doing. In other words, what could possibly be happening to justify such high stock prices?
Spurred by pent-up demand, leading indicators are literally off the charts right now. Take cruise liners, for example:
Last year, they canceled cruises and reimbursed voyagers-to-be with trip vouchers. Those voucher-holders, in turn, redeemed their cruises for this year (2021). Non-voucher-holding regular people who wanted to explore the ocean's vastness in 2021 then had to buy tickets for 2022. So now, if you want to go on a cruise, it's going to be a couple of years.
The cruise liners are merely one example of what's happening in the larger U.S. economy. Money that wanted to spent last year is either being spent now or is earmarked for the near future. Thus, the economy is revving up, and businesses are doing well by extension.
[9:13] Two no's and a yes aren't enough to send you through to Hollywood on American Idol, but they are enough to get investors thinking. For investors with time horizons of 10+ years, you may weather the volatility storm. The S&P has closed at 25 new all-time highs this year; more record-breaking days are certainly within the realm of possibilities.
If you're a shorter-term investor, on the other hand, you may err a bit more bearish. Given the high valuations, a 10% market drop is a possibility. Some tech moguls that grew hundreds of percentage points since the March 2020 drop have fallen consistently over the past couple of weeks.
WHERE DOES THAT LEAVE US?
[10:22] The stock market is expensive, but bonds aren't paying high yields. We're at a bit of a crossroads, which brings up a popular saying around our office: If you're an income-seeking investor, that doesn't mean you're a bond investor—other securities may be suitable, including utilities, real estate investment trusts (REITs), master limited partnerships (MLPs, which we aren't huge fans of), and so on.
Our team is keeping our eyes peeled for investment opportunities so that when (if) the levy breaks somewhere, we can act promptly and appropriately. We won't be stuck in this weird doldrum forever. If the market drops 10-20%, that may present a solid buying opportunity. If the bond yields increase to 2.5-3%, that may also present a buying opportunity.
Some months we leave the PRM excited, eager to make moves. This month, we're watching and waiting.
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1Fernando, Jason. “Price-to-Earnings Ratio – P/E Ratio.” Investopedia.com, 8 Feb 2021. https://www.investopedia.com/terms/p/price-earningsratio.asp#:~:text=The%20price%2Dto%2Dearnings%20ratio,multiple%20or%20the%20earnings%20multiple (Accessed 17 May 2021)
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing includes risk including the possible loss of principal. No strategy assures success or protects against loss.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to marker and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Growth investments may be more volatile than other investments because they are more sensitive to investor perceptions of the issuing company’s growth of earning potential.
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