We like the idea of a generic newspaper. In the Business & Finance section the headline could read “Future Uncertain” and “Companies Raise Dividends”. On any given day, the details of the headlines vary, but over the long term, the headlines rarely change substantially – it’s just the underlying details that make the newspaper a daily event.
Which leads us to one historical truth - all times in the market are uncertain. Give us a year and we’ll tell you how the world was uncertain. Vietnam War, Hyper-Inflation, Cold War, Gulf War, Stock Market Bubble, 9/11, Housing Crash, Financial Crisis – the list goes on and on, and this is just the past 50 years.
But somehow over the long term the stock market keeps doing well. How can that be?
The simple answer is that even through wars, depressions, crashes, bubbles, and all calamities, the people of America go to work to increase the profits of their companies. The American economy has shown consistently staggering productivity.
In fact, as a whole, profits of all corporations when added up together have DOUBLED just about every ten years. This includes the hundreds of companies that go bankrupt every year, and the companies that become wildly profitable like Amazon, Google, & Berkshire Hathaway. Peter Lynch said “So, you have to say to yourself, ‘What are corporate profits going to do?’ Historically, corporate profits have grown about eight percent a year. Eight percent a year. They double every nine years. They quadruple every 18. They go up six-fold every 25 years.” http://www.pbs.org/wgbh/pages/frontline/shows/betting/pros/lynch.html
So even though our political future is very uncertain with Russia, Syria, and North Korea, and our economy is uncertain with major political reforms and whole sectors of the economy being changed dramatically due to innovation, the best companies are continuing their laser like focus on increasing productivity and profits, which ends up helping us the shareholders.
If you look at the total return of the US stock market as determined by the widely-followed S&P 500, the total annualized return during the period of 1/1/1977 – 1/1/2017 was 10.004% if you include reinvesting dividends.
That’s what we are aiming for at Denver Wealth Management – to capture the long-term return of the stock market for our investors who are invested aggressively (as we add bonds or fixed income to your portfolio, our goal is to be less volatile than the overall stock market both to the positive and negative). We don’t know when we’ll have years with outsized returns – or when we’ll have AN ENTIRE DECADE of zero returns (2001-2011 S&P 500). Therefore, we think it makes sense to diversify our investments.
We realize that just saying the phrase “diversify your investments” is boring enough to put an insomniac right to sleep. But you pay us to manage risk and make money so here we go.
Remember two paragraphs ago when we mentioned corporate profits doubling every 10 years? That’s true in almost all scenarios. However, the most important factor is not corporate earnings, it’s HOW MUCH WE’RE PAYING FOR THOSE EARNINGS – and right now, we’re paying a lot!
The current S&P 500 price-earnings ratio (P/E Ratio), or how much of a company’s earnings a dollar buys us, is 26.3. That means, for every $100 we invest into the stock market today, we are buying $3.80 earnings from publicly traded companies.
That’s a lot of money to buy just a little bit of earnings – and it’s above the historical average. So one of two things are likely:
- Companies in the US need to increase profits so that the $100 we invest in the stock market today buys us more in earnings (which potentially increases the value of our investment)
- The stock market has to drop from $100 to a lower price to get us back in line with historical valuation
Now Scenario 1 (potential increase in profits) can happen in a few different ways:
- Companies can improve their products and processes and make more money
- Inflation can cause the cost of everything to go up (including companies’ products)
- Companies buyout or merge with another business to expand their market
- Corporations get a big tax break and profits go up immediately
The market is betting very heavily on option 4. Corporate tax rates go down and the expensive cost of the stock market is instantly justified. But Republicans are having some trouble coming together to pass legislation and the market is starting to worry that the tax cuts won’t happen in 2017.
Whenever we try to use the word “guarantee” in our quarterly newsletter, LPL’s Compliance Department doesn’t like it. However, we think we can make one guarantee that they will allow. We guarantee that we cannot predict the fluctuations of the stock market. Those who try fail and it is a very expensive lesson.
So, what’s a long term investor to do, knowing that the appreciation we’ve all seen in our accounts can be lost at any time in a stock market drop?
Diversify, Diversify, Diversify
Despite getting all the attention, the S&P 500 is only one part of the investable universe. We also need small-sized companies, international companies, real estate, bonds, and companies that are invested in emerging markets like Croatia & Peru.
Another way to diversify is by having multiple strategies in your account. We always own a combination of diversified ETFs (that mirror the S&P 500 Index and other indexes) and mutual funds, where we pay a fund manager to select investments they believe will outperform. In fact, we spend the majority of our time doing one of three things:
- Writing and helping to implement financial plans for clients
- Researching investments’ management and track records
- Designing portfolios that manage risk according to our clients’ needs
We believe that doing extensive due diligence on every investment we buy, is well worth the time and effort knowing that we are only buying what we believe are high quality investment managers.
This is a long letter so to summarize here are the three main points:
- The world is always uncertain
- The US stock market is expensive compared to its historical valuation
- Diversification is the key to managing the possible downside in an expensive market
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 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.
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.
Exchange Traded Funds concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly.
Investing in mutual funds involves risk, including possible loss of principal.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
No strategy can assure success or protect against loss.