The Price Is Right?
FC Advisors Quarterly Investment Update – Q3 2018
Believe it or not, there are actually two completely different ways of looking at investment markets. Most people, almost by default, subscribe to the idea that the price you see in the market is always correct. Basically, everything is worth what someone is willing to pay for it. If you can buy it for that price, and you can sell it for that price, then the price is right! It’s clean and simple, so most people just take it at face value and move on.
However, this way of thinking occasionally gets people into trouble because it allows people to disengage their critical thinking. Without critical thinking, a consistently rising price with an exciting story about why the sky is the limit can look like an incredible investment opportunity. Remember Dotcom stocks in 2000? Rising prices attracted attention and excitement, which created a self-fulfilling prophecy of yet more price increases and even more excitement. It went on for long enough that anyone who wasn’t on board was written off as out of touch. Until eventually there was nobody left who could be convinced to buy at such high prices. Then suddenly, the price had nowhere to go but down, and if you believe that the price is always right, then falling prices are scary! On this rollercoaster ride, a few people made money, but most people lost a lot.
Thankfully, the other way of looking at investment markets is a little less exciting. There are some people who actually believe that the price is always wrong! This school of thought subscribes to the notion that all things have a price, but that the price does not necessarily correspond to what that thing is actually worth. The concept of what something is worth is known as “intrinsic value.” It takes time and energy to do the work necessary to estimate the intrinsic value of a business. Most of the time, after you do the work, it turns out that the price is pretty close to where you think intrinsic value is. So why would anyone spend all that time and energy? Because you get to relax and you keep more of the money you make. When you are convinced that the price is rising for irrational reasons, you don’t have to anxiously chase those prices ever higher. When you are convinced that the price is falling for irrational reasons, you don’t have to worry about falling prices; in fact you can use them to your advantage!
It is our goal to help all of our clients enjoy the peace of mind that comes from understanding that the price is NOT always right. Today, we firmly believe that the price of most financial assets, especially US stocks, exceeds intrinsic value. Therefore, we prefer to err on the side of caution in order to protect our clients’ wealth so that we can be more aggressive when prices are lower and fear is widespread.
- The Quarter in Review
- Sentiment & Value Update
- Chasing Benchmarks
- Losses & Recoveries
The Quarter in Review
US stocks resumed their march higher and reached new all-time highs on expectations of strong earnings growth. Marijuana related stocks became the new super-hot investment. Meanwhile, most international stock markets, particularly in emerging markets, suffered losses as the strengthening dollar dampened returns and stoked fears of debt defaults. In the bond market, interest rates rose as both GDP growth and inflation continued to trend higher. Once again the only comfortable place to be was US stocks.
Relevant Index Performance
Total Returns as of 9/28/18
Index Qtr. to Date Year to Date
S&P 500 7.71% 10.56%
MSCI World ex-US 0.98% -1.62%
MSCI Emerging Mkts. -1.09% -7.68%
S&P Municipal Index -0.14% -0.16%
10-Year Treasury -0.57% -2.11%
Sentiment & Value
The chart above shows our opinion on where various markets are as of September 28th 2018. Many of the best purchase decisions are made when prices are cheap and sentiment is bearish or depressed (bottom left quadrant). Conversely, many of the best sell decisions are made when prices are expensive and sentiment is bullish or euphoric (top right quadrant). This chart and the comments below are intended as a behavioral guide, not as a timing tool.
Fear has come back into the price of international equities, but US equity investors have actually become more complacent. The stellar performance of the S&P 500 so far this year, masks some disturbing weakness in the index. 40% of the companies (204 to be exact) in the S&P 500 are actually down year-to-date. Additionally, 5 of the largest companies: Apple, Microsoft, Amazon, Google (aka Alphabet) and Netflix account for more 70% of the price appreciation in the S&P 500. Without these 5 companies, the “S&P 495” price would only be up 3.19% year-to-date. All of these details suggest that US equity markets are more fragile than they appear. There is no telling when or how US equity prices will return to more normal valuations. Historically, some sort of market crash ends up washing out excessive optimism and forcing weak companies out of business. Prices and expectations are high enough now that virtually any negative development that captures the attention of the market could precipitate a major correction in equity prices. For that reason, we believe it is best to continue allocating portfolios more conservatively than normal.
All things being equal, if the S&P 500 were to trade below 2,400, we would be interested in buying US stocks and if the 10-year treasury yielded more than 3.25% we would begin adding to long-term bond positions.
Issue: “FOMO” or Fear Of Missing Out is on the rise. Increasingly, investors who have missed out on the returns from the 9-year bull market in stocks are worrying about missing out on even more future gains.
Impact: Investments motivated by FOMO are among the most dangerous investments investors can make. These “buy high” decisions are almost always followed by panic selling once prices fall.
FC Advisors’ Take: FOMO is a clear sign that a herd mentality of greed & optimism about future returns is pushing the market higher. One of the biggest risks of believing that the “price is always right” is that it often tricks us into taking the most risk at precisely the time that we are getting the least reward for taking extra risk. Every major asset market crash has been preceded by a robust run-up in prices. Dotcom stocks, real estate, and crypto currencies… the list goes on and we will surely be adding to the list many more times in the future. For instance, it’s a good bet that marijuana stocks will be next! In each case, suitable investment analysis in which risks and rewards were evaluated against each other gave way to unbridled optimism as prices rose and fears were cast aside.
When FOMO becomes widespread, a market top is often at hand. There is no reason that the market cannot keep running higher, but history teaches us that the more the market price overshoots “fair value” to the high side, the more it will eventually overshoot to the downside. Higher reward and lower risk investment opportunities will almost certainly present themselves during the next recession, if not sooner.
Issue: Since 2009 no other major asset class has come close to delivering the performance of US stocks. The S&P 500 is on one of its biggest and longest runs of all-time. Increasingly, investors are considering US stocks to be a “safe haven” asset class.
Impact: Investors often end up accidentally buying high when an asset class has had consistently strong investment performance. Eventually, the “no-brainer” opportunity turns into a crowded trade and losses become inevitable.
FC Advisors’ Take: Nothing lasts forever. At this time we consider taking incrementally more risk in US stocks to be a poor investment decision. The most basic tool for valuing stocks is known as the P/E or Price to Earnings Ratio. Simply put, this ratio shows an investor how much they are paying for each dollar of earnings. For example, a company that earns $0.50 per share, with each share trading at $10, would have a P/E ratio of 20 times earnings. Generally, higher multiples suggest that investors are betting on more growth in the future. Currently the P/E ratio of the S&P 500 is 21 times earnings. The long-term average for the S&P 500 is 16 times earnings. So today’s prices are relatively high. But digging a little deeper suggests that US equity investors are throwing caution to the wind.
Losses & Recoveries
Issue: A lot of attention gets paid to the missed opportunities in stocks near the end of bull markets, even though history repeatedly teaches us that the best opportunities present themselves at the beginning of new bull markets.
Impact: Hoping to catch the last pieces of the stock market upside, when expectations and prices are high, sets investors up for bigger losses. With history as our guide, the psychological and financial pain of these losses will prevent investors from participating adequately in the ensuing recovery.
FC Advisors’ Take: How do you lose 50%? First you lose 20%, and then you lose another 37.5% from there. The math behind the way losses accumulate is excruciating. It makes putting any new money at risk increasingly difficult. Worst of all, the amount you need to gain in order to work your way back increases exponentially.
While striving to limit losses is critical, that is only part of the story. The big payoff comes to those who are prepared to incrementally add exposure to stocks in the wake of a market crash. This will invariably be when prices and risks are at their lowest and the potential for gains is at its highest. Fear of yet more losses will also be very high. Despite that, no matter how much (or little we hope!) we lose in the eventual crash, we will all have access to the same set of opportunities at the beginning of the next bull market. If history repeats itself, only a small portion of today’s investors will have the wherewithal to take incrementally more risk from the beginning. If you want to be one of the few who can cash in on the BIG opportunity, the time to prepare is now.
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Following Claire Advisors, LLC DBA FC Advisors is a Registered Investment Adviser. This brochure is solely for informational purposes and is not intended to provide investment advice. Advisory services are only offered to clients or prospective clients where FC Advisors and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by FC Advisors unless a client service agreement is in place.