Tag Archives: investing

Valuations Are 80% Of The Stock Investing Story

By Rob Bennett I often make the claim that it is a terrible mistake for buy-and-holders not to take valuations into consideration when setting their stock allocations, because the peer-reviewed research in this field shows that valuations are the most important factor bearing on whether an investor achieves long-term investing success. I say that if you get valuations right, you are almost certain to do well in the long run even if your understanding of all other issues is poor, and that if you get them wrong, you are almost certain to do poorly in the long run even if your understanding of all other issues is strong. I sum up the point by stating that the valuations issue comprises roughly 80 percent of the stock investing story. It’s an informed estimate. I don’t believe that there is any way to say precisely how big an impact understanding valuations will have on an investor’s long-term success. But the evidence that I have seen has persuaded me that the valuations factor is of far more importance than most people realize, that it may well be 80 percent of the stock investing story or perhaps even a bit more than that. How much would you say that price matters when buying a car? It’s certainly not the only factor. You need to be sure that a car is well made. A poorly designed car is not a good deal even at a low price. And you need to be sure that the car you buy is one well suited to your needs. Someone who desires a sports car will not be happy with even a well-designed family van. And there are lots of personal considerations that need to be taken into account. Some people like red cars. Some people like black cars. Getting the color right can add a good bit to your enjoyment of the car you buy. Still, I think it can be said that researching prices and negotiating a good deal on price is 80 percent of what makes one a successful car buyer. Getting the color right is easy – you just need to be willing to drive to a second dealer if the first one you visit does not have the right color in stock. And it doesn’t take too much effort to identify the best style of car to satisfy your particular needs. We all know what is out there. You might need to check out a few vehicles to decide which particular sports car or which particular family van is right for you. But it is not difficult to get that aspect of the car buying experience settled in your favor. Nor does it take much research to learn which cars have a reputation for being built well. Getting the price right is harder. If you accept the dealer’s price, you are almost certainly going to overpay by hundreds of dollars, and quite possibly by several thousand dollars. If you do enough research to enter the dealer’s lot with confidence that you know the fair market value of the vehicle that you intend to purchase, and are willing to invest the time and energy needed to negotiate a good deal, you are going to enjoy a huge dollar return for the hours invested. You can improve your car deal by thousands of dollars by working the price aspect of the matter, potentially turning a very bad deal into a very good deal by focusing on this all-important issue. There is now 34 years of peer-reviewed research telling us that it works precisely the same way when buying stocks rather than cars. The safe withdrawal rate in 2000 was 1.6 percent real. The safe withdrawal rate in 1982 was 9 percent real. This means that a retiree with a $1 million portfolio who began her retirement in 1982 could live the life available on a $90,000 budget for her remaining years, while a retiree with a $1 million portfolio who began her retirement in 2000 could only live the life available on a $16,000 budget for her remaining years. That’s a big difference! It is critical to take valuations into consideration when planning a retirement. I think it would be fair to say the numbers show that valuations are roughly 80 percent of the retirement planning story. The story is the same for investors who are in the stage of life where they are accumulating assets, rather than living off the earnings from them. A regression analysis of the 145 years of historical data available to us shows that the most likely 10-year annualized return for stocks purchased in 1982 was 15 percent real. The most likely 10-year annualized return for stocks purchased in 2000 was a negative 1 percent real. That’s a difference of 16 percentage points of return! For 10 years running! Knowing about that difference and taking advantage of the knowledge by going with a higher stock allocation when going-forward returns are likely to be good than you go with when going-forward returns are likely to be poor turns the magic of compounding returns very much in your favor. I think it would be fair to say the numbers show that valuations are roughly 80 percent of the asset allocation story too. Lots of non-valuation factors matter. Interest rates matter. Unemployment rates matter. Consumer confidence levels matter. Inflation rates matter. And on and on. But those factors are all factored into the price that is available to the individual investor considering a stock purchase. So, while these other factors play a role in the investing game, we as individual investors need not pay attention to them. There is only one decision in our control – what percentage of our portfolio will be comprised of stocks. If we buy at good prices, we always do well in the long term. There has never once in the history of the market been an exception to this rule. And if we buy at bad prices, we always do poorly in the long run. Again, there has never been an exception. Most investors accept that valuations matter. But few realize how big a factor the valuations factor is (I can’t help but wonder if the reason might be that there is so much money to be made on the selling side by persuading investors that valuations are not a big deal). The reality is that the stock market is like every other market known to humankind – price is by far the dominant factor in the determination of whether market participants are able to achieve a good deal or not. Disclosure: None.

Technically Speaking: The Real Value Of Cash

With the ” inmates running the asylum ” during a holiday-shortened trading week, the upward bias to the market is set to continue. However, as I addressed last week: ” As we progress through the last two months of the year, historical tendencies suggest a bias to the upside . This is particularly the case given the weakness this past summer which has left many mutual and hedge funds trailing their benchmarks. The need to play ‘catch-up’ will likely create a push into larger capitalization stocks as portfolios are ‘window dressed’ for year end reporting . This traditional ‘Santa Claus’ rally, however, does not guarantee the resumption of the ongoing ‘bull market’ into 2016. The chart below lays out my expectation for the market through the end of the year. ” (click to enlarge) ” With the markets currently oversold on a very short-term basis, the current probability is a rally into the ‘Thanksgiving’ holiday next week and potentially into the first week of December . As opposed to my rudimentary projections, the push higher will likely be a ‘choppy’ advance rather than a straight line. ” So far, the analysis over the last several weeks has continued to play out as expected. However, and this is crucially important, a near-term expectation of a bullish advance due to the recent correction and seasonal tendencies is not the same as long-term bullish outlook . As stated above, while seasonality likely holds the cards through the end of this year, projecting much beyond that window is foolishness. The Real Value Of Cash This brings to mind a call I had on the radio show recently discussing his advisor’s reluctance to hold cash . The argument against holding cash goes this way: ” If you hold cash, you lose value over time to inflation .” This is a true statement if you hold cash for an EXTREMELY long period. However, holding cash as a ” hedge ” against market volatility during periods of elevated uncertainty is a different matter entirely. As I discussed previously: ” I have written previously that historically it is relatively unimportant the markets are making new highs. The reality is that new highs represent about 5% of the markets action while the other 95% of the advance was making up previous losses. ‘ Getting back to even’ is not a long-term investing strategy . ” (click to enlarge) In a market environment that is extremely overvalued, the projection of long-term forward returns is exceedingly low. This, of course, does not mean that markets just trade sideways, but in rather large swings between exhilarating rises and spirit-crushing declines. This is an extremely important concept in understanding the “real value of cash.” (click to enlarge) The chart below shows the inflation-adjusted return of $100 invested in the S&P 500 ( using data provided by Dr. Robert Shiller ). The chart also shows Dr. Shiller’s CAPE ratio. However, I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves back to cash at a ratio of 23x . I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970s, there is a downward slope in the value of cash . However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises. (click to enlarge) While no individual could effectively manage money this way, the importance of “cash” as an asset class is revealed. While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at lower valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover. While we can debate over methodologies, allocations, etc., the point here is that ” time frames ” are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of the loss of purchasing power is appropriate. However, if cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future. Much of the mainstream media will quickly disagree with the concept of holding cash and tout long-term returns as the reason to just remain invested in both good times and bad. The problem is that it is YOUR money at risk. Furthermore, most individuals lack the ” time ” necessary to truly capture 30- to 60-year return averages. For individuals, trying to save for their retirement, there are several important considerations with respect to cash as an asset class: Cash is an effective hedge against market loss. Cash provides an opportunity to take advantage of market declines. Cash provides stability during times of uncertainty (reduces emotional mistakes) Importantly, I am not talking about being 100% in cash. I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity. With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a ” hedge ” against loss becomes much more important. As John Hussman recently noted: ” The overall economic and financial landscape, then, is one where obscene valuations imply zero or negative S&P 500 total returns for more than a decade – an outcome that is largely baked-in-the-cake regardless of shorter term economic or speculative factors. Presently, market internals remain unfavorable as well. Coming off of recent overvalued, overbought, overbullish extremes, this has historically opened a clear vulnerability of the market to air-pockets, free-falls and crashes. ” As stated above, near zero returns do not imply that each year will have a zero rate of return. However, as a quick review of the past 15 years shows, markets can trade in very wide ranges leaving those who ” rode it out ” little to show for their emotional wear. Given the length of the current market advance, deteriorating internals, high valuations and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most. Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time. Just something to think about.