Presented by Bashar Baraz, VP Wealth Management
A bunch of the Camarda team recently attended a financial industry professional conference, and I was fortunate to (once again) see investment legend Jeremy Siegel, economist, and professor at the renowned Wharton business school of the Ivy League University of Pennsylvania (which by the way was founded by Benjamin Franklin).
Jeremy’s a very smart guy and does very brilliant research. For instance, he caught what seems to be a major flaw in Robert Shiller’s (Yale man, poor devil, but also a Noble Laureate) very famous CAPE (Cyclically Adjusted Price Earnings ratio), arguing Shiller did not consider that a major change in accounting rules is what suppressed earnings (low E in the P/E), sending the CAPE value through the roof and implying the mother of all bear markets is coming. This is like changing the definition of a foot to 20 inches, then saying 12 inches is shy of a foot. The 12 inches, of course, did not change.
Anyway, Jeremy’s major message is simple and really, really important. Over the long term, diversified stocks are very safe and predicable. They produce reliable real returns – the return after inflation is subtracted out, so the money is expressed in constant buying power – of around 7%, lots more than bonds, CD’s, or cash. This is a really important point that even smart, successful people tend to overlook because we get caught up in the short term and let emotions like fear and greed guide us, instead of the long term data. Please take a moment to try to internalize this. Stock markets bounce up and down all the time, but the long term cancels all the bounce out, and all we are left with is a nice steep smooth appreciation line.
Another really sublime point Jeremy made was with respect to valuations and returns are implicit in the price-earnings ratio, a very basic measure of value – relating the trading price of a stock to what the stock is really “worth” – something you have seen me mention quite a bit. The P/E ratio simple divides the price of the stock by the earnings per share. A simple example will help those not familiar with the concept. Say we have a company that makes $1000 per year in profit, and that there are a total of 100 shares of this company’s stock in existence. $1000 in profits divided by 100 shares equals $10 per share in profit. If these shares trade for $200 each, we have a price to earnings of $200/$10 or 20. This is close to where the average S&P 500 stock is trading in early 2018. If we flip the ratio – put earnings over price or E/P – we get something called earnings yield, in this example $10/$200 or 5%. Jeremy’s very elegant insight – something as easy for many investors to miss as the forest for the trees – is that the earnings yield is a very good predictor of the long term real return we can expect. For this example, 5% average projected return from buying stocks at a 20 P/E (which remembers is the same as 5% earnings yield or EY). By the way, don’t confuse this earnings yield with the dividend yield. The earnings are what the company makes, in total, but the dividend is the part of what it makes that it actually pays out to investors (some companies share a lot of their earnings via dividends, some share none, instead of keeping the cash for other purposes). To put this into current context, US indexes after the February 2 big selloff (which I will coin “Devil’s Friday” after the S&P’s 666 point plunge), are still sporting pretty frothy P/E’s, with the S&P at about 22 (a 4.6% EY) and the Dow Jones Industrials at about 27 (3.7% EY). While these numbers seem low – and remember they are after inflation, so you can add about 2% inflation back if you want to get what’s called the nominal return – compared to alternatives like bond yields and bank accounts they are still quite high. To wrap this up, while we believe US stocks to be relatively expensive compared to many cheaper non-US stock markets (which have lower P/E’s and higher EY’s, and hence higher expected long term returns), and overdue for a correction or (lower) price adjustment, we still think US stocks will be profitable long term for investors and should have a piece of their portfolios – just not the only piece, and just not the biggest piece. To put this in context, a recent emerging markets index – including companies like Alibaba and Samsung – had a P/E of about 13, for an EY of 7.8%. If we take $500,000 and compound for 10 years at the Dow’s 3.7%, we project about $720K. If we project at emerging markets’ 7.8%, we get nearly $1.1M, or about 50% more. And that’s just for 10 years if we go longer, the advantage becomes truly staggering. This is the big reason you hear me rant about valuations so often. In the end, they tend to be the single biggest determinate of investment success.