Your Risk is My Reward.

March 13, 2015

Last week I wrote a piece on human evolution. The idea that millions of years spent adapting to certain situations have left us woefully unprepared for others. Investing being foremost among them.
Sure enough, I'd no sooner hit the send button than a client called and announced that she'd had enough of the equity markets. Too much risk. Time to sell.   Just like her ancestor, Australopithecus, when confronted with risk?  She was ready to run and hide. Even as the inverse may have been the safer decision. Because risk is pervasive throughout all worthwhile human endeavors. Risk, properly calibrated, ranks among life's most positive and powerful forces.
Don't shrink from it. Embrace it.

Six years into this bull market, many investors believe the end is nigh. They say the market is too expensive. The raptors, hyenas and saber tooth tigers of yore have been replaced by asset bubbles. Greek debt implosions. Bad central bank policies. Collapsing energy prices. The rising dollar. Or, the Tyrannosaurus Rex of modern investment concerns, the inevitable collapse of the financial system.
While most people experience brief moments of occasional fear, there is an entire class of investors who are being driven by it. Residual anxieties related to 2008 that prevent them from acting in their best interests.
Relax, people. For your sake and that of your financial future? The S&P 500 hit an all-time high only two weeks ago. While stocks are pricier than they've been in a while, they're certainly not expensive. Particularly when compared with interest rates.
Bears like to use the 10-year CAPE ratio, representing an average price-to-earnings ratio of the last ten years. Effectively offering a more realistic assessment as to the value of a stock or index.
Bears often note that the 10-year CAPE was created by Ben Graham. Warren Buffett's exemplar and the father of value investing. Then close their argument by citing that the 10-year CAPE reveals that pricey nature of stocks.
Yet, Graham did not codify the 10-year PE average.  Actually, Graham taught that you want to use "the average earnings of a period between five and 10 years." There was nothing special about the 10-year number. Only the average over a longer period, which smoothed out the highs and lows of the business cycle. Providing a more accurate portrayal of a company's valuation.
Continuing with the theme-but utilizing the five-year average P/E-we determine that the stock market is cheaper today than the average value of the last twenty years. Stocks are not overly expensive. In fact, they're less expensive than they were at the start of '07. And standard deviations less than they were in 2009.
Still, every time stocks pull back, fearful investors fall prey to their caveman brains. Wanting to sell everything and run back to their caves. And while I've no doubt this results from the residual post-traumatic stress disorder from which many continue to suffer after 2008, selling and running represents the worst thing to do!
One need only consider the S&P 500's playbook these last few years. While we have yet to experience that elusive 10 percent plus retrenchment, every smaller pullback has seen the S&P 500 descend to its 125-day moving average. There, it kisses that trend line and then jumps higher yet again. Look at the chart below. It shows how it's doing exactly that again. Following the playbook of the last few years. History, repeating itself, again and again. We would not be surprised to see equities hit new highs in the months to come.
But, this market has risen too high for too long!
True, this market run signifies the fifth biggest and the fourth longest bull market in history. In a few months, it will surpass the 1974-1980 market and become the third longest. But that doesn't mean it can't go considerably higher.
February saw stocks rise broadly the world over. The S&P 500 jumped five percent. The MSCI All-Country World Index did even better.
Many of the hair-raising headlines that had traumatized investors began to dissipate. Fourth quarter earnings were solid, with over 60 percent of the S&P 500 beating expectations. Moreover, central banks around the world prepared to bestow gifts upon stock investors the world over by cutting interest rates and easing monetary policy. The most notable example being that of Europe, which implemented an American-style bond buying program. It was enough to make me a little sentimental.
Still, our caveman brains were racked with fear. Major indices, now sitting in record territories, would have to pull back, right? Every move higher spawned more fears of a market top.
Yet, investors fail to realize that these are the very conditions that propel good markets higher! The stock market exists to disappoint as many investors as possible as frequently as it can. So long as investors' cave man brains tell them to sell and run, this market is going higher.
The S&P 500 spent 13 years-2000 to 2013-trading within a range. On three occurrences within that timeframe, the index reached its ceiling, that point of technical resistance, only to correct precipitously. Finally, in the spring of 2013, the index broke through resistance. Releasing a decade and a half of latent energy. Since then, the market has punctured resistance and hit multiple new all-time highs.
Typically, when a stock breaks through a trend line, or achieves an all-time high, the stock or index's momentum will carry it considerably higher. Momentum traders often rely on this very idea. Purchasing positions as they break through long-term resistance. Holding them as they race ever higher. Of course, the average investor does not have the psychological fabric of the serious trader. Unlike professional traders, he is typically not a student of history. Interested in psychology. Adroit in mathematics. All of which dooms the average investor from the outset.
Having achieved new all-time highs without having become overtly expensive, we see no reason these markets can't head higher. Especially given the fundamental underpinnings.
Every year, investors should view the market environment in a vacuum. Performing a comprehensive and unbiased analysis of stocks and their alternatives. So determining which assets classes possess characteristics endemic to maximize upside. Conversely, one arrives at an idea as which asset classes lack favorable attributes. Only by doing so can an investor attain an objective vantage point of what lay ahead. So, let's peruse the big picture.
Economically, 2015 global GDP estimates sit at 2.9 percent. Higher than the 2.5 percent estimates of 2014. Respected analysts believe that the U.S. can achieve an above-trend growth rate of 3 percent for the year. This, because the global economy is strengthening.
Interest rates in most developed countries remain at historic lows. So leading to low borrowing and financing costs for businesses seeking to obtain loans. Foreign central banks appear set to retain low rates throughout the year. As soon as banks begin to increase the rate of loan issuance, which has legged thus far, foreign business activity will percolate higher.
Consumer sentiment will likely continue to improve as domestic consumers benefit by lower energy prices and an improving labor picture. Both of which will support more consumer spending and less risk aversion. We believe the same will occur in Europe, as the ECB bond-buying program begins, and the excitement around Greece dissipates.
Investor sentiment remains tempered (bullish!) even as global capital flows continue to find their way to Wall Street. European and Asian stimulus programs will continue to be the tide that lifts all boats, as many overseas investors have no better place to put capital to work than in U.S. equity markets. Moreover, U.S. investors, while not overly bullish, will soon realize that there is little other game in town for their retirement funds.
European Equities are coming back on line. The ECB's new bond-buying program has propelled European equities nearly three times higher than their U.S. counterparts year to date. And even as the euro continues to fall against the dollar, investors can hedge out that negative arbitrage. We believe, in fact, that European stocks will be among this year's brightest stars in the sky. While they've legged U.S. equities for the last few years, that relationship is likely to invert.
Finally, inflation remains in check, with the U.S. core inflation rate at roughly 1.3 percent. Equally, Europe and China expect inflation in the 1 to 2 percent range. Wedded to slow-but-improving GDP growth, and improving global sentiment, we believe this provides cover to the Fed to keep rates lower for longer. Which will be positive for stocks.
Of course, the higher markets go the more investors should analyze their prospects. For each day in the black is a day closer to the apex. Yet record highs and growing valuations should not hamper enthusiasm to put investment capital to work. For bull markets, by their very nature, exist to achieve new highs, pull back, and achieve new highs again.
If you've little tolerance for risk nor any need to grow retirement capital, then the stock market should be avoided. Yet, if your nest egg may not be enough to persist through a multi-decade retirement, then you'll have to dip your toes into the equity pond. Those so needing to dip include the vast majority of Americans.
As of 2013, the median retirement account balance among all U.S. households headed by people age 55 to 64 was a mere $14,500. With interest rates providing little by way of bond yields, we believe that a lot of people will soon realize they require enhanced levels of risk exposure.
Of course, most want all of the upside with little of the down. The risk to reward ratio, that exists throughout all of life's worthwhile endeavors, requires that you take on one to get the other. But, if you calibrate wisely, and are willing to forgo those wild swings for the fences, you can generally have the best of all worlds. Market upside. While forgoing the devastating generational meltdowns. This, like most worthwhile pursuits, takes time. But it does lead to a desired outcome.
Remember, the more acute is the fear of risk, the more the benefit for those of us who embrace it. As Warren Buffett counseled, you can't produce a baby in a month by impregnating nine different women. Regardless of talent or effort, some things just take time.

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