By |2019-09-24T12:00:00-04:00September 16th, 2019|Blog, Great Investors Series|

The superrich are selling stocks, buying property, and keeping cash ready.

– Market Watch, August 5

In last month’s article, we discussed why it’s important to ignore the media’s pessimism. This month, we explore the pitfalls of listening to cocktail party chatter instead of expert advice when it comes to the stock market.

When E.F. Hutton Talks, People Listen

One of my favorite television commercials when I was growing up was an advertisement for a stock brokerage firm called E.F. Hutton. Their tagline was, “When E.F. Hutton talks, people listen.,” and the ad featured a comic vignette of a Hutton client telling a friend about the advice he was receiving, while a busy restaurant full of people all stopped what they were doing to listen in.

I have lost count of how many times I have seen a vignette like this play out in real life at a cocktail party. Someone starts describing how he recently got out of the stock market and “went to cash,” and suddenly everyone in the room is listening, as though this investor knows something the rest of us don’t. It is almost as if he is wearing a badge that signifies that he is a member of “The Smart Money Club,” and so we better listen to what he is saying.

A recent news item made me think of this phenomenon again. On August 10th, MarketWatch published a story about a group called “Tiger 21,” a worldwide network of some of the wealthiest investors in the world. These members of “The Smart Money Club” are just about as bearish on stocks as they have ever been and are collectively sitting on more cash than they have in over six years.

Their approach is “keep cash ready.” I’m left wondering to myself, “Ready for what?”

“This Market is Expensive”

If we were to ask one of these 750 cash-laden investors why they are so certain that cash is the best bet, I strongly suspect they would answer, “Because this market is expensive.” This phrase is a favorite of the cocktail party set. It makes the listener believe that this person knows a great deal about how to value companies.

On the contrary, my experience has been that this declaration is often made without any rigorous analysis at all. Typically, the person making this claim has done little or no real homework of any kind. Instead, this assertion is usually built loosely on one of the following two popular culture myths, which sound scary, but have nothing at all to do with the actual valuation of company share prices:

  1. The stock market is trading at an all-time highFor some reason this statement has a degree of grave connotation, as if it is an unusual and scary condition for investors to experience an all-time high in equity prices. In actual point of fact, it is not at all unusual for equity markets to be trading at all time highs. The S&P 500 has been at an all-time high just about one third of the trading days since 1945!

    It is also a myth that an all-time high is a market condition to be feared. On the contrary, it is typically a sign that things are going well for equities and the markets and economy are strong. In fact, a recent study showed that since 1945, an investor who timed her investments to occur at an all-time market high has done considerably better than someone who invested at random entry points.

  2. This is the longest bull market in history. It is difficult to understand the logic that the length of time that stocks have been advancing has anything at all to do with how far over (or under) valued they may be. There is no correlation between those two data points.

    That being said, it is also worth noting that, although the S&P 500 has not in fact had a bear market (as defined as a 20 percent drop in value) since 2008-2009, it came awfully close in 2011 (down 19.4 percent) and then again in 2018 (down 19.8%). If it looks like a bear, it growls like a bear, and it claws like a bear …  it’s a bear.

Valuations: The Real Story

Valuation is in the eye of the beholder and is more subjective than objective, which is why stock prices are constantly changing, as investors trade shares between themselves based upon their relative opinions of the current value of that stock. There is no definitive value of any stock, much less an entire market of stocks. However, logic does demand that certain relationships make sense:

  1. As a company earns more money, and/or the future expected earnings of a company become greater, the value of that company becomes greater and a higher share price should be justified.
  2. Interest rates must play a part here too. If a company’s share price is supposed to be a mechanism to discount its future earnings back to a reasonable current share price, interest rates are the means of discounting those future earnings into the present. The higher the discount rate, the less valuable future earnings are today, and valuations should be lower. The lower the discount rate, the more valuable future earnings are, and valuations should be higher.

In today’s world, stock market valuations are benefiting from tailwinds in both of these areas. Economic performance and output are performing quite well, and earnings are growing. In fact, as of March of this year, the annual rate of growth of the earnings of the S&P 500 was 16.42 percent. In addition, future earnings are very valuable in today’s dollars, thanks to record-low interest rates in today’s financial markets.

One of our favorite ways to measure valuation is to compare the Dividend Yield of the S&P 500 to the yield available from Treasury bonds. The Dividend Yield represents, for the combined 500 companies, the amount of cash being paid out to shareholders, compared to the aggregate price of the index. Today’s dividend yield of 1.8 percent tells us that the S&P 500 is paying out dividends of 1.8 percent of its aggregate price. In contrast, the 10-year Treasury bond currently yields 1.735 percent, and the 30-year bond yields 2.213 percent.

Historically speaking, equity dividend yields are typically lower than bond yields, because equity dividends have the advantage that they usually grow over time, to the tune of a 5 percent long-term compound growth rate. Although these relationships have changed slightly in recent weeks, there was a point in August when the S&P 500 dividend yield was actually greater than the 30-year Treasury yield – a condition which has not occurred in over 10 years.

So, what does this data tell us about equity valuations? We are happy to own a portfolio of 500 companies paying us 1.8 percent in dividends, which are likely to almost double over the next 10 years, when our alternative is a 10-year bond paying us a yield of 1.735 percent, which will not grow over time.

Warren Buffet summed it up best in a recent interview on CNBC, where he noted that stocks are a huge bargain with interest rates at their current low levels. In his words, “I think stocks are ridiculously cheap if you believe that 3 percent on the 30-year bond makes sense.” We couldn’t agree more.

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People at cocktail parties may sound like they know what they’re talking about, but it’s not also based on facts. That’s where we can help. We’ll cut through the panic and the emotions and help you put together a plan that will lead to success.

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By |2019-09-24T12:00:00-04:00September 16th, 2019|Blog, Great Investors Series|

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