Hope you're enjoying your summer, it's crazy to think we're almost halfway through (which, in Phoenix, is a good thing).
The three things this week covers prediction (which I talk about a lot), growth and value stocks (which I also talk about a lot), and a heartfelt note to a hairdresser.
I end up recycling topics a bit. Not because I can't find new stuff to write about, it's just that certain topics are more important than others, so I feel like I need to revisit them repeatedly.
Adam Harding, CFP
(If you're getting this for the first time, Three Things is my regular blog/newsletter where I pick some things I think will be interesting, write some words about those things, and then send those words to you. Thanks a million for reading this and I'm always interested in what you think about anything I communicate).
Just for a minute let's say it’s 2002 and you're noticing that housing prices seemed to have risen throughout the entire Dot-Com crash (2000-2002), despite a struggling overall economy. In light of this, you believe there's a housing bubble and that the economy is going to collapse.
First off, apparently you're a complete genius and I'd like to applaud your foresight. If this was you and you'd like a job as an analyst with Harding Investments & Planning, let's chat. Okay, back to the hypothetical....
Here's the thing: it’s 2002 and your prediction will take at least 5 more years to come to fruition. In fact, it may have (hypothetically) looked something this:
Year 2002: "It looks like a housing bubble is forming. I'm going to start getting defensive in my portfolio."
Year 2003: "Yep, a housing bubble is definitely forming. Let's continue to get defensive."
Year 2004: "Wow, this thing just keeps getting more inflated. Now I'm really getting defensive."
Year 2005: "How much more obvious can this be?"
Year 2006: "Maybe I was wrong... Maybe this is the new normal."
Year 2007: *POP*
Despite an accurate prediction of what was going to happen, your resolve would be tested while you waited for that thing to happen.
Let me be crystal clear on my stance here:
Almost no one would have the guts and the commitment to stick with this prediction through each of the years above.
Those who did stick with this prediction would need to account for the opportunity cost of being 5 years early --particularly because the stock market performed well in that environment.
So when we think about predictions, we have to consider the implications of being right or wrong, but also the implications if we're right early. In a more recent example, I've been communicating a commitment to the viability of a globally diversified portfolio, value stocks, and smaller companies. Those predictions haven't looked good when compared to a Large Growth stocks in a US-only portfolio. Only time will unveil how right or wrong or early I may have been.
In any case, when we invest we have to evaluate what the investment is actually for. We have to contextualize the predictions we're making and then weigh them against our objectives. As Morgan Housel put it:
If you tell me you’ve found a way to double your money in a week, I’m not going to believe you by default.
But if my family was starving and I owed someone money next month that I don’t have, I would listen. And I would probably believe whatever crazy prediction you have, because I’d desperately want and need it to be right.
So part of what we have to do is build strategies and financial plans which avoid the requirement for high risk/return predictions to be exactly right. Put differently, we should build plans that accept calculated failures in our ability to predict the future accurately. The calculated failures today (like being globally diversified rather than US-only) may end up being the strategic wins sometime in the future.... It all comes down to context.
Growth stocks are absolutely crushing value stocks this year.
...In fact, this has been the trend for more than a decade now.
I've touched on this a handful of times this year because I think it's one of the most important developments in capital markets.
To put things bluntly, I believe we're in a new Tech Bubble.
At the end of the day, companies exist to make money for the people who own those companies. To make money and distribute profits, a company has to have earnings, then a profit margin, and then it can issue a dividend. Yes, some companies don't issue dividends in pursuit of future growth (think Amazon), but the eventual goal of every company is to pay its owners so that the owners can buy stuff.
Yes, even people who own Amazon stock may eventually sell it so that they can buy a house or car or send a kid to college. But the person they're selling it to are either (a) is hoping it keeps going up in price so that they can sell it to someone else and buy their own house/car/etc. or (b) they're looking for it to start paying out dividends so they can use the cash flow for something.... We can use this understanding to assume that every company eventually should be designed to produce profit based on its earnings. This requires it's earnings to be robust in comparison to its price (i.e. it needs to have a relatively low P/E ratio).
This brings me to Price-to-Earnings ratios...
Definition from Investopedia: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
P/E ratios are used by investors and analysts to determine the relative value of a company's shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
Here's the P/E ratio of the S&P 500 (i.e. the US Stock Market):
The above chart shows the current P/E ratio of the S&P 500, you can notice a couple big spikes in the 2000 and 2008 crashes because company earnings fell so fast that the P/E ratios spiked. But the long term average for the market is about 15 and today it's around 22.
I don't necessarily believe the entire market is overvalued at this point... After all, interest rates are historically low and that tends to support stocks trading at more elevated valuations.
However, there is some euphoria in the tech sector.
Let's consider some examples:
Zoom Video Communications has exploded as a result of video conferencing being a new standard requirement in today's workforce. The current P/E ratio of Zoom? Approximately 1,622.
Crowdstrike has a current P/E of 466.
...I could go on and on and on with examples of this.
But to be clear, I'm not suggesting these stocks will crash or not continue rising further upward. After all, crisis situations tend to forge the new companies that will end up being the big stocks in several years, and maybe these are going to be the new companies. Or maybe they're the Pets.com of this generation. I'm just pointing out that cheap money through monetary policy is essentially stoking the fire of a new tech bubble by allowing businesses to nearly abandon earnings and a profit motive.
Given my explanations of predictions in Thing 1 above, I'd be hesitant to do anything based on this prediction because I could be wrong or early.
Instead, it's worth remembering the following when you're investing:
Data covering nearly a century backs up the notion that value stocks—those with lower relative prices—have had higher expected returns. On average, they have outperformed growth stocks by 4.54% annually since 1928.But there are no guarantees, and results vary over time. Growth stocks have recently outperformed value stocks significantly and 2020 is a true example of that. Yet, that outperformance has been a stark departure from long‑term averages.While there’s no way to know where stocks are going next, value has trailed growth in the past before rebounding strongly.... And if all of these words above don't do it for you, then here's a quick graphic to highlight what I'm saying:
I'm not gifted in the hair department, so I don't know much about visiting the hairdresser. But I stumbled on this letter this week and wanted to share.
Give it a read. I think it will remind you that impact can be made in many ways.
In case you can't read the image above, here's what the letter says.
My wife was suffering from dementia, and you treated her as if you’d been working with dementia patients all your life. You let us sit next to each other, and when it came time for her cut you turned her chair towards me so I could watch her expression as you cut her hair.
It turned out even better than I thought it would.
Sadly, she died in March. And that haircut was one of the last, best moments of her life. She felt so pretty. She visited the mirror in her bathroom several times during the day and would come out beaming.
To see her so happy was priceless.
It’s so easy to take things like that for granted.
A grateful customer
Wow. Just wow. Regardless of what you do, I hope you love it and realize the impact. This is why I love what I do: predictions and P/E ratios and tax optimization are fine, but being part of people's lives is everything.
That's all for this week.
Three Things: Predictions, Value/Growth, Hairdresser
July 11, 2020