December 2003
Many readers are deeply involved in making prudent investment decisions regarding their own businesses, but when it comes to making decisions regarding their personal stock portfolios, discipline and reality are often checked at the door. Smart people do dumb things when investing their own money because emotions often overrule analytical thought. Reality is distorted by needs, hopes and dreams. We are concerned that investors still have unrealistic expectations about the future returns for their stock portfolios because they desperately want to get their savings back to where they were before the "bubble burst" almost four years ago.
Wishing won't make it so and investors need to adjust their expectations and prepare for the new investment climate of lower average annual returns so they can develop realistic personal budgets and stick to prudent investment programs designed to meet their financial needs for their approaching retirement years.
Looking at the chart to the right, the stock market is currently trading at the upper end of its historical valuation range but that doesn't mean it cannot go higher and stretch valuations even further. All you need to do is look back to the 1920's and the late 1990's as perfect examples of markets that have temporarily disregarded valuations. Nevertheless, we know that stock prices eventually do converge with their intrinsic value and astute investors that understand this can take action to protect their portfolios against this disconnect of price and value. Today's investment landscape is extraordinary and some stock market gurus are describing it as "perfect". However, a wise investor would benefit from a careful appraisal of the current economic climate and the fundamental factors that affect stock prices.
To paint the current economic picture, the U.S. economy has just recorded its fastest growth in twenty years with 8.2% real growth in the third quarter GDP. Unemployment is on the decline. Companies are logging near record profits on modest sales gains and workers are more productive than ever, due to the heavy investment in technology made during the 90's and the deep cost cutting that occurred following the slowdown. These facts are difficult to ignore, and the stock market has responded by gaining anywhere from 30% to 60% (depending on the index being measured) in just over 6 months. For investors that worry about holding on to these gains, the concern is that this economic progress is already incorporated into today's stock prices, leaving little room for error.
The stock market is driven by a number of things, some economic in nature, others purely psychological. There are three economic factors that drive future stock market performance. The first two on this short list are corporate earnings growth and current market values (stock prices). The lower stock prices are in relation to corporate earnings, the higher the potential return. Corporate profits have already bounced back to levels seen before the last recession and overall stock prices are near their highest historical levels versus these record earnings. The price-to-earnings ratio for the S&P 500 Index is about 25x next year's estimated earnings after expensing stock options, etc.
The final fundamental driver of the stock market is the level of interest rates. When rates rise, the return of risk-free U.S. government bonds become more enticing. Stocks will appear comparatively less attractive until their prices fall to a level where the potential reward is worth the assumed risk of owning stocks. The exact opposite occurs as rates fall. And what has happened over the past twenty years? Interest rates have fallen dramatically. U.S. Treasury bond yields have declined from around 16% in 1981 to about 4-5% today. This has had an extremely positive impact on stocks.
It is a primary reason investors enjoyed the greatest bull market in U.S. history. Falling interest rates have provided a strong tail wind for the stock market for about two decades. But, we are now seeing the formation of a different weather pattern and expectations need to change.
Our view is that these long-term drivers of stocks will soon not be working in investors favor. Looking forward, interest rates are poised to rise as the economic rebound solidifies itself. It really is not a question of if interest rates will rise, but when and by how much. As for profit growth, it is important to note that the profits of Corporate America cannot grow faster than the entire U.S. economy for long. It is just a mathematical certainty. Long-term corporate earnings growth will probably average about 5-6% going forward, not the 10-15% growth rate the market is currently assuming. The valuations of most stocks (price/earnings ratios) are already high because of those assumptions. Most investors, when asked about their long-term return expectations, casually mention returns of 10% to 15%. Unfortunately, they will likely earn much less.
So what's an investor to do? First, it makes good sense to re-evaluate one's expectations of investment returns and spending habits. Next, acknowledge that the old sage advice to just "buy and hold" is probably no longer appropriate or wise in light of the market's changing climate. The strong winds of profit growth and falling interest rates are dying down. Finally, investors will need to actively manage their portfolio to grind out additional returns by having the discipline to buy only when the price is right and to trim or sell when other investors are acting foolishly optimistic.
Jason P. Tank, CFA
jason@frontstreet.com