As you saw in the last post, our economic system tends to move in cycles. Long term and short term. According to Ray Dalio. we could be at the tail end of both of these cycles, but that remains to be seen. Instead of worrying about what we can not control, we can instead focus on what we discussed in the first post; what we can control. Buying great businesses at attractive prices. If we do get a crash that means opportunity for us, not misery. We just have to be properly prepared (remember your 3 P’s) As I mentioned before, right now is a difficult time to find those attractive prices. The great business side is easy, the waiting is the hardest part (Tom Petty was not wrong) Let’s look at an overall market valuation method that can show why it’s so difficult for us to find deals right now.
Earnings to Price Yield
No I didn’t say that backwards, this is a great method for a quick snapshot of likely returns in the overall market. This is also known as the earnings yield. It tells us what the expected return to shareholder will be, based on the current earnings of the market. And it’s very easy to calculate (easy math is the best math).
This is calculated as the inverse of the Price to earnings ratio (PE) and gives you an idea of what sort of returns you are likely to get.
Eg.
If the PE of the S&P was 15 (close to the market average) then we simply flip it, making it 1/15, which gives us a likely return of 6.67%.
The math:
(1/15)* 100 = 6.67%
This very close to the historical market return of 7% (that’s without dividends). I believe this adds validity to this metric.
Right now the market has a Schiller PE of 28.90, giving us a likely market return of only 3.46%.
(1/28.90)* 100 = 3.46%
The risk free rate
Not great. But, it’s still better than what most people refer to as the ‘Risk Free’ rate of return, which is the 10 year Treasury Bill (T-Bill). The current T-bill is yielding 2.42%. This is what a large number of investors look at before investing in the stock market. There is much more risk (especially right now) putting your money in the market, compared to buying a T-bill. And right now, investors are only getting paid an extra 1% for that risk. That is a very narrow gap, and will continue to narrow if the market continues its path upwards, or if T-bills keep moving up in yield. I think this creates added fragility to what I see as an already fragile market. As I said before, there is much more downward pressure on the market than there is upward pressure. I also believe the natural gravity of the market pulls upward, so it takes quite a large force push it downward.
Buffett's Favorite tool
A word from Buffett:
"The tour we've taken through the last century proves that market irrationality of an extreme kind periodically erupts--and compellingly suggests that investors wanting to do well had better learn how to deal with the next outbreak. What's needed is an antidote, and in my opinion that's quantification. If you quantify, you won't necessarily rise to brilliance, but neither will you sink into craziness.
On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GDP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago (1999) the ratio rose to an unprecedented level. That should have been a very strong warning signal.”
Here’s the chart:
(Advisor Perspectives, 2017)
How to use the Chart
"For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you." - Warren Buffett
In other words, if we get a crash, and the market falls below the 80% mark, we should start buying the companies we love. And we should buy them hand over fist. The best part is, when this occurs, those businesses will be on sale, greatly increasing our purchasing power for those shares. Pretty awesome. You can see the two most recent periods where this occurred:
1. After the Dot com bubble in 2000
2. After the housing market crash in 2008
I’m not sure what the next one will be called, but I know there will be one.
As you can see below, right now we're sitting at 125.3%. Not quite as high as we were in Q1 2015, but still, high. Much higher than we were in the 2008 crash. This tells us that right now the stock market is expensive. Not a great time to be a buyer. Maybe not even a good time to be a long term holder of stock.
if you look at 2009, you can see the market bottomed at 59.5%, that would have been an amazing time to buy, you would have killed it. But even if we just followed Buffett's guidelines and waited until we crossed that 80% mark, we would have also done extremely well, especially if we continued to buy as the market continued to fall.
Conclusion
As you may have noticed, based on multiple metrics, the market is expensive. But this doesn’t mean it can’t get more expensive, it absolutely can. Instead of getting caught up in all the craziness we have to remember to follow our Three P’s:
Prepare
Plan &
Pre-commit
Right now is the perfect time to learn as much as we can about investing. To fine tune our process, and to build our investing Wish-List. What the high market value means is that it’s much more difficult for us to find great businesses on sale. We have to be patient. It’s not easy sitting on the sidelines while overpriced stocks and ETFs continue to move upwards. It’s difficult not to jump in with the crowd, and see what happens, but that’s the practice. If it was easy, everyone would do it.
So while we wait, we prepare by continuing to save and hoard as much cash as possible. We plan out our investing strategy so that we can jump in when the businesses are on sale again. And we pre-commit to our plan, either through our broker, through put options, or through or own willpower (which is the toughest). Either way, we’ll be ready. And it will pay off tremendously.
Thanks for reading
We’ll talk again soon
~Ryan Chudyk~
PS. Next week I’m doing a series on Warren Buffett. It’s going to be 7 days of Buffett, and it’s going to be awesome. Stay tuned.
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