I’m concerned because I have heard too many people recently say something along the lines of “I know the US stock market hit its all-time high recently, and that if I invest now and it goes down, I can just ride it out because it always comes back.” [Emphasis theirs.] While that is a true statement, that thinking doesn’t go quite deep enough. I have to ask, “How long is your time horizon? In other words, how long can you wait for it to come back? So far this year, you didn’t have to wait too long. But will this continue, and at what cost to your long-term wealth if it takes a long time?
Let’s do a bit of perspective-taking. Reporting on the 4th quarter 2018 results, the headlines in January read “The US stock market has suffered its worst quarterly decline in years.” The S&P 500 fell by 13.5% in Q4 2019. Investors were conflicted because the market had just hit an all-time high in September. Then in April, the headlines read “The US stock market has had its best quarter in years.” The S&P 500 was down 4.4%, including dividends, for the full year 2018 and gained 13.6% in Q1 2019. But guess what? After losing 13.5% one must gain 15.6% just to be even. And that happened. A new high was set at the beginning of May. But then the decline in May was 6.5%. The volatility of the recent market has understandably left many investors on edge. Some have resorted to the rationalization above.
Reporters of the financial press never cease to amaze me. They continue to look to the “news” of the day to explain such volatility simply because they are reporters of the news. To be fair, they don’t know what they don’t know. The “news” may be the latest Federal Reserve pronouncement, trade war, inflation, tariffs, population shifts, etc. The real cause of the volatility is pricing model uncertainty (PMU). This concept was introduced to us by world-class economist Woody Brock, PhD, and relates to the inability to determine the true value of an investment. PMU is what has been going on lately and is driving this round of increased volatility.
“The real cause of volatility is pricing model uncertainty … the inability to determine the true value of an investment.”- Scott Neal
To better understand where we are headed, it is good to look to a longer analysis of what has driven the market to the levels we see today. According to Brock, the key turning point in the market was 1981. The market had produced negative real returns for the 15 years since 1966. He paints five factors that account for the remarkable growth of earnings and stock prices.
There has been a dramatic decrease in interest rates. In 1981 the Fed rate was 15%; for the past few years it has been near zero. The reduction in interest rates leads to a reduction in the cost of capital which, in turn, increases earnings.
Profits of a company either go to labor or to back into the capital of the firm for growth. However, Brock contends that there are really two kinds of capital: “normal” capital that is employed in the production of goods and services in a perfectly competitive market, and “monopoly” or excess capital, which stems from the rise of more oligopolies and monopolies. Monopoly capital’s share of national income has been growing very quickly at the expense of labor.
Large tech companies such as Facebook, Amazon, Google, and others are enjoying monopoly-like power and reap much higher than average profits accordingly.
Labor has seen a reduction in its bargaining power as labor unions have been in decline for several years. Globalization has also hurt labor’s position.
Aggressive share repurchases by companies has led to an increase in earnings per share.
We should now be asking ourselves this: Are these conditions likely to continue resulting in continued growth? Or will we see a reversion to the mean? We believe that, in today’s economy, it is not likely that all five of these factors will persist, and there is a possibility that none of them will. Without earnings growth the only way for the stock market to continue to rise is for the PE ratio to be raised to levels that many would declare to be dangerous. PE is already above average and is mean-reverting. Either way, we advise our clients to be prepared for lower stock market returns over the next few years. We believe it will become more challenging, but achievable, to protect capital while earning modest returns. It will require diligence and patience, the likes of which has not been required for quite some time.
Scott Neal is president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. He can be reached via email at firstname.lastname@example.org or by calling 1-800-344-9098.