Kevin: Hello, Kevin Coyle and John Finley, November 7th 2019. Quick update on where we are at year-to-date on the markets.
John: Today the US market hit a new high, so it is up about 25% on the year. International developed stocks are up 17% and the emerging markets are up 13%.
Kevin: Now we’ve had a nice little bump since the end of the 3rd quarter but put that in the context of where we started the year after the decline in 2018. And going back maybe even early in the year of 2018.
John: Everyone remembers how ugly the 4th quarter last year was when stocks were down about 19% in the US. So we needed to recover from that but even if you go back to February 2018 compared to today, stocks are up only about 10%.
Kevin: Yes, so we have been in a range just shy of the last 2 years, had a nice little bump out where news seems to be better over the last 2 months. The challenge is to help folks to structure their affairs in these types of environments. It seems like in the last 10 years these markets have been climbing this wall of worry, people have been concerned about it even more so now. Stocks have gone up so much John, they have to go down.
John: Well, that’s one theory, that we’re in a bubble. We need to step back and ask ourselves; what actually drives stock prices higher? The driver of stock prices are the earnings of those companies. We have had stocks triple since the end of the financial crisis but at the same time earnings have tripled as well. So the fundamentals have supported stock prices where they are today.
Kevin: How about, stocks are overpriced relative to history?
John: A common measure of relative stock valuation is the price-to-earnings ratio. Historically, we have a pretty high ratio now in the 75 percentile or so. But it’s different now since the financial crisis. We have had a divergence of bond prices going up, the yields going a lot lower. So your alternative to stocks is not as attractive. People are more inclined to invest in stocks when interest rates are so low.
Kevin: Especially if earnings are going up, even albeit slowly that we have in the current environment. How about that the gains are concentrated in just a few companies?
John: Most bull markets are led by a handful of concentrated stocks, and this is no different.
Kevin: So how much have they gone up over the last 10 years, the large cap growth stock, the Googles, Amazon’s and Netflix’s?
John: The “FAANG stocks” (Facebook, Apple, Amazon, Netflix and Google (now Alphabet)) have created $3 trillion in wealth in the last decade, which represents about 16% of the total increase in the market.
Kevin: So that can get kind of inflated in your mind by the headline news as well. How about the central banks are conspiring to keep rates low and inflate asset prices?
John: It is very common to hear in the financial press that the central banks around the world all have this big lever that they can move interest rates up and down with. The other side of that argument says that interest rates are the price of money and, like any price, it’s set by supply and demand in the market place. So if you believe that markets set the prices then what we’ve had are low growth and low inflation which have caused interest rates to be so low.
Kevin: Well since the end of September we’re seeing some signs hopefully of some life in Europe and perhaps you do have real economic activity starting to percolate, which has been the challenge over the last 10 years. Then we come back full circle to what do we do on the margin? Clients are trying to structure their financial affairs to meet their objectives. If I take money out of a risky asset, I’m lowering my expected return in exchange for a lower potential volatility exposure, i.e., price declines. I’m sitting here now, I’m worried about the markets, I’m listening to the news, how do I reconcile this?
John: For me, a good way to think about investing in stocks is to think like you’ve just said: you’ve got 2 choices; safe assets or risky assets that have the potential to give you a higher rate of return. In finance theory, we talk about the equity risk premium; it’s a measure of how much of excess return do we expect to get by putting our money at risk.
Kevin: That excess return would be because you’re dealing with the risk. You have the uncertainty of corporate earnings, but as companies grow, they will hopefully provide that equity growth premium.
John: Right! So we can calculate what this equity risk premium is, but I’ll spare you the math. For example, we all agree that there was a bubble back at the end of the 1990s, the tech bubble. The equity risk premium had shrunk to about 2% at that time.
Kevin: So that’s the rate of return that you’re going to get from a riskier asset when compared to say the 30-year treasury bond.
John: Right, that’s because stocks were so high at that time.
Kevin: So you have the 30-year treasury at 2% and the expected return from stocks would be something in the 6% – 7% range right now.
John: Right, so equity risk premium is about 5½% and the highest it has been is the last 20 years or so was in the financial crisis when it was 6½%. If you look at it by that measure alone, you would say we are not necessarily in a bubble.
Kevin: And if you’re equipped and have your structure where you can tolerate the volatility along the way then you stay the course.
John: Exactly right!
Kevin: So anyway, there will be a test later so I hope you took good notes. Until next time, cheers!!