What's Fair ?
The Stay Invested portfolio was UP today: $165.29 (-0.15%)
Overall GAIN/LOSS YTD: +$6,311.55 (+6.14%)
Our benchmark index, the S&P 500 is UP Year-To-Date +11.84%
(daily performance is updated after the close, early blog posts typically show the previous days performance)
"The stock market is filled with individuals who know the price of everything, but the value of nothing.”
― Phillip Fisher
What's Fair Value?
I was asked again if I think the stock market is expensive, I'm always stumped by this question because I have to ask, "compared to what"? This time I'm going to try and step into the shoes of the person asking and explain myself. Try this sometime, explain why you think the way you do and try to objectively identify your own influences and biases; it hard.
First I'll give credit to one of my primary influences, Mr. Leon Cooperman, formerly head of Omega Advisers. Mr. Cooperman has influenced the way I look at the market and the way I parse information more than anyone else. Sure I follow and read Warren Buffet and many other great investors, but Mr. Cooperman explains his own thoughts better than anyone; I aspire to that.
Is the market expensive? Short answer is no, the long answer is below. We live in a world of low interest rates, interest rates determine everything. We've been told that interest rates will hover right around 3% for the foreseeable future, so I think for the foreseeable future stocks will prove to be a superior investment.
In an effort to explain myself, here's how I parse out my opinion.
What's driving rates: Depending on which news source you like there is approximately $9 - $11 Trillion dollars of sovereign debt in the world today at negative interest rates; that's unusual, that's high and its holding the whole world down. Negative rates prevent growth. If the U.S lends money to Germany or Japan for 10 years we get zero back because their bonds pay zero.
Is the current environment normal: No, so as investors we need to look at what’s normal and invest where the returns make sense. Buying bonds that have zero or negative rates don't make sense.
Labor Force growth: The labor force in US grows on average at about ½ of 1% per year.
Productivity growth: Productivity of the labor force grows at about 1.5% per year. It should be higher, but its held in check by increasing growth in non-capital expenditures.
Real Growth: LFG + PG = Real Growth. Combining the labor force and productivity growth determine real growth, so that’s 2% real growth.
GDP: While GDP is still growing, we’re slowing to towards a 2% level right now. We just got a 2.6% read when 2.4% was expected, but the rate of growth is expected to slow, I prefer to lean conservative anyway.
Nominal Rate: The target inflation rate is 2%, so if we add together Inflation + Real Growth we have a 4% nominal rate.
Is 10-Year Bond Normal: No, In a 4% environment the 10-year government bond should be 4%, not 2.6%; and we can assume at the current pace that it may take several years to get to a normal rate. Given the sensitivity markets have had to rate increases, an increase to 4% would cause a crash, again, not normal.
S&P 500 Multiple: In a 4% environment the S&P 500 should trade at around 16-17 times earnings. The S&P earnings I’m using is 170 for the year, with a 16X-17X earnings the S&P is should be trading around 2720 to 2890. The S&P 500 is currently at 2,784 which leads me to believe that the market as a whole is at fair value. Fair value means exactly what it sounds like, it's neither expensive or cheap.
When the market is trading at fair value investors need to be looking for individual stocks that are trading at a discount. A good place to start is by looking at stocks that are trading at multiples that are less than 16-17x earnings that have the potential to grow well in excess of their current price over the next 12 months. Any of the free stock scanning tools online can parse out low P/E stocks as a starting point. Or look at the New Lows list available in the dashboard. I would also be looking for stocks whose Forward Price/Earnings is significantly lower than the Trailing Twelve Month TTM Price/Earnings ratio. When the forward PE is lower it indicates that the earnings are projected to increase and the stock price should increase as a result of better earnings.
Is this a good time to put money to work? If you’re investing in stocks that can be bought below fair value, yes. Good companies at 52 week lows, or trading near or below book value. Stocks get mis-priced for many reasons that don’t necessarily mean the company is bad. If there were indications that the market was in for a major decline, I’d say no. This is where my thinking shifts to "What Concerns Me".
Recession: The first thing I’m looking for is an indication of an oncoming recession. While the economy is slowing its growth, there is nothing to indicate a recession.
The Fed: If the Federal Reserve were to get hostile with rates I would pull money out of stocks; right now we see a Fed that is accommodating the markets on every level. In fact interest rates adjusted for inflation are zero.
Bubbles: Normally prior to a big decline we see speculative valuations, there really isn’t any sign of speculative valuations in the broad market and most importantly we don’t see the retail investor involved with speculative valuation levels (aka: DOT COM boom, Tulip bulbs, Bitcoin).
Geo-Political: Lastly geopolitical events throw markets into turmoil, but we can’t predict those. There's all kinds of noise in the world but nothing geo-political that makes me think a catastrophe is at hand. I’ve said many times, I can’t build a portfolio around geo-political events and anyone who tries is just living in fear.
Long term concerns: My long term concerns do reflect those of Cooperman, Buffet and many others who invest with a macro economic outlook. Over time each of these concerns has either evolved or changed to reflect the future as I see it changing.
There is simply too much public and private debt in the global financial system. The economy slowed very abruptly in response to minuscule rises in rates. This didn't make any sense to me at first but as I connected the dots and worked my way back to Alan Greenspan's comments about Capital Investment I could see what's going on. Reductions in Capital Investment are fueling the need to borrow and a need for central banks to keep rates low to fuel more borrowing and maintain the ability to service those debts.
The changes to the tax laws were correct for corporate America but probably gave too much to wealthy people at a time when the economy was not in need of more stimulation. Typically adding stimulation late in a business cycle is expensive because you don't get much bang for the buck and you run the risk of running the economy too hot. We've been lucky so far because our Fed chairman have handled rates correctly and the tax package is generating significant numbers of new jobs.
Typically I don't comment on politics but as the country continues to move to the extreme left and we're seeing populist candidates emerge around the world touting similar ideologies I have concerns. The popularity of the candidates who espouse democratic-socialist policies is a significant concern for anyone who believes in free markets and capitalism. The move politically to the left results primarily from income disparity. Income disparity is best resolved through market forces and education to increase the size of the pie and opportunities for all vs the wealth redistribution that can’t possibly full-fill everyone’s needs and the wants being identified can’t be paid for in this manner.
The United States is almost 250 years old. In that time we have become the greatest economic power in history. Capitalism made that possible. While Capitalism has flaws, Socialism has no benefits, there are plenty of examples to cite but the most important example is to look at countries that are adopting capitalism or parts of it to lift their people out of poverty; namely China. It’s all very understandable to see what is going on in the larger economy and why the wealth gap has become so large. Dealing with the problem is hard, but its impossible when we elect people who think that making money and being financially successful is evil and that anything gained from your hard work should be redistributed to those who haven’t been as successful. I happen to believe that I am my brothers keeper, that I am responsible for the welfare of others, but this new political ideology won't improve people lives. You can't change another person and anything that comes for free isn't free and isn't valued. The things we value the most are the things we worked the hardest to obtain.
I think the solution lies in seeing all people as a highly valued resource. Instead we hear the same argument over-and-over that 'these' people who have less are deprived of opportunity and have been left behind. Somewhere in that argument is an agenda for programs to tax more and distribute more through programs that many of ‘The Left Behind’ can’t qualify for or the process of qualifying is so arduous they simply don’t apply.
Ben Bernanke understood in 2008 that the economy was blowing up and he had to take action, along with others, he didn’t do it alone, to get liquidity back into the US economy. If he hadn’t we would still be in a greater depression than we saw in the 1930’s. The biggest problem in 2008 was debt, and the best way to reverse debt is to get wealth up. 5% of increases in wealth work their way immediately into consumption. Bernanke thought the fastest way to get wealth up was to get the stock market up. What Bernanke missed was that there is a disproportionate number of people who own stocks. If every American were invested in the market through an index fund as I wrote in my Wall IPO post, this would have worked brilliantly. In retrospect the effort worked to keep the country out of poverty, but many Americans didn't participate in the boom economy of the last decade. So to deal with the problem Bernanke created, the government had to try and suppress that growth, as Leon Cooperman put it, the government essentially said, “You guys got a big windfall from the stock market, so now we’re going to give everyone no return on your savings for as far out as we can all see”. The low rate environment was a double barrel shot gun blast to anyone not invested in the market and trying to save. So now if we adjust the interest rates for inflation on bonds, treasuries, coupons, savings accounts, CD’s all the traditional savings vehicles, we can see that savers are losing ground since the rates earned are lower than inflation.
So now the politicians on the left are saying, because the wealthy have done so well over the last decade, we want to take it all back. Elizabeth Warren wants a wealth tax, A.O.C wants a 70% tax, basically taking that wealth out of the system, to process it through government bureaucracies in order to redistribute the wealth to a disproportionate number of people who need it and meet their criteria for approval. In my opinion this is unconscionable because it reduces investment that can grow and create opportunities and instead sends the money to programs where there is no opportunity for it to grow. Growth equals jobs, better education,better healthcare, better homes and much more.
I personally believe in the progressive tax system, wealthy people probably should pay more; but the detail we must get right is how much should wealthy people pay. The top 20% of Americans pay 87% of Income taxes. Households with $150,000 or more in income make up 52% of total income nationally but pay the largest portion of total taxes, this is what a progressive tax system is. What’s never been made clear and understood by all is how much should the wealthy pay because that will determine how much revenue our government collects in taxes. We can’t simply continue to demand more spending and then tax the same group more and more until there is nothing left to invest. My fear in this area is that we’re removing the ambition of many to go out an innovate and achieve something great for fear that all the hard work will simply be taxed away. I've asked a number of people who work hourly pay jobs what they think wealthy people pay in taxes. The people I asked thought a wealthy person, on average earns $250,000 a year and has investments. The average of all answers was 25%, some said 0% because they have loop holes and some said more. When I told them the Marginal tax rate for someone earning $250,000 in California is 47% but with a good CPA at a cost of around $2000-$5000 per tax season they count get an effective tax rate of about 36.5%; they didn't believe me, and accused me of being a 'Republican'. Sticking with the effective tax rate, we also have to add in the rest of the burden of living in a high tax state (CA, NY, CT, etc). When we add in sales tax, fuel tax and property tax we find that our wealthy person earning $250,000 is paying 45% of his income in taxes.
Consider this fellow who earns $250,000 and lives in San Francisco, CA. Over $91,000 of income is paid out in state and federal taxes alone. But that's not the total tax burden.
Here's the total tax burden for our 'Wealthy' individual, $111,398 in taxes every year, assuming he owns a home with an assessed value of $1,000,000. That $1M home in San Francisco is hard to find.
Alan Greenspan has illustrated many times in different ways that every dollar taken out of capital investment and placed into public programs (social security, Medicare, Medicaid, etc) lowers our ability to increase productivity dollar-for-dollar. This is the best explanation for why wages are not rising as fast as they should be, even though unemployment is at the lowest levels we've seen in decades, wages are only up about 3%. It’s not robots, it’s not evil wealthy people stealing the money, it’s not CEO salaries; the culprit is the ever increasing drain on capital investment. Only through capital investment do we get new jobs, new training, higher wages and new opportunities for all.
In a previous post I wrote with tongue in cheek about doing an IPO for the Southern Border Wall, symbol MYWL and suggested that the newly formed public corporation would pay its dividends to the people, not in cash but in payments to their brokerage accounts. Basically every individual would be required to have an account and would receive shares in MYWL with dividend payments made to an index fund for the total stock market. Every dividend payment would go automatically into every citizen’s account, compounding over their lifetime to create a nest egg. In addition this could reduce the growth in social security costs and allow the government to lower social security payments and redirect that portion of your payroll taxes to your index fund. Eventually all payments to social security, Medicare and Medicaid would very slowly get lowered, over time to a sustainable level that reflects the population and demographics, while redirecting those reductions to your index fund. Over the course of a lifetime every American would have a sizable retirement and medical fund to deal with any eventuality.
I don't imagine anyone will take this seriously, but consider this. There is not a single financial fiduciary adviser that would instruct their clients to do nothing and rely on government programs as a plan for retirement or to create savings for health, education and personal welfare. The plan they would advise would include a regular savings program to an index fund, some bonds and if you have extra cash, maybe some dividend paying stocks.
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Keep Me Honest
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Healthcare and Biotech sectors outperform (1-3-2019)
S&P reaches 3,000 by year end (1-11-2019)
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VEEV reaches $145/share (2-14-2019)