There are a number of ways to look at divergences. People buying Gold in 2006-2010 were probably thinking the same thing as Saul today, as Gold prices continually increased and peaked in 2012 and 2013 while the stock market tanked in 2008/2009 and languished for a bit after that. But, Gold’s been dead money for 4 years now.
I’m not saying our situation (like most here, my returns have been great over the past decade) is like Gold was in 2011. But, I also don’t want to kid myself that what’s happened is going to continue unabated. To be really honest with myself, the kinds of stocks that we favor here have had the winds at their backs for a while now. But, “Sector Rotation” does occur as different kinds of investments generally fall in and out of favor with the market in general. On the SA Tesla board, for instance, it’s been pointed out that investments in battery production are hard to come by because Venture Capitalists see software companies as having much higher potential returns for not much more risk and certainly much less investment capital requirements. Is that a relatively temporary thing, or is it a new normal?
It seems clear that as the economy and stock market continue to do well that interest rates are set to rise this year and maybe next. Past market behavior is that as interest rates rise, stocks lose momentum. If you can get a 10% return on a “safe” investment vehicle, why take a chance on the riskier stock market? So, it’s kind of self-feeding in that way - the more people who believe that the more people take their money out of stocks, which makes the prophecy come true. I don’t pretend to know what is causing the current “correction” that everyone else is talking about, but I wouldn’t be surprised if it was linked to interest rate rise expectations. In addition, inflation has been at historically low levels for a while now and if that changes, that’ll not only drive interest rates up, it’ll reduce the effective return on our market investments.
Of course, no-one else believes we can do what we’re actually doing. Like TMF’s email to Saul talking about things being down, this blog came out recently: https://www.financialsamurai.com/silver-linings-stock-market… declaring we’ve officially entered correction territory. As I read the blog and other articles this guy has written, I find myself both in firm agreement on some things and in violent disagreement on others. For instance, here are couple items from that blog:
I argue its been too easy for the 35 and under generation to build wealth, thereby creating a false sense of security. I agree with this. I work with people of disparate ages, and by far the younger people see the stock market as something that always goes up. Yeah, they intellectually know it can go down, but they haven’t actually seen their own net worth go down so they don’t know what that really feels like and what it takes to survive. I have the same problem in terms of living on what I invest. I read about people here who live off their investments with no other new money coming in, and while I recognize I’m in a different boat because I’m still working and earning good money and continually adding to my investments and so I can view declines as opportunities in which to invest new money since I don’t need my already invested money on which to live, I know it’ll be different for me (and I’m intellectually prepared), but when I’m really retired and have to do it, will I be able to stand up to the pressure of not having a job’s income to fall back on? I respect everyone here who are living off their investments and continuing to have them grow.
The consensus 2018 S&P 500 earnings estimate is ~$155 (+17.8% from 2017). Therefore, at 2,500 on the S&P 500, the market is trading at a reasonable 16.1X forward earnings vs. long term average of ~15X. The consensus earnings expectation for 2019 is for earnings to grow by another 10% to $171, or 14.7X 2019 earnings. Valuations are generally considered “reasonable” if the P/E to Growth ratio is around 1X e.g. 15X P/E and 15% earnings growth. Therefore, at the moment, it looks like investors are getting a valuation discount.
For me, that addresses the “bubble” concerns that some investors have today, AND reinforces part of Saul’s methodology for valuing stocks. Simply put, if companies are making more, then their stock is worth more. So, it’s not a valuation bubble like tulip bulbs or crypto-currencies, but tangible profits increasing. Of course, it’s not just P/Es, but growth that really fuels Saul’s returns. Not much talk about growth generally, I find.
According to analysis by Goldman Sachs, since WWII the average correction is -13% over a course of four months. It then takes an average of four more months before the S&P 500 recovers all its losses. In other words, don’t use all your dry powder all at once if the stock market is down 10%+ in just a couple weeks. Rather, leg in through multiple tranches because timing the market is too difficult. If you have a long-term mentality, you’ll be able to better contain your rush to sell and rush to buy.
The down 4 months and then recover in 4 months behavior is for Corrections, though. Look at the table in the article at actual Bear Markets, and the differences are sobering: down for over a year (13 months), then taking almost two years (22 months) to recover. We haven’t had one of those in almost a decade now. Some say we’re overdue. I think Saul has it right when he agrees, but points out that there’s nothing better to do than ride it up and out. People have been saying we’re overdue for a Bear Market for a few years now. Anyone who sold then has lost out big, is probably rightfully scared to get back in now, and so has to wait until it actually occurs, which by then could mean that the downside will be higher than when they actually bailed!
But then the article goes off the rails for me.
As investors, it’s important to constantly remind ourselves that over the long run we are not smarter than the market. He continues this in another article, https://www.financialsamurai.com/recommended-net-worth-alloc… , I don’t care how much you’ve been able to outperform the stock market over the years with your $10,000 stock trading account. The fact of the matter is your performance will normalize over the medium-to-long run. As you grow your assets to the hundreds of thousands or millions of dollars, you aren’t going to be whipping around your capital as easily as before because your risk tolerance will change.
He continues: You are not a financial professional. If you are a software engineer, your expertise is in creating online programs not giving investment advice. If you are an artist, your expertise may be in painting portraits, not recommending a pair trade with Apple and Google stock. If you are a Major League pitcher, your expertise is throwing a nasty cutter, not investing $50 million in a gaming company and going broke like Curt Schilling did of the Boston Red Sox.
It’s clear to me that he’s not talking about us. He does conclude with this, with which I agree: If you can’t come up with a coherent 10 minute presentation to a loved one why you are investing the way you are, you might as well be throwing darts. And of course what makes this board so valuable is that we do have in-depth posts about why we’re investing in our companies.
I also strongly disagree with this statementL There is no risk-less investment unless you are putting less than $250,000 in CDs, money markets, or buying US treasuries. Those investments pay less than inflation, so I guess you could say that there’s no risk, but instead a guarantee that you’ll lose money!
And then we all can agree with: If you want evidence of people not knowing what they are talking about, just turn on CNBC and watch them trot out bullish pundits when the markets are going up and bearish pundits when the markets are going down.
OK, this is getting too long. After layout out both pearls of wisdom and well-meaning advice that doesn’t apply to most of us here, this person goes on about diversification and investing in bonds as you get older, etc.
Back to Saul’s original, rhetorical question, the real question for me is whether the kind of mostly small (for publicly traded), high growth companies on which Saul concentrates will continue to exist as the market changes moving forward. If most companies aren’t doing well and expanding, then demand to switch from Cisco to Arista, or from EMC to Pure, or to migrate existing databases, or to adopt data analytics, etc. may be reduced and then our companies may not continue to do as well. Just as individuals will put of buying, for instance, a new car when they’re not doing well, companies will put off infrastructure improvements if they’re not doing well.
For instance, there’s an argument to be made that investing in ANET is a multiplier proxy for investing in Microsoft’s Azure business. Through Azure, Microsoft is Arista’s biggest customer by far (more than 10% the last time I looked). If Azure doesn’t do well, MS won’t buy more Arista products. Yet, I haven’t seen anyone’s analysis of Arista factor in how well Microsoft will do in 2018/2019. Sure, we look at how overall demand is increasing, but I’m not sure we go deep enough to analyze how the companies that buy Arista’s products will do in the coming year or two. It’s SOP (Standard Operating Procedure) to look at consumer demand when analyzing retail companies, for instance.
Anyway, sorry for the ramble - hopefully some of the points I’m making resonate or at least initiate us considering why we’re doing so well and how we can continue to do so well when the rest of the market isn’t doing so well.
