A few weeks ago, I wrote an article titled “Returns Over the Next 10 Years,” which has generated a lot of follow-up conversations. The article’s motivation was a piece from Goldman Sachs that painted a pretty gloomy outlook for stock market returns over the next decade.
I pointed out that future market returns are highly correlated to current valuations, meaning that above-average valuations lead to below-average returns and vice versa. This is a valuable truth to know and understand, but it’s not actionable. Valuations can stay above average for extended time periods, and valuations can remain below average for extended time periods – you can’t use valuations as a signal for timing markets.
Current market valuations are indeed above average by nearly any measure of valuation. Yet, it’s important to understand that high valuations are dangerous, but in and of themselves, they are not damaging. The damage comes when valuations are high AND a catalyst hits (Dot Com Bubble, GFC, Covid, etc.). Expanding valuations – meaning stock prices are rising faster than profits – is what makes markets more fragile.
TAKEN
Personally, I want my clients to be aware of this fragility so they won’t be surprised by what happens next. My standard PSA on this topic reminds me of a scene from the movie Taken starring Liam Neeson.
Neeson plays an ex-CIA agent who reluctantly lets his teenage daughter take a European vacation with her friend. The daughter calls her father frantic with terror, as there is an intruder in the house, and her friend has already been kidnapped. With complete poise and confidence, Neeson walks his daughter through what she needs to do step-by-step. At this point in the thriller, you get the impression that the daughter believes her dad’s guidance will help her avoid being kidnapped, and then he says this famous line, which provides the namesake for the film, “This next part is very important. They’re going to take you.”
Here’s the connection. I cannot help my clients sidestep market volatility – just like Bryan Mills (Liam Neeson’s character) can’t stop the kidnapping of his daughter. These valuations are like an intruder in the house; they will lead to market mayhem; it’s inevitable. As an advisor, “what I do have are a very particular set of skills,” these are skills to help navigate my clients through those troubling markets and come out the other end unscathed.
My client messaging is quite simple: This next part is very important. Markets will eventually go down. Delivering that message with poise, reassuring that this is all very normal and that we don’t have to get out of control when markets are out of control, is exactly what my clients need to hear.
Taking Action
Yes, high valuations do point to muted future returns. Yes, you can’t time markets based on valuations. BUT, there are some prudent measures you can take when markets are elevated. These measures are like an emergency preparedness kit – they won’t avoid catastrophe but rather aid you in the moment of catastrophe. Here are four action items you can execute when markets are feeling rich:
1) Deleverage – Your balance sheet is made up of assets and liabilities. The goal is always for your investment assets to grow at a reasonably higher rate than the cost of your debt. When valuations get stretched, it can hinder future returns, so you want to recalculate those expected returns versus the interest rates on your current debt. It’s a great opportunity to shave some profits from your high-performing investments and use those proceeds to pay down some of those higher interest-rate loans.
(2) Raise cash for earmarked expenses – I’d encourage you to sit down and think about some of the larger one-off expenses you have coming up over the next few years—things like replacing the roof, buying a new vehicle or installing a pool in the backyard. Again, you should look to raise cash from some of those high-performing investments and side pockets, which will soon be spent in a money market account. This is a very important and timely exercise that every investor should do before the end of the year.
(3) Dollar cost average new monies – Maybe you sold a business or a home or received a large bonus at work. If you’ve come into some cash that should be invested and it is new money to you, I would be looking to average these monies into your portfolio. By sprinkling this cash into your portfolio over a defined time period, you don’t have to pick the perfect day to invest, and you can opt for the average price over a six-to-twelve-month period. At a minimum, this tactic will create some psychological relief and take that timing pressure off of you. If markets go up, you can be happy that you have some money invested, if markets go down you can be happy that things went on sale for your next scheduled purchase.
(4) Rebalance – This is the perfect time of the year to revisit your portfolio and the original design when this portfolio was initially crafted. Over the last few years, stocks have gone up while bonds have stayed mostly flat, so those allocations in your portfolio have probably drifted from that original design. I personally subscribe to a methodology I call Expense Based Planning so I am comfortable with this drift, but with prices rising and often lifestyles shifting, I think many clients’ spending habits have changed. So, revisiting the numbers and looking at how many years of expenses are set aside in cash and high-quality bonds is a good exercise to run through. Ultimately, you want to rebalance everything to your intended design. Just like what was described in some of these other timely tactics, you essentially trim some from what has been very profitable and use those proceeds to reinvest in some of the laggards – we call this rebalancing.
Handle with Care
Again, I want to reemphasize this concept of fragility for you – fragile markets are dangerous but not damaged. When you see that fragile stamp on a box, you know it’s holding breakables, but it doesn’t mean anything is broken.
So, what’s the soft-landing scenario for markets from here? It’d be that earnings (profits) grow at a pace faster than stock prices for an extended time period to normalize valuations. The problem is that earnings growth is above expectations, which usually leads to increased excitement, improving sentiment, and higher valuations.
This fragility I speak of is created out of euphoria and excess; that’s how valuations get out of hand. This is often a cultural phenomenon, too; this euphoria permeates beyond the stock market. This headline from Bloomberg probably helps to illustrate my point best, “Crypto Tycoon Pays $6.2 Million for Banana Duct-Taped to a Wall.” To assure that nothing is lost in translation here, the famed auction house, Sotheby’s, had a bidding war to the tune of $6.2 million for literally a banana duct taped to a wall. Yes, this is the world we are currently living in.
Soft landings are rare, typically it takes a catalyst, a shock to the system to reset or normalize prices. I don’t invite this or wish this upon markets, and this has rather just been a historical reality.
A Comforting Truth
With all of this going on, where do we find comfort? We are dividend growth investors, and the historical truth is simple: (1) dividends aren’t volatile like stock prices and (2) dividends, unlike stock prices, are always positive, they can’t be negative. These facts about dividends even apply to the major stock market indices like the S&P 500. If one were to have invested in an S&P index over the last 50 years, they would’ve received a dividend each and every year, and in a majority of those years, they would’ve experienced a year-over-year increase in dividend income. The primary issue with this index is the amount of dividend income it pays relative to its price – the yield sits at roughly 1.2%. That yield produces a “minimum wage” sort of paycheck for investors, which doesn’t bode well for a financial plan but sure does carve out a nice niche for us and our business 🙂
Winterizing
Here’s the conclusion. Markets are rich, which means they are becoming more fragile. Yet, this reality can’t lead us to sit out of the markets because missing some of the best years, months, or even days of market performance can damage our long-term results. So, we stay invested, but we are aware that these cycles of euphoria and fear are par for the course, and they lead to prices following that same rising and falling cycle. Strategically, we stay the course, and tactically, we deleverage, raise cash for earmarked expenses, dollar-cost-average in with new monies, and rebalance our portfolios.
I recently bought a home in Idaho, which I will say is an absolutely beautiful part of our country. It snows in Idaho, a very foreign concept for a Californian. When the winter season approaches, locals know the routine of winterizing. They take the necessary actions to protect their property during the changing season. Markets aren’t much different, markets have seasons too, so let’s just call my advice today a winterizing of your portfolio to prepare for when those seasons do change.
Trevor Cummings
PWA Group Director, Partner
tcummings@thebahnsengroup.com
Blaine Carver
Private Wealth Advisor
bcarver@thebahnsengroup.com
