Imagine the greatest money-making machine the world has ever seen. That machine is corporate America. More specifically, that machine consists of thousands of companies. This money-making machine creates wealth by producing earnings that are paid out as dividends or are reinvested to produce even more earnings. Think of it — you and others like you can own a piece of the greatest money-making making machine known to man.
At the end of last year this machine (corporate America) was valued at a mind-boggling $27.4 trillion. For the five years ending through 2016 this machine (corporate America) created wealth at an average pace of $2.3 trillion per year. That number is equivalent to 2,342,000 new millionaires each year.
While millions of Americans own a part (stocks) of this machine, millions of others are intimidated by it. Why? The amount of earnings produced by the machine varies over time and the amount that investors are willing to pay for those earnings varies over time.
The amount that investors will pay for the earnings is often referred to as the price-earnings ratio. Investors are trying to anticipate future earnings. Stock prices follow corporate earnings. Corporate earnings follow the business cycle. Throughout American history, the economy has had periods of expansion followed by periods of contraction. We call the periods of contraction “recessions.” Corporate earnings can drop dramatically during recessions and this wreaks havoc on stock prices.
While both buyers and sellers of shares of stock focus on a myriad of factors, the single greatest risk to stock prices is the threat of a recession. Expansions do not last forever. While no one knows when the current expansion will end, it is highly probable that stock prices will drop at least 50 percent in anticipation of the next recession.
That is a scary thought, and it limits the amount many will invest in the world’s greatest money-making machine. Nobody wants to lose 50 percent. Is it possible to benefit from this great money-making machine while still having protection when the machine malfunctions due to a recession? That is a great question and opinions differ.
You probably know that for most people it is hard to change their minds. For most of my career, I believed that stock prices appropriately reflected all available information at all times. That premise was supported by the work done by Nobel prize winning economists. Another Nobel prize winning economist came to a different conclusion. Specifically, he concluded that stocks were priced too high when investors were overly exuberant and too low when investors panicked.
I now believe that the stock market fails to properly anticipate the next recession and then overreacts when the next recession actually happens. Having said that, I also believe the stock market itself provides warnings of threatening recessions.
If you are driving and weather conditions deteriorate, what do you do? If you are a prudent driver, you slow down. If conditions are bad enough, you get off the road.
Investment advisors typically offer a variety of speeds, but they recommend the same speed regardless of conditions. These speeds might be labeled “aggressive,” “growth,” “balanced,” “moderate,” and “conservative” or similar names. The idea is to pick a speed (or size of bounces) that fits the investor and live with that speed regardless of market conditions. I call this approach “live with the bounces.” It is the approach I recommended and used most of my career. Coe Financial Services still offers “live with the bounces” but most of our clients prefer a more active approach.
Using a highly quantitative approach based on metrics that have been shown to be highly reliable, Coe Financial Services now makes intentional, timely defensive moves. No method of defense is foolproof. The stock market has a long habit of confounding and even humiliating the best and the brightest.
I am now convinced that substantial protection is possible. Avoiding the huge losses is actually more important than staying up with the market in good times.
Without protection, there is good reason to believe that stock market investors are likely to be disappointed with returns over the next 8 to 10 years. It is almost inconceivable that the US will avoid a recession in the next decade. Not only that, there is ample reason to believe that stocks are priced so high relative to earnings that future returns are likely to be low.
Academics and investment professionals are familiar with CAPE, a cyclically adjusted price-earnings ratio. Stock prices are divided by a moving average of inflation adjusted earnings over the last 10 years. When this ratio gets very high, as it has been recently, historical results suggest future returns for stock market investors are likely to be disappointing.
When stock prices plummeted in 2008-2009, many people lost sleep. They did not know what to do. They wondered how collapsing stock prices would impact their retirement. While a few got out in time to avoid the damage, many sold after it really got bad. Many also missed the gains of the recovery.