April 1, 2019: S&P 500 As A Business

Apr 2, 2019 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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For regular SAA and TAA portfolios, the next re-balance will be on Monday, April 22, 2019. You can also find the re-balance calendar for 2019 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

S&P 500 As A Business

The most important assumption for a strategic (buy and hold) stock investor is that it’s futile to predict and capture short and intermediate term stock movement. Owning a stock means that you become a fractional shareholder or owner (among other fellow shareholders) of this company. You should ignore stock price movement and focus on its underlying business. Put it another way, you should assume that you are investing in a private business such as a restaurant in your town. The only times you should look at stock price are the times when you buy and when you sell. The time horizon to hold this stock should be a long term, or as we previously studied and advocated many times, 20 years or longer (see, for example, March 18, 2019: The Risk Of Stock Investing). 

Warren Buffett has tried to convey this concept but unfortunately, as he said, some people get this idea instantly and many struggled forever. The culprit, of course, is that there is this stock exchange/market that constantly prices your stock any second and it’s extremely hard not to be affected by such appraisal. 

We have always advocated investing in a low cost stock index fund such as S&P 500 index (like VFINX (Vanguard (S&P 500) Index)). Investing in an index fund is no different from investing in a business, except in this case, it’s an aggregate conglomerate: an S&P 500 index is a collection of 500 (sub)businesses. In this newsletter, we want to examine this concept more closely.

The ‘business’ of S&P 500

Now let’s look at S&P 500 as a single ‘business’. We further want to assume this ‘business’ has no publicly quoted price so that we can simply concentrate on its real business. All we have is its ‘earnings’. As a ‘private’ business owner, that’s all we can rely on.

What we can see is that

  • Based on S&P, roughly, the total revenue of S&P 500 companies in Q4 2018 is about 56% of the US GDP. The ratio has ranged from 50% to 65% in the last decade. So we can confidently say that the ‘business’ represents the majority of US economy, or at least it’s a very good barometer of the US economy. 
  • A ‘business’ that never lost any money since 1871 (based on Robert Shiller’s data). See the following chart:
S&P 500 trailing 12 month earnings since 1871:

The three big drops happened in 1920s, 1930s and 2008-2009. But this ‘business’ never lost money. 

  • Of course, this ‘business’ is not much affected by a single company’s specific problems such as a plane crash (recent Boeing disaster), a drug trial failure or a scandal of a company’s management. 
  • A ‘business’ that grows its real earnings (i.e. after inflation) annually at roughly 6% since 1871. What that means is that not only it preserves the purchasing power of your initial capital invested, you actually are able to grow it at 6% pace annually. So this is a very good investment to beat inflation and even grow your wealth in a long long time. 
  • As an added bonus, this ‘business’ does restructuring annually: it periodically adds or acquires ‘good’ businesses (companies) to its collection while in the meantime, deleting or kicks out ‘bad’ businesses. 
  • Finally, the fundamental ‘axiom’ of equity risk premium in a fair capital market will ensure that, regardless of how general economy goes, these collection of good enough business operators will reward their shareholders with inflation and fixed income beating returns — in a long long time, a fair capital market should reward business owners extra returns than those who just put money in savings, otherwise, without such incentive, eventually businesses will disappear. See some of our previous newsletters on this subject (example, October 31, 2016: Economy Power And Long Term Stock Returns)

Discussions

So we, as investors, are fortunate to find a ‘business’ that never lost money and has grown its after inflation earnings (real earnings) at 6% annual rate in a long term period. However, as discussed in March 18, 2019: The Risk Of Stock Investing, there are also some serious risks to consider. Among them, the time horizon (holding period) and the initial valuation are the two major factors. 

Practically, a simple rule of thumb is to plan out your personal finance and make sure you only allocate capital that’s needed 20 or more years later. You then put the rest of your capital to a good fixed income portfolio such as the total bond fund portfolios on our Brokerage Investors page to accommodate your short term need. We will have a more in depth discussion on this type of asset allocation approach. 

Unfortunately, for investors who just start out, the returns of the next 20 years might not look bright as right now, stock valuation is at one of historical extremes. A simple estimate probably gives us about 3-4% annualized return for the next 20 year period (a flat return in the first 12 years followed by a normal 10% annual return, averaged out in the 20 years). Of course, this is still better than the 2.8% yield of the 30 year Treasury bond. But regardless, a buy and hold strategic investor should be prepared for a very bumpy and low return ride in a long period to come. 

Market overview

Investors decided to ignore the yield curve inversion for now and pushed the price of S&P 500 (and most stocks) higher last week. Stocks are now in an up trend to break their highs made in last September. Bonds continued to rally. It’s also encouraging to see high yield bonds are also in a firm up trend for now. However, the current up trends for risk assets such as stocks are built in an environment with extended price rise, extremely high valuation and slowing global economy. we again call for caution. Staying the course in a well planned strategy. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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