Since the stock market bottomed in 2009 (during the Financial Crisis), the US stock market has enjoyed an unbelievable ride higher with very few major corrections. In fact, from the March 2009 bottom, the market is up over 700%. With such a great, “seat of your pants” type of ride over the last decade, it might make sense to take a step back and assess where we are now.
To offer some perspective on the stock market - below are five measures that illustrate where market valuations currently stand:
1. S&P 500 Price to Earnings Ratio (P/E Ratio)
The S&P 500 P/E Ratio measures the combined price of all 500 Standard & Poor constituents against their aggregate earnings-per-share. Its latest reading is 25.39, which means investors are paying just over $25 for every dollar of earnings.
The P/E ratio has historically been below 20, so this would suggest that the market is currently over-valued. However, when we look at the forecasted P/E, it is currently 21.87 which is more inline with historical averages.
In addition to this: Lower interest rates can justify higher valuations, all else being equal - there is an inverse relationship between interest rates and valuations which I will write about in the future.
Indicator Conclusion: Mildly Overvalued
2. S&P 500 Cyclically Adjusted P/E Ratio (CAPE Ratio)
Similar to the P/E ratio, the CAPE ratio divides the S&P 500’s current price by its 10-year earnings, adjusted for inflation.
Why adjust the traditional P/E Ratio?
By using a 10-year period, this tends to smooth out year-to-year fluctuations in earnings which can be somewhat volatile over shorter periods of time. The idea is a higher CAPE ratio could reflect lower future returns, whereas a lower figure would indicate higher returns. The CAPE Ratio was developed by Noble prize winner Robert Shiller of Yale back in the 1990’s; however, this idea is not exactly new, Benjamin Graham (the father of value investing) and David Dodd recommended using 7-10 year averages in their seminal 1934 book Security Analysis when using valuation ratios.
There is some research that shows over long periods of time this ratio tends to predict future long-term returns fairly well. However, the CAPE ratio isn’t expected to predict what the market might do over short periods of time. Having said that, large spikes in the CAPE ratio have often preceded recessions, and it’s important to realize that the metric is currently approaching its highest level on record.
The CAPE ratio currently stands at 38, which is 26% higher than its 5-year average, 40% higher than its 10-year average, and more than double its 100-year average.
Indicator Conclusion: Significantly Overvalued
3. The Buffett Indicator
In 2001 Warren Buffett said that US Market Capitalization as a percentage of GDP is “probably the best single measure of where valuations stand at any given moment,” The ratio measures the aggregate value of the US stock market relative to the country’s economic output.
Where is it now?
It is currently at its highest level ever.
Investors are paying over $2 for every dollar of US GDP, compared to a long-term average of $0.82. Buffett went on to say, "for me…if the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire"
I’m not one to argue with Buffett’s thoughts, so this isn’t a great sign.
Indicator Conclusion: Significantly Overvalued
4. S&P 500 Dividend Yield
The dividend yield is the aggregate dividend of all the companies in the S&P 500 divided by the price of the S&P 500. Basically, this is how much the 500 largest US companies are paying investors in terms of dividends.
All else being equal, a low or falling dividend yield means high or rising share prices. Currently the S&P 500 dividend yield is at a 20-year low. Over the last 10-years it has hovered between 1.75% - 2.25%, it’s currently at 1.26%. And there are only two ways for this number to increase, either dividends increase, or stock prices drop. I know which one I’d prefer.
Indicator Conclusion: Overvalued
5. The Yield Curve
Long-term treasury rates are almost always higher than those of shorter-term rates.
Because investors expect to be compensated for lending money over longer periods of time due to risk and the time value of money.
However, when shorter-term rates are higher than longer-term rates - the opposite of what is “normal”, it signals shaky confidence in the economy, and typically leads investors to shift from riskier assets to safer assets, in essence moving from stocks to bonds. This phenomenon, known as an inverted yield curve, has rather consistently foreshadowed recessions and market downturns.
A popular yield curve measure used by the market is the spread between the 10-year treasury vs. the 2-year treasury. Just before the last four recessions, the 10-2 spread went negative and the stock market turned negative shortly thereafter. The good news is currently the yield curve is “normal” with the 10-2 spread sitting right around its historical average.
Indicator Conclusion: Normal
Is a Market Correction Coming?
The short answer is yes.
Because corrections happen somewhat regularly. Since the Financial Crisis there have been 4 corrections of 15% or greater, with 1 of these 4 corrections being the Covid correction of over 30%.
Not only can corrections occur by prices dropping, but corrections can also come from prices staying flat (for years) despite company growth—rising earnings, sales, book value, among others without price increases (think the 1970’s). Either way, the market has always ebbed and flowed over time, oscillating between overvaluation and corrections, but the long-term trend is positive if you have the time.
While I don’t advise dancing in and out of the market based upon headline news. I do think it’s prudent to have some understanding of where we might be in terms of the economic cycle and market valuations.
Why is this prudent?
This gives you a good reason to take some time to thoroughly review what you own, why you own it, and what the future might realistically hold for your portfolio. Having realistic expectations is fundamental to successful investing. With valuations where they are currently, it would be well-advised to use this to temper your future return expectations.
If you have a well-thought out, well-designed portfolio coupled with a rock-solid financial plan then you shouldn’t be overly concerned with market fluctuations.
Although, that’s a big “if.”
-Paul R. Rossi, CFA
I’m a huge proponent of self-improvement and growth. The idea of making small improvements compounds over time and can become extremely meaningful.
Let me give you an example:
Most people would agree that typically making a 1% improvement isn’t much of an improvement. And I would agree. On the other end of the spectrum, a 100% or 200% or even 1,000% improvement is quite substantial.
However, what if you are able to make many 1% improvements over time, this is where things get quite interesting. Assume you are able to make a 1% improvement everyday for just 1 year. How much do you think you would improve?
These would all be great improvements, but the actual answer would be a 3,788% improvement. At the end of a year you would be over 37 times better than you were when you started. All from just a 1% improvement every day. The formula is: (1 + 0.01) ^ 365
This is an example of the power of compound growth. Einstein has been attributed to saying, “compound interest (growth) is the 8th wonder of the world.” And even if he didn’t say it, I’m sure he would agree with this idea.
Compound growth is incredibly powerful and is quite possibly under appreciated by most people outside of mathematicians and athletes. One such person who I’m confident understands the power of continuous improvement is Wayne Gretzky.
It truly is hard to comprehend just how great Wayne Gretzky was on the ice. He made the All-National Hockey League First-Team 8 times, holds the record for most points all-time, most points in a season, most all-time assists, youngest player to score 50 points, most game winning goals in play-offs, and the list goes on and on. He retired in 1999 and STILL holds 60 records in the NHL. And if you can’t remember all his amazing records, you can just call him by his moniker, “The Great One.”
He understood the idea of continuous improvement, hard work, and living a fulfilled life. Here are some of his own words on these subjects.
We all can't be Wayne Gretzky, but we can strive to take his ideas and incorporate them in our lives.
-Paul R. Rossi, CFA
It wasn't easy, but here's a list of some of my favorite Warren Buffett quotes I compiled.
What made this so hard?
Choosing just 25 made it hard, I could have easily come up with a list of several hundred.
How did I come up with this list?
I went through several books I have about him and numerous shareholder letter's he's written over the years and used quotes that gave a broad range of invaluable insights to living a happy healthy life. A person would be hard pressed to not do well if they lived by his way of thinking. Some of my thoughts are in italics.
So here they are:
The 25 Greatest Quotes of Warren Buffett
-Paul R. Rossi, CFA
It’s easy to get a bit mixed up by the many moving parts and features of Medicare. This article hopes to help you make sense of the alphabet soup which is known as Medicare.
Quick note: At the bottom of this article, I've included a 2-page PDF tear sheet that can be downloaded, printed off for future use, or worst case, on those nights you are having difficulty falling asleep, it can be used as a sleeping aid.
The information below provides some information on the major coverage options, called parts A, B, C, D, and some of their more significant aspects. Use it to help you think about what level and combination of coverage suits you and your family the best.
Medicare Part A (hospital coverage): Part A is the portion of Medicare that pays hospital costs. Part A also includes some benefits for skilled home care, hospice care, and the first 100 days of skilled nursing care. You probably won’t have to pay any premiums for Part A, because you already paid for it with payroll taxes while you were working. In 2021, you have to pay the first $1,484 of the cost of each hospital stay. Part A covers the rest for the first 60 days, and then you pay the first $371 per day for days 61–90. After that, there are “lifetime reserve” days (you have a total of 60 days to use in your lifetime, and then they are done), for which you pay the first $742 per day. You are responsible for the full cost of any additional days.
Medicare Part B (medical coverage): Part B is the portion of Medicare that covers outpatient health care visits such as doctors, outpatient surgery, diagnostic testing, durable medical equipment, and ambulance services. Part B is not free. You’ll pay premiums ($148.50 per month in 2021)—and if your income is over a certain amount, your premiums are subject to surcharges. These surcharges are based upon your modified adjusted gross income as reported on your IRS tax return from 2 years ago, which can be as much as $504.90 per month for income above $500,000.
Under Part B, you are responsible for the first $203 of covered medical services. Once that deductible is met each year, you will typically owe 20% of the cost of such services, although you may also owe “excess charges” for some providers.
Medicare Part C (Medicare Advantage): Part C plans are private plans that contract with Medicare to provide Medicare A and B benefits. Many of these bundled plans are available for only the cost of the standard Part B premium. More than 60% of Medicare Advantage enrollees are in HMO plans, with the vast majority of the rest in PPO plans.
Medicare Part D (prescription drug coverage): Part D plans are optional prescription drug plans available to everyone who has Medicare. These private plans contract with Medicare to provide at least a standard level of prescription coverage. They are available both as stand-alone plans and as part of Part C (Medicare Advantage) plans. Premiums vary, and there are surcharges for those with higher incomes, but as of 2021, they ranged from $12.30 to $77.10 per month.
*Medicare Supplemental Insurance (Medigap). Medigap policies are private policies designed to cover expenses not covered under Part A or Part B (above). To make things confusing they follow standardized forms, designated with letters A through N. Medigap policies add to the “alphabet soup” confusion. Example: Medicare Part A and Medigap Plan A are not the same thing. Any Medigap policy designated with a particular letter provides a specific set of benefits, regardless of which company issues it.
It's important when approaching 65 years of age that you do your research to determine what is best for you and your family.
Generally when you turn 65, this is called your Initial Enrollment Period. It lasts for 7 months, starting 3 months before you turn 65, and ending 3 months after the month you turn 65.
If you miss your 7-month Initial Enrollment Period, you may have to wait to sign up and pay a monthly late enrollment penalty for as long as you have Part B coverage. The penalty goes up the longer you wait. You may also have to pay a penalty if you have to pay a Part A premium, also called “Premium-Part A.”
Regardless of which Medicare option you choose, you need to do it in a timely manner. Otherwise, you could encounter periods of time when you,
This is something you don't want to miss, put a reminder in your phone. In fact, I would recommend a full 6-months before you turn 65, you start your Medicare research so by the time you are in the 7-month Initial Enrollment Period you can sign up and you'll will know exactly what options you'd like and you'll have a good idea of all the costs.
To do your research and for a more complete description of costs, what is and is not covered visit www.medicare.gov
- Paul R. Rossi, CFA
As Warren Buffett's quote above refers to, risk is not knowing or understanding what you are doing.
To help combat this "risk," I’ve put together a list of some important measures to consider when evaluating your investment portfolio.
These metrics can be used to measure individual stocks, ETFs, and mutual funds.
Underlying Holdings: Probably the single most important information to know. This is the driver of how your portfolio (or the fund) has performed in the past and how it will perform in the future. Know what you own and why.
Geographic Exposure: Measures where in the world are the funds’ largest holdings located geographically. Where are these companies based? Are they located in U.S., European, or in Asia? Why is this important? Different countries have different accounting standards, regulatory requirements, and governmental intervention.
Weighted Average PE Ratio: Measures what the weighed average price/earnings ratio is of the funds’ underlying holdings. The higher the number, the more investors are paying for every dollar of earnings. All else being equal, lower is better.
Valuation Percentage: The valuation percentage shows how far above or below its current price the stocks or funds historical valuation is. This factors a long-term average of the Price to Sales Ratio and Price to Earnings Ratio and mathematically determines whether the current price is high or low relative to those historic valuation multiples. A negative value indicates the current price is above the historical valuation while a positive value indicates it is currently trading at a discount to the historical valuation. This is NOT a measurement of how the stock's price relates to its "intrinsic value” but is instead a measurement of how the market is valuing the stock or fund relative to how it was valued historically.
Return on Equity (ROE): Measures the rate of return on the money invested by stock owners. ROE shows how well a company uses investment funds to generate income and growth. Return on equity is useful for comparing companies within a sector and industry. It’s also useful at the fund and portfolio level. Return on Equity = Net Income / Average Common Shareholder's Equity. All else being equal, higher is better.
Dividend Yield (and Current Yield): The sum of all dividends paid (and interest paid), divided by current share price; a higher dividend yield (and current yield) indicates a larger payout.
Dividend Payout Ratio: The percentage of company net income paid as dividends to shareholders. Typically, investors who want income from their investments favor a higher dividend payout ratio.
Dividend Growth: Period over period growth of dividends paid, usually expressed as trailing 12-month (TTM) growth. Growth in dividends can be a sign of strong financial health.
Dividend Consistency: The track record of paying dividends to shareholders at a regular interval, usually quarterly, over a given lookback period; a company cutting or canceling a dividend payment is a negative event.
Total Returns: Unlike price return, total return includes dividends and interest in addition to price appreciation; a higher total return is better. It’s important to look over various time periods and under various market conditions (Bull markets, Bear markets, and sideways markets). As I’m sure you’ve heard before, “past returns are no guarantee of future returns.”
Sharpe Ratio: The Sharpe Ratio measures the risk-adjusted return of a security. This is a useful metric for analyzing the return you are receiving on a security in comparison to the amount of volatility expected. Sharpe Ratio is measured as annualized return on Lookback Period - Risk-Free Rate) / Historical Annualized Standard Deviation of Monthly Price Returns.
Benchmark: For a security, a fund, or a portfolio, a benchmark is used to track against. Generally, the benchmark is an index or weighted return stream of multiple indices that help give an idea of what your investment should strive to match or beat. Measuring against the proper benchmark is critical to properly understanding performance and risk. Benchmarks are also used to calculate risk metrics like Alpha, Sharpe Ratio, and Beta for securities and portfolios.
Upside/Downside Capture Ratio: The upside/downside capture ratio measures the ratio of the upside and downside of an investment vs a benchmark. This ratio explains how an investment typically performs in relation to their benchmark index. An upside/downside ratio of 100 means that the investment typically performs the same as the benchmark, regardless of if it is rising or falling. If the benchmark increases by 10%, the investment increases by 10%. If the benchmark decreases by 5%, the investment decreases by 5%. Sometimes, an investment may rise 15% when their benchmark rises by 10% but falls 12% when the market falls 10%. In this case, we calculate the upside/downside capture ratio by dividing the investment's upside return and dividing by the downside return: (.15/.10)/(.12/.10) = 1.25. Multiplying this by 100 gives us an upside/downside capture ratio of 125 for this investment. All else being equal, higher is better.
Expense Ratio: The percentage of fund assets that shareholders pay as management fees and operating expenses. A lower expense ratio means less fees. All else being equal, lower is better.
Market Cap Allocation: The percentage of fund assets invested in large-cap, mid-cap, and small-cap stocks.
Understanding what you own and why is critically important. What I argue is even more important is understanding that having 100% accuracy to what the future holds is impossible, so taking measured risks is really what investors are doing when they invest.
As Napoleon said, "Nothing is more difficult, and therefore more precious, than to be able to decide."
-Paul R. Rossi, CFA
What is Portfolio Rebalancing?
Portfolio rebalancing is the systematic process of periodically realigning an investment portfolio’s actual allocations with the allocation percentages that were originally planned. This is accomplished by reducing positions that have become an outsized percentage of the portfolio (due to relative outperformance) or increasing positions that make up a lesser-than ideal percentage of total holdings (due to relative underperformance).
Why is this done? Typically, it’s done to ensure the portfolio matches an investors risk tolerance, time horizon, and goals.
Some things to consider when rebalancing:
The two most commonly used rebalancing policies are based on:
So which strategy is best for managing risk and maximizing performance?
A research platform I use within my own financial planning business has recently done a deep dive into this particularly important question that I thought was interesting.
The research was conducted using 6 different rebalancing strategies, each beginning with a broad based 60% equity (stock) and 40% fixed income (bond) portfolio.
Each of the 6 portfolio rebalancing strategies was studied over a 25 year period, the analysis looked at performance and volatility.
This 25 year period includes four bull markets and three bear markets. The findings show the pros and cons of different rebalancing policies and may inform your own best practices for portfolio management.
Some of the questions that were answered are:
On a cumulative basis, rebalancing strategies that rely on the triggering of drift thresholds outperform those with rebalancing strategies based on calendar frequencies. And while portfolios that never rebalance do perform relatively well over time, such a strategy can miss out on secular growth if only a small percentage is allocated to asset classes that eventually become market leaders, even if only temporarily. While more frequent rebalancing keeps actual portfolio allocations more in line with target allocations, the risk-management benefits diminish when a portfolio is rebalanced too frequently.
The optimal rebalancing strategy for managing risk, maximizing performance, and minimizing costs will change over time, based in part on market conditions. However, more important than any of these factors is your comfort level with the chosen rebalancing strategy and your comprehensive financial plan.
As is often said, "peace of mind can be priceless."
-Paul R. Rossi, CFA
Probably and Potentially Quite a Bit - read on
Below are some questions that you should review as Biden's proposed tax plan might have dramatic implications for you and your family.
Do you make pre-tax contributions to traditional retirement accounts (e.g., a 401(k) or IRA)?
Do you hold appreciated assets with a low cost basis (excluding pre-tax assets such as IRAs, most annuities, and other items of income in respect of a decedent)?
Do you earn wages in excess of $400,000?
Does your household income exceed $400,000?
Does your household income exceed $1,000,000?
Does the value of your estate exceed $3.5 million (or $7 million, if you are married)?
Are you a small business owner?
Are you an informal caregiver for an individual in need of long-term care services?
Do you have significant corporate ownership interests?
As always, it's important to talk with a tax professional to ensure you are making the best decision for your own particular situation.
-Paul R. Rossi, CFA
Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors.
With so much research being done on various aspects of investing, surprisingly little effort has been made to explain the factors that influence individual investors’ decision making. The authors (Nerik Cronq, Stephan Siegel, and Frank Yushow) whose published work was in the 'Journal of Financial Economics' shows that an investor’s investment style (i.e., value versus growth) can be derived from two sources: a genetic or biological predisposition and environmental factors. The authors reference several previous studies and provide their own analysis to contribute a new perspective about why investors gravitate toward value or growth investments.
Differences in individual investor behavior stem from:
Several factors explain an individual investor’s investment preference for either value- or growth-oriented portfolios. The authors estimate that genetic differences account for approximately 26% of the orientation when measured by Price/Earnings ratio and 27% when measured by Morningstar’s Value-Growth Score. This result is consistent with the findings of previous researchers, who have shown that approximately 30% of the cross-sectional variation in financial risk preferences is explained by genetic predispositions. In addition to biological considerations, the analysis demonstrates that particular individual life experiences have a large impact on investment styles.
Significant macroeconomic events (think of Global Financial Crisis, Dotcom Bubble, etc.) that investors experience can also have long-term and persistent effects on that individual’s behavior much later in life.
Conversely and consistent with previous studies, the research find that investors with:
This research contributes to and supports the growing body of evidence regarding behavioral finance, which demonstrates that life experiences, behavioral biases, and genetics have a dramatic impact on investors’ behavior.
This research, coupled with the growing body of literature on cognitive biases can be extremely helpful for individual investors to help understand their tendencies and why they may lean toward various investment strategies or products. By digging a bit deeper and learning more about ourselves, we can make better informed decisions.
-Paul R. Rossi, CFA
Every day we’re bombarded with reports of what’s hot and what’s not – fueling a Fear-Of-Missing-Out (FOMO). Fear of missing out is a phenomenon that affects many aspects of our daily lives, and it’s far more prevalent than you might think.
In fact, FOMO was added to the Oxford English Online Dictionary in 2013, along with such other contemporary expressions as selfie and twerk. The emergence of social media has only compounded the FOMO effect.
The anxiety that we feel when we believe something better is happening elsewhere is ubiquitous, and investors are especially susceptible to its influence. Why? Because who doesn’t want to make money fast? In fact, Wall Street has embraced our susceptibility to this weakness and created an investment fund with FOMO in its name.
Unfortunately, FOMO and your investments are a combustible combination, similar to mixing bleach and ammonia together, a very deadly recipe. And something to avoid at all cost.
At some point, you’ll likely hear your neighbor, your friend, your friends friend, your co-worker, or somebody who made a lot of money quickly. If you are like most people, you’ll likely want to follow whatever they did. Why? Because your investments aren’t achieving the same results. Almost by definition, a well-built “all-weather” portfolio will never achieve stellar results over the very short-term; however, the superpower of this type of investing is in the strategy’s ability to do extraordinarily well over time, just ask Warren Buffett, Peter Lynch, or Sir John Templeton.
There’s a huge temptation to change course and invest in the latest hot streak. Fueling this urge is what’s called recency bias, a well-known cognitive bias that says: what’s happened most recently is more readily available in the mind and therefore the recent past = the future.
But changing your investment strategy to take advantage of a run that has already taken place isn’t a sound investing strategy, it’s FOMO and recency bias working against you. You can think of this way: Many times, this strategy would have you selling assets that may be undervalued, in order to buy expensive assets that have already gone up. This is buying high and selling low, which is the exact opposite of what you want to do, which is buy low and sell high.
Don’t be Fooled by FOMO
History is littered with examples of hot trends that reversed.
In each case, FOMO caused investors to be more afraid of missing out than what the potential loses could be. In hindsight, for those people who changed their long-term investment strategy it was a serious and costly error.
When everyone from those in the media to your own acquaintances tells you to place heavy bets on one or more “hot” stock or sector that has recently done well, be wary. Be very wary.
How does a wise investor avoid falling prey to FOMO?
Remember the simple adage: “If it sounds too good to be true, then it probably is.”
-Paul R. Rossi, CFA
It’s a debate raging across the country that seemingly everyone has an opinion about. From Main Street to Wall Street, everyone wants to know; will the U.S. stock market suffer a severe correction or keep grinding higher?
Let’s examine a couple of valid arguments why the U.S. stock market might keep charging higher between now and the end of the year.
Reason #1: Earnings have come roaring back from the recent pandemic induced recession. EPS (Earnings Per Share) on the S&P 500 are at an all-time high. The 500 largest public companies in the U.S. generated earnings that are up 29% from pre-pandemic levels (2020) and are up 386% from the depths of the forced shutdown. In a nutshell, the largest U.S. companies have never earned more money than they are earning today. I repeat, the largest U.S. companies have never earned more money than right now. Mic drop.
And it's growth in earnings per share that drive stock prices up.
See chart below, 32+ years of Earnings Per Share - it's never been higher.
Reason #2: Interest rates are extremely low (from a historical perspective). Interest rates to valuations are like what gravity is to matter, they are inextricably linked. The higher the level of interest rates, the lower the value of future earnings are worth today, and therefore a downward pull on stock prices. At the same time, higher rates add to the interest on mortgages, business loans, and corporate bonds, which makes it more expensive and harder for individuals and businesses to borrow money. With that said, interest rates are at some of the lowest levels going back decades. Take a look at 10-year Treasury rates over the past 30+ years.
Paul R. Rossi, CFA