I can't think of any other 97 year-old-person I'd rather listen to than Charlie Munger. Billionaire Charlie Munger is one of the most successful investors of all time and he also happens to be Warren Buffett's partner for over 50 years.
Charlie Munger is Vice-Chairman of Berkshire Hathaway, on the Board of Costco, and Chairman of the Board of the Daily Journal Corporation (a newspaper publisher and software developer).
Of course Mr. Munger is well-known for his investing prowess, but he is equally respected for his thoughts outside of investing. Investors and just about everyone would be well advised to follow many of the principals and ideas Mr. Munger has shared over the years.
This content comes from Theron Mohamed at Markets Insider. Below are lightly edited comments from yesterday's Daily Journal annual shareholder meeting covering his thoughts from Bitcoin to marriage, and many things in-between. Enjoy...and here's to soaking up some of Mr. Mungers worldly wisdom.
"These things do happen in a market economy, you get crazy booms. I've been around for a long time and my policy's always been to just ride it out."
"A lot of investors are buying stocks in a frenzy, frequently on credit, because they see them going up. That's a very dangerous way to invest."
"Shareholders should be more sensible and not crowd into stocks and just buy them just because they're going up and they like to gamble."
"I think it must end badly but I don't know when."
"That's the kind of thing that can happen when you get a whole lot of people who are using liquid stock markets to gamble the way they would bet on racehorses."
"The frenzy is fed by people who are getting commissions and other revenues out of this new bunch of gamblers. When things get extreme you have things like that short squeeze."
"It's very dangerous and it's really stupid to have a culture which encourages as much gambling in stocks by people who have the mindset of racetrack bettors. Of course that is going to cause trouble, as it did."
Robinhood and Trading Apps
"If you're selling people gambling services where you make profits off the top like many of these new brokers who specialize in luring gamblers in, it's a dirty way to make money and I think we're crazy to allow it."
"[Wretched excess in the financial system] is most egregious in the momentum trading by novice investors lured in by new types of brokerage operations like Robinhood. All of this activity is regrettable, civilization would do better without it."
"Human greed and the aggression of the brokerage community creates these bubbles from time to time. Wise people just stay out of them."
"When you pay for order flow, you're probably charging your customers more in pretending to be free. It's a very dishonorable, low-grade way to talk. Nobody should believe that Robinhood's trades are free."
Stock Valuations When Interest Rates Are Low
"Everybody is willing to hold stocks at higher price-earnings multiples when interest rates are as low as they are now. I don't think it's necessarily crazy that good companies sell at way higher multiples than they used to."
"On the other hand, I didn't get rich by buying stocks at high price-earnings multiples in the midst of crazy, speculative booms, and I'm not going to change."
"The world would be better off without them. This kind of crazy speculation, in enterprises not even found or picked out yet, is a sign of an irritating bubble. The investment-banking profession will sell shit as long as shit can be sold."
"I don't think bitcoin is going to end up the medium of exchange for the world. It's too volatile to serve well as a medium of exchange."
"It's really kind of an artificial substitute for gold and since I never buy any gold, I never buy any bitcoin. I recommend that other people follow my practice."
"[The Daily Journal] will not be following Tesla into bitcoin."
Tesla and Bitcoin
Munger was asked to choose which was more ridiculous, bitcoin trading at $50,000 or Tesla's fully diluted enterprise value of $1 trillion.
He quoted author Samuel Johnson, who when presented with two choices, said, "I can't decide the order of precedency between a flea and a louse."
"I feel the same way about those choices," Munger said. "I don't know which is worse."
"Banking, run intelligently, is a very good business. The kind of executives who have a Buffett-like mindset and never get in trouble are a minority group, not a majority group."
"It's hard to run a bank intelligently. There's a lot of temptation to do dumb things which will make the earnings next quarter go up, but are bad for the long term."
"There's no question that Wells Fargo has disappointed long-term investors like Berkshire. The old management were not consciously malevolent or thieving, but they had terrible judgment in having a culture of cross-selling, with incentives on the poorly paid employees that were too great to sell stuff the customers didn't really need.
"When the evidence came in that the system wasn't working very well because some of the employees were cheating some of the customers, they came down hard on the employees instead of changing the system. That was a big error in judgment. It's regrettable."
"You can understand why Warren [Buffett] got disenchanted with Wells Fargo I'm a little more lenient. I expect less out of bankers than he does."
"BYD stock did nothing for the first five years we held it and last year it quintupled. What happened was that BYD is very well-positioned for the transfer of Chinese automobile production from gasoline-driven cars to electricity-driven cars."
"It's in a wonderful position and that excited the people in China - which has its share of crazy speculators - and so the stock went way up."
Selling Overvalued Stocks
"I so rarely hold a company like BYD that goes to a nosebleed price, that I don't think I've got a system yet. I'm just learning as I go along."
"It's been amazing that one little company, starting up not all that many decades ago, could become as big as Costco did, as fast as Costco did. Part of the reason for that was cultural. They have created a strong culture of fanaticism about cost and quality and efficiency and honor, all the good things, and it's all worked."
"People really trust Costco to deliver enormous values and that is why Costco presents some danger to Amazon. They've got a better reputation for providing value than practically anybody, including Amazon."
"Value investing, the way I conceive it, is always wanting to get more value than you pay for when you buy a stock. That approach will never go out of style."
"All good investing is value investing. It's just that some people look for value in strong companies and some people look for value in weak companies."
Amazon Founder Jeff Bezos
"I'm a great admirer of Jeff Bezos, whom I consider one of the smartest businessmen who ever lived."
Alibaba Founder Jack Ma
"Jack Ma was very arrogant to be telling the Chinese government how dumb they were and how stupid their policies were and so forth. Considering their system, that is not what he should have been doing."
The Pandemic Enriching the Wealthy
"We were trying to save the whole economy under terrible conditions. We made the rich richer not as a deliberate choice; it was an accidental byproduct of trying to save the whole civilization. It was probably wise that we acted exactly as we did."
Modern Monetary Theory
"So far, the evidence would be that maybe the modern monetary theory is right. Put me down as skeptical."
"I'm way less afraid of inequality than most people who are bleating about it. Inequality is absolutely an inevitable consequence of having the policies that make a nation grow richer and richer and elevate the poor. I don't mind a little inequality."
Munger bemoaned the rising amount of "hatred and irrationality" in politics, but argued the country had been well-governed for the past century.
"The system of checks and balances and elections that our founders gave us, actually gave us pretty much the right policies during my lifetime, and I hope that will continue in the future."
The Evolution of Business
"Long-term business success is a lot like biology. In biology, the individuals all die and eventually so do all the species. And capitalism is almost as brutal as that."
"Think of what's died in my lifetime. Who ever dreamed when I was young that Kodak and General Motors would go bankrupt? It's incredible what's happened in terms of the destruction."
"I think I had the right temperament. When people gave me a good idea, I quickly mastered it and started using it and just used it for the rest of my life. It's such a simple idea. Without the method of learning, you're like a one-legged man in an ass-kicking contest."
"It's one of the most ignorant professions in the world," Munger said, highlighting that many psychologists fail to connect their theories and insights with other types of knowledge.
Adapting to Technological Change
"If you have a fixable disadvantage, remove it, and if it's unfixable, learn to live without it. What else can you do?"
Challenging One's Beliefs
"I'm not really equipped to comment on a subject until I can state the arguments against my conclusion better than the people on the other side. If you're looking for disconfirming evidence, that's a good way to help remove ignorance."
"When we shout our knowledge out, we're really pounding it in, we're not enlarging it."
"Warren and I are better at buying mature industries than we are at backing startups. I would hate to compete with Sequoia in their field, they would run rings around me."
"I got close to Sequoia when, with Li Lu, we bought into BYD. We were buying into a venture-capital-type investment, but in the public market. With that one exception, I've stayed out of Sequoia's business because they're so much better at it than I would be."
The Queen's Gambit and Investing
"I have seen an episode or two. What I think is interesting about chess is to some extent, you can't learn it unless you have a natural gift. And even if you have a natural gift, you can't be good at it unless you start playing at a very young age and get huge experience."
"Any intelligent person can get to be pretty good as an investor and avoid certain obvious traps, but I don't think everybody can be a great investor or a great chess player."
Do Managers Have a Moral Responsibility to Have their Shares Trade as Close to Fair Value as Possible?
"I don't think you can make that a moral responsibility because if you do that, I'm a moral leper. The Daily Journal stock sells way above the price I would pay if I were buying a new stock."
"The management should tell it like it is as all times and not be a big promoter of its own stock."
Oil and Gas
"The oil-and-gas industry will be here for a long, long time even if we stop using many hydrocarbons in transportation. The hydrocarbons are also needed as chemical feedstocks. I'm not saying that oil and gas is going to be a wonderful business, but I don't think it's going away."
Wealth and Happiness
"Most people are born with a happy stat, and their happy stat has more to do with their [inherent] happiness than their outcomes in life," Munger said. He argued that most people wouldn't be significantly happier if they were richer or much more miserable if they were poorer.
Physics and Investing
"I don't use much physics in solving my investing problems. Occasionally some damn fool will suggest something that violates the laws of physics, and I will always turn off my mind the minute I realize the poor bastard doesn't know any physics."
"A little wisdom in spouse selection is very desirable. You can hardly think of a decision that matters more to human felicity than who you marry."
Creativity in Old Age
"I don't have any wonderful new thoughts. To the extent that my thoughts have helped my life, I've pretty well run the course. I don't think I'm likely to have any new thoughts that are going to work miracles either. But I find that the old ways of doing things still work. I'm kind of pleased that I'm still functioning at all. I'm not trying to move mountains."
Secrets to a Long, Happy, and Healthy Life
"I'm alive because of a lucky genetic accident. I don't have any secrets. I think I would have lived a long time if I'd lived a different life."
"The first rule of a happy life is low expectations. If you have unrealistic expectations, you're going to be miserable all your life. Also, when you get reverses, if you just suck it up and cope, that helps more than if you just fretfully stew yourself into a lot of misery."
Rose Blumkin [of Nebraska Furniture Mart] had quite an effect on the Berkshire culture. Her mottos were, 'Always tell the truth' and 'Never lie to anybody about anything.' Those are pretty good rules and they're pretty simple."
Life After the Pandemic
"When the pandemic is over, I don't think we're going back to just the way things were. We're going to do a lot less travel and a lot more Zooming. The world is going to be quite different."
-Paul R. Ross, CFA
Does the thought of plowing money into a start-up company or buying shares of a company that recently went public excite you? Are you enticed by high-risk/high-return investments?
Or do you prefer the "sure thing," believing that slow and steady can win a lot of races? If so, you might be considered a more risk-averse investor.
There is no right or wrong type of investor, just what's right for you. Most people fall somewhere in between these two extremes. But knowing what your needs are, and what type of investor you are, can help get a sense of your risk tolerance and ultimately help you invest in a way that will build wealth over time.
Like a finger print is unique to each individual, no two people will have the same views on investing.
In less than 2 minutes, you can find out where you stand, are you a Tortoise or a Hare?
Mark the responses below after each sentence that best describe your immediate reaction to each of the following statements.
Try not to overthink your answers.
Score yourself below.
Drum roll please...
Whatever your score, be it 8 or 40, or somewhere in between, knowing this number is critical to your investing success. Knowing your comfort level will go a long way in determining what type of investments are suitable for you and which ones are not.
Investors would be wise to follow the ancient Greek aphorism "nosce te ipsum," more commonly known as "know thyself."
-Paul R. Rossi, CFA
For a deeper dive into your risk tolerance and to see if your investment/retirement portfolio is correctly aligned with who you are, click here.
One of the fundamental laws of the universe, is the Law of Gravity. Einstein taught us that gravity is the bending of space/time, which we perceive as objects being drawn toward each other.
Finance's "Law of Gravity" is the idea of the relationship between risk and return. The idea is pretty straight forward: The riskier the investment, the potential greater the return. Said another way, the lower the risk, the lower the expected return. The relationship between risk and return is positivity correlated, therefore the more an investor is willing to dial up their risk, the more return they expect to make.
Let's take two relatively straight forward examples which will clearly reveal the gravity law in finance.
Low Risk example: Putting your money in your local FDIC insured bank is a extremely safe investment. In a nut shell, there is next to no chance that you will lose your principal amount (up to the FDIC limit of course). For this ultra safe investment, investors today are earning between 0.0% - 0.50% (annually).
Keep in mind, when you factor in inflation, this 'safe' investment actually loses purchasing power over time - but this for another conversation (read here) which talks about inflation and its effect on purchasing power.
High Risk example: Taking this same money out of your bank and placing all of it on one hand of Black Jack at your favorite casino. The risk is extremely high that you will lose all of your money on that single bet, however, there is a chance that you will 'win' your bet and double your money in an extremely short period of time - a great return over an extremely short period of time. So this high risk action has the potential of high returns.
So next time you hear of an investment opportunity that sounds 'too good to be true,' take a minute to think of the simple relationship that return = risk.
-Paul R. Rossi, CFA
The 10-Year Treasury is down over 59% AND is up over 94%.
How is this possible?
If you measure over the last 3 years, the 10-Year Treasury is down 59%.
If you measure over the last 6 months the 10-Year Treasury is up over 94%.
Time frames matter.
-Paul R. Rossi, CFA
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” – Charles Dickens, the famous opening quote from the 1859 book, A Tale of Two Cities.
Eerily, this quote sounds like it could have been written yesterday.
At one point, A Tale of Two Cities was cited as the best-selling novel of all time. Dickens was a champion of the poor in his writings and in his life as he became the most popular novelist of his time. Astoundingly, his works have never gone out of print.
Growing up in England he lived in poverty, leaving school as a young boy to work in a factory to help support his family due to his father continually living beyond his means. His father eventually went to debtors' prison. Looking at his early life, most would never have predicted who he would eventually become, and the impact he would have.
Looking back over the past 10-years, for some investors, it was as Dicken’s wrote, it ‘was the season of Light…it was the best of times.”
What have the 5 best performing companies in the S&P 500 done over the last 10 years?
The top 5 performing stocks were:
Doing a thought experiment, investing $10k into each company 10-years ago would have turned this combined $50,000 investment into over $2,800,000. A gain of 5,752% gain. It truly was, “the best of times” for these investors.
Conversely, how did the 5 worst performing companies in the S&P 500 do over the last 10 years?
Investing $10,000 into each of these companies would have turned the $50,000 investment into less than $12,000, losing -$38,000. A whopping loss of -75% and a difference of over $2,838,000 in terminal wealth between these two investors. For these investors, “it was the worst of times.”
What can we learn from this?
Different investors can experience wildly different returns. Investing can be extremely rewarding and horribly painful over the exact same time-period.
-Paul R. Rossi, CFA
The financial services industry and in particularly the investment and portfolio management sub-field has a quite a few industry specific terms. As a group, financial professionals tend to think most people who are not in our industry understand many of terms we use so freely - which of course isn't necessarily true.
So I've attached a link to a great resource of financial glossary terms provided by YCharts.com.
If you are an avid financial reader or DIY investor you might want to book mark this page, and then when you come across a term you aren't sure about, you'll now have a way to bring yourself up to speed. The link is at the very end of this article. From the several hundred definitions provided, here are a couple of examples, taken directly from the financial glossary (Altman Z-Score and Beta) at YCharts.com:
CAUTION: The Altman Z-Score is meant to be applied only to manufacturing firms that are near bankruptcy. It was not based on a sample including non-manufacturing firms (service firms, banks, etc.). Use it at your own risk with those companies, but beware that bankruptcy probabilities may be misstated.
The Altman Z-Score helps investors to gauge the probability of a company going bankrupt. Generally, firms with a score above 3.00 have a low probability of bankruptcy, and those with a Z-Score of less than 1.81 have a relatively high probability of bankruptcy.
Note that this is a probabilistic model, so it will not classify perfectly.
The score was first published in a 1968 paper by Edward Altman titled "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy."
Altman re-tested the model in a 2000 paper titled "Predicting financial distress of companies: Revisiting the Z-score and Zeta models". The paper showed that the model still had utility for looking at manufacturers, though the number of misclassifications did increase over time.
FormulaZ = 1.2 x (Working Capital / Total Assets) + 1.4 x (Retained Earnings / Total Assets) + 3.3 x (Earnings Before Interest and Taxes / Total Assets) + 0.6 x (Market Value of Equity / Total Liabilities) + 1.0 x (Sales / Total Assets)
Working Capital = Current Assets - Current Liabilities
Market Value of Equity = Market Cap + Preferred Stock
Beta is a measure of the risk of a stock when it is included in a well-diversified portfolio.
In financial theory, the Capital Asset Pricing Model (CAPM) breaks down expected stock returns into two components. The first is the return that would be expected based on covariance with the movements of the market (for most stocks, when the market as a whole goes up, the price of the stock will also go up). This is considered systematic risk. The second part is the increase in the price of a stock that is not explained by the market (nonsystematic risk). The first part - covariance with the market - is what Beta captures.
When Beta is positive, the stock price tends to move in the same direction as the market, and the magnitude of Beta tells by how much. If a stock's Beta is greater than 1, that means that when the market index goes up 1%, we expect the stock will go up by more than 1%. On the contrary, if the market goes down by 1%, we expect the stock to go down by more than 1%. Negative betas signify a negative correlation. When the market goes up, a stock with a negative beta would be expected to go down.
For readers with a background in regression analysis, Beta is the slope of the linear regression shown in the formula below, where Returns are the return on an individual stock or portfolio, R_f is the risk free rate, R_Market is the return on a market portfolio, and e is an error term.
So take a look around and enjoy a great resource from the YChart.com website. Click the link below.
-Paul R. Rossi, CFA
Financial Glossary (ycharts.com)
So, it’s that time of year (again). In the spirit of making predictions that will actually come true, here are our Top 10 predictions in order of certainty. In other words, Prediction #10 is pretty-darn-certain to happen while Prediction #1 is absolutely guaranteed.
#10. Stock Market Volatility Will Continue
The stock market, the bond market, the commodities markets, the geopolitical landscape, pretty much all endeavors where people are involved are volatile – some more than others. This is a feature not a bug.
#9. Sectors Will Rotate
The S&P 500 has eleven sectors (technology, financial, real estate, health care, etc.), and guess what? Various sectors fall in and out of favor and therefore their returns will be all over the map. Market prognosticators will give a reason as why this happened...but always after-the-fact.
#8. Congress Will Continue To Be a Lightning-Rod
Why? Because 535 people come from all over the country having all different agendas. However, the one agenda they all share is wanting to get reelected.
#7. The Business Media Will Continue To Talk About What The Fed Is Going To Do Next
Economists enjoy talking about when the Fed is going to lower or raise short-term interest rates. Why? Because it gives people the idea that some so called experts know what the Fed is going to do - the secret is, they don't. Predicting almost anything related to the economy is next to impossible. My advice is to get comfortable being uncomfortable.
#6. There Will Be Earnings Disappointments
Some companies will do worse than expected. Some will even go out of business. Some will disappoint and then surprise in the future.
#5. There Will Be Earnings Surprises
Some companies will do better than expected. Some of these companies will buy other companies. Trying to predict which companies will continue to do well is harder than understanding quantum mechanics. Capitalism is fierce, tread lightly.
#4. The Housing Market Will Change
Mortgage rates, lending standards, building permits, and employment all effect the housing market, and these 4 inputs are always changing so it’s nearly impossible for housing not to change.
#3. The U.S. Dollar Will Fluctuate
Many factors affect the movement of the U.S. dollar and it's virtually impossible to predict the direction, but many will try. Don’t be one of them.
#2. Patient Long-Term Investors with a Well-Thought Out Plan Will Do Well
Past performance of course will not guarantee future results, but it is a pretty-good indication of what the range of outcomes will likely be.
#1. My team Will Continue To Serve You In a Fiduciary Capacity
As always, we believe that making decisions based on evidence rather than predictions will give you the best odds of success. Together, we will help plan, build, and execute a financial roadmap that will allow you to live on purpose. And that is one prediction that is absolutely guaranteed.
-Paul R. Rossi, CFA
Founded in 1892, General Electric has been around for over 128 years and the company has built and produced an amazing array of products from light bulbs, to jet engines, to magnetic resonance Imaging (MRI) machines, and almost everything in between during various periods of time. Understandably, many business school students and investors have studied, analyzed, and marveled over GE's long-term success.
You can see below that a $10,000 investment in GE back in 1981 grew to almost $600,000 in less than 20 years. This is truly an amazing record and something very few companies achieve. In fact, the +20% annualized returns that GE produced over that time period are very similar to the returns Apple has produced from 2000-2020. Quite astounding to say the least.
But even with all its success, both for consumers and its shareholders, no company is immune to the extremely competitive business world. Like every global company today, GE competes in the most competitive arena the world has to offer, that arena is called Capitalism.
Capitalism is fierce.
And as such, the story changes dramatically for people who invested in GE anytime over the last 20 years. See the chart of GE below (2000 - 2020). GE has been dead money for two decades. Especially if you review how well the overall stock market performed during that same time period. $10,000 invested in GE back in 2000, an investor lost a whopping 7,400, leaving only $2,600. During this same time period, that same $10,000 invested the overall stock market grew to over $30,000.
As much as you, stock market analysts, Forbes, or your neighbor loves a particular company, even the most successful companies, some with 100+ year old track records might not provide good returns going forward. Sometimes history isn't a guide to the future and back in 2000 it wasn't for GE.
Understanding where a company competes, what are its biggest threats, what the business landscape looks like, determining their competitive advantage, answering another 100 or so difficult questions, and then properly being able to determine its value is paramount to having a chance of investing success.
Ask yourself, back in 2000 after GE's amazing growth, wouldn't you have thought GE would continue to do well for the next 20 years? Competition is fierce, tread lightly.
illustration by Tim Sheaffer
Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.”
The brutal “punch in the mouth” brought on by Covid-19 caused markets worldwide to collapse and the repercussions sent shock waves throughout our daily lives. It’s changed how we work, learn, shop, eat, interact and generally how we live.
Having a plan is one thing (and albeit it a very important thing) but being able to stick to a well-thought-out plan is equally important, as Iron Mike Tyson’s quote implies.
If you were not sure before 2020, markets are volatile and can move extremely fast. It's best to think that we will get punched in the face from time to time and plan accordingly.
So how do we make sure our emotions don’t get in the way of our best judgement when we are getting punched in the face? The best time to build a resolute plan is prior-to, not during the barrage. A plan that anticipates getting punched in the face.
Why do we want to do this? Because our minds can be our own worst enemy under duress and we don't want to change our plan when getting punched in the face.
Several years ago Daniel Kahneman, the 2002 Nobel prize winning economist wrote about System 1 and System 2 thinking in his seminal book, “Thinking, Fast and Slow.” He describes how System 1 thinking helps us make everyday decisions and react quickly when we need to, while System 2 thinking helps us make more purposeful decisions and work on more complicated tasks. For both System 1 and System 2 thinking, our minds try to save energy by using heuristics to make decisions more efficiently. And most of the time this works fine, but biases can pop up which can lead us astray - these biases can do real damage when we don't even realize they are behind the scenes causing havoc. The challenge is to understand the biases we may have, the even bigger challenge is understanding the biases we don’t even know we have that are influencing us.
Psychologists and behavioral scientists have researched and documented well over a hundred and fifty different biases that can lead us astray when making decisions. We’ll discuss just a few biases that are particularly damaging when it comes to investing.
If you said yes, you are not alone. 90% of all drivers in a famous study of everyday people said they were above-average drivers - myself included. Unfortunately, basic math tells us this isn't possible. This is overconfidence bias. We all tend to be unrealistically optimistic about our chances of success and our abilities. When it comes to making investing decisions, this can result in investors thinking they can outsmart the market. This type of thinking leads people to believe they have a superior edge when in reality they do not.
Quickly Putting It All Together:
Here are a few things you can do to help make the best (System 2) decisions possible and overcome those nasty biases and unrelenting emotions.
Cheers to an emotional and bias free investing future!
-Paul R. Rossi, CFA
What is an IPO?
An IPO (Initial Public Offering) is when a private company transitions from being a private company to public company and it's at this point in time that Joe and Jane public can for the first time invest and own shares of the company.
By nature, IPOs are risky. Why? Well investors have relatively limited financial history on the company going public. Why? Because many private companies are smaller and don't have a long track record and prior to "going public," the private companies are not required to have audited financial statements.
So how does anyone know which companies are good buys and which ones will turn out to be bad investments? Good question...and a very tough question.
What should you look for when evaluating a new IPO?
Interestingly enough, similar analysis should go into an IPO and a company that is already public. Things like understanding their financial situation by analyzing their balance sheet, income statement, and cash flow statement. You should know the various financial ratios (Quick Ratio, Debt/Equity Ratio, Conversion Ratio, ROE, etc.) and how these ratios have been trending over time. Are they getting better or worse? You should understand the various drivers that will impact the company - both good and bad. What is the company's (TAM) Total Addressable Market? Who are their biggest competitors? What is the company's advantage and is their advantage sustainable? What Warren Buffett calls this a company's "durable competitive advantage."
And after you've thoroughly read through the company's prospectus (including the foot notes), answered an additional 101 questions or so, you can then move on to trying to value the company. While there are several ways, from Price/Sales, Price/Earnings, Price/EBITDA, to name a few, generally the most robust way is to do a comprehensive discounted cash flow analysis (DFC). A DFC is a process that uses the projected future cash flows of the company into perpetuity and discounting them back based upon current risk and interest rate levels. Once you have this DFC you can then stress the results by changing various assumptions, like initial cash flows, growth rates, and discount rates to see how the valuation changes.
So build a DCF, then take these various DFC valuations and compare this with the IPO valuation to see if buying into this company make sense.
What makes buying an IPO even more difficult to evaluate is the fact that many of them don't have positive cash flow. So how do you value a company that doesn't make money? Again, another great question and another difficult one. The big driver will be the assumptions used in what the company might look like in several quarters or even several years down the road. So playing fortune teller becomes a necessary requirement. Something, I'm typically not a fan of. Uggg.
So having read all this, while history is never an accurate forecast of the future, sometimes it can provide valuable sign posts with which to gain some insight. If you have a high tolerance for taking big risks then maybe allocating a portion of your investment portfolio to IPO's might be for you. However it would be prudent to understand and recognize that buying IPO's is the quintessential, "buyer beware" transaction.
-Paul R. Rossi, CFA
The Stock Market is Volatile.
It's volatile on a daily basis. It's volatile on a monthly basis. And it's volatile on a yearly basis.
Take a look at the first two charts below which show the 20-year period of monthly and yearly returns respectively for:
As the 10 time World Series champion New York Yankees catcher Yogi Berra famously said, "You can observe a lot just by watching."
So let's do that, the "average" monthly return for the stock market (orange line and number) is 0.68%, yet it's not uncommon for the stock market to experience negative monthly returns of -10% and even -15%. Most recently we experienced a -8% drop in February of 2020 followed by a -12% drop in March of 2020, to then rebound with +18% return in April and an almost +8% return in May.
Notice the lines of both the orange (stock market) and purple (large company growth index) vacillate quite frequently between positive and negative monthly returns, meaning it's been very common for there to be many negative months. Conversely, if you look closely at the blue line (bond market), you'll notice the volatility is substantially lower than the orange and the purple line. As the graph and number show the bond index has averaged a monthly return of 0.35% over the last 20 years and has been substantially less volatile than the stock market.
When we look at the yearly returns of these same 3 indexes you'll notice the less frequent negative returns for both the stock market and the large cap growth indexes. In fact, the last 20 years has been pretty average in terms of the number of yearly negative returns. We've had 5 years with negative returns in the stock market (2000, 2001, 2002, 2008, and 2018), so said another way, we've had 15 years of positive returns. Notice the average yearly returns for the 3 indexes, the large company growth average 9.46%, the stock market averaged 7.51%, and the bond market averaged 4.25%. Keep these return percentages in mind when you look at the third and last chart.
As mentioned above, 25% of the time the stock market has experienced negative calendar returns. Yet, despite the stock market posting negative returns once every 4 years (on average), investors who were able to stomach the volatility, were rewarded handsomely. An initial $10,000 grew to over $50,000 in the stock market, while the bond market index grew to just over $20,000. What's utterly amazing is the growth of the large company growth index (QQQ), which turned every $10,000 into over $100,000. A 10x return on every dollar invested - this is truly remarkable.
It's important to understand your goals and know your ability to withstand market volatility, because, "If you don't know where you are going, you'll end up someplace else," as Yogi Berra also said. Without a rock solid plan and your ability to stick to it, you might end up in a place that you didn't imagine.
-Paul R. Rossi, CFA
I'm thankful for so many things in my life, that sometimes I feel I've won the lottery. Why do I say this?
Because it's true.
First, let's start with family:
I have a great relationship with my wife and children that I feel very fortunate. I'll admit, I'm very intentional in how I communicate and interact with my family and don't take it for granted. While 2020 has been an extremely challenging year for so many people, I feel very fortunate because it's allowed some very positive things to come out of an extremely challenging period - and I believe many times challenging situations can provide positive growth, sometimes in truly unexpected ways.
Second, my clients and friends:
I never take for granted the relationships outside of my family. I have a special relationship in my clients lives as I learn what's most important to them and I get to help them achieve it. There is tremendous amount of trust that my clients must have in me, and I don't take this for granted. In addition to my clients, I have great friends that I truly appreciate. Many of these friendships span more than 25+ years with countless memorable memories.
So in the spirit of Thanksgiving and being thankful, I am thankful for and would like to say thank you to my:
And this blog wouldn't be complete without a Turkey chart or two. Enjoy!
Turkey Production is out pacing US population growth! Is there an investment opportunity here? :)
-Paul R. Rossi, CFA
I've heard many people over the years express their concern that investing in the stock market feels like gambling - where there is little chance of winning. The remark typically sounds something like this, “The market goes up and then it goes down and you don't make money, it feels like gambling.”
So I decided to see if there is some validity to this belief.
First I looked at various casino games and the odds of winning. Then I gathered stock market data from 1937 through September of 2020, using rolling periods to provide as many measurement periods as possible. Keep in mind, during this 83-year time period the market experienced 14 recessions (including our current recession) , 2 world wars, the Cuban missile crisis, the assassination of JFK, the crash of 1987, 9/11, Covid, and countless other tragic events that rocked our world. Interesting enough, after combing through the data, I can understand how people might feel this way, because over the very very short-term the stock market has had similar chances of generating positive returns as some casino games.
Take a look at the chart below: Black Jack, Craps, and the 1-Day holding period for the stock market have similar probabilities of winning (historically). What also might be enlightening is the probability of "winning" in the stock market dramatically increases as the holding period increases. Over the last 83 years, the probability jumps to over 92% if an investor held for 5-years and is over 99% with a 15-year holding period.
Imagine if you could play casino games and have percentages approaching anywhere near these levels.
Maybe the moral of the story is what we all try to teach our children, that patience truly is a virtue.
I like the long-term odds of winning in the stock market. As the Worlds Most Interesting Man might say, “Stay patient my friend.”
-Paul R. Rossi, CFA
Investors with complex needs are increasingly seeking out independent advice—and one way to ensure you’re getting independent advice is to work with an independent financial advisor. Sounds pretty straight forward, if you want independent advice, then seek out firms that are independent.
So what are 5 benefits of working with an independent financial advisor?
-Paul R. Rossi, CFA
In the short-term the markets trade on greed and fear, but in the medium to long-term, they trade on First Principles.
What are First Principles?
Before we get to that, let us understand what greed and fear are as it relates to investing. Greed is the idea of not wanting to lose out on an opportunity to make money especially when you see others around you making what seems like easy money. As Warren Buffett said, “Long ago Sir Isaac Newton gave us three laws of motion which were the work of genius, but Sir Isaac Newton's talents didn't extend to investing: He lost a bundle in the South Sea Bubble explaining later, ‘I can calculate the movement of the stars but not the madness of men.’ If he had not been traumatized by this loss Sir Isaac might well have gone on to discover the 4th law of motion for investors as-a-whole returns decrease as motion increases.” Sir Isaac lost millions in today’s dollar equivalent by falling into the greed trap by seeing others around him making seemingly easy money on what amounted to nothing more than a house-of-cards. It didn’t end well for him. Greed is dangerous.
On the other side of greed is fear.
“Fear is an emotion induced by perceived danger or threat, which causes physiological changes and ultimately behavioral changes, such as fleeing, hiding, or freezing from perceived traumatic events. Fear in human beings may occur in response to a certain stimulus occurring in the present, or in anticipation or expectation of a future threat perceived as a risk to oneself. The fear response arises from the perception of danger leading to confrontation with or escape from/avoiding the threat, which in extreme cases of fear can be a freeze response or paralysis.” – Google search and definition.
Interestingly enough, fear like greed can be immeasurably harmful. This can happen by taking action when doing nothing is the right thing or conversely by freezing-up and not taking action when you should.
Fundamentally this comes down to rationality. The more rational you can become, the more successful as an investor you can become.
How do we reduce our level of fear and strive to be more rational? By taking a step back from the situation and thinking about what’s happening and asking ourselves a series of questions. Am I seeing things as they really are? Do I understand the situation? If not, how can I learn more about it? What are the short-term, medium-term, and long-term consequences of what’s happening? Will this situation be impactful in 5+ years from now? What are other successful investors doing? Can history be used to see if anything can be gleaned from the past? What’s similar to what’s happened in the past and what might be different? While there are many more questions that can and should be asked prior to determining what the right course of action is, you can see that self-reflection and having a deeper understanding of the situation is paramount during times of heightened uncertainly. What is critically important is getting to a deeper understanding of the situation, what is called getting to the “First Principles”.
What are First Principles?
First Principles thinking is a process by which a person seeks to break down a problem to its simplest elements to find a solution. The first-principles approach has deep roots, in fact, it was a process credited to Aristotle. Over 2300 years ago, Aristotle said that a first principle is the ‘first basis from which a thing is known’ and that pursuing First Principles is the key to doing any sort of systemic inquiry. Quite simply, First Principles is the most fundamental idea which makes it the highest in importance when trying to understand a particular subject.
So, what are First Principles in terms of investing?
First Principles idea in investing is the understanding of ‘valuation’ and how to value an asset. Ironically, the concept is quite simple: The value of any income producing asset is the present value of its future cash flows. What does this mean? It means taking all the projected future cash flows that a company will generate in the future and discounting these cash flows to the present value using an appropriate discount rate. When you do the math, you find that the vast majority of a company’s value is wrapped up in the future years’ cash flow and not in this year or even next years’ cash flow. Click here to see an example.
Investing First Principles: A company’s intrinsic value is based on its long-term cash flows that will be generated far into the future.
Greed and fear will always be a part of the market. Volatility isn’t going away. What’s most important is understanding the First Principles approach to the market and realizing that individual companies and subsequently stock markets are valued on their long-term cash flow generating ability. Everything else is greed and fear.
-Paul R. Rossi, CFA
Annual rebalancing can help boost returns and reduce your volatility.
As 2020 wraps up, it’s time for investors to start thinking about rebalancing their portfolio(s). And while it is important to examine rebalancing every year, it can be especially important this year due to the large return differences in asset classes.
For example, through early November 2020, looking at the variability of returns from different sectors and market indices is quite dramatic:
Rebalancing is the process of buying and selling assets to move your portfolio in alignment with its original target allocation. Restoring your mix can both boost returns and lower volatility, unfortunately many investors do not understand why and how to properly execute this process.
Without understanding the science of rebalancing, which is the theory behind it, average investors do not properly implement the art of rebalancing their portfolios, the actual shifting of the right assets. At best, they simply buy and hold their investments.
A Basic Example of Rebalancing
As a simple example, imagine two investments, A and B, which on alternate years have returns of 0% and 30% respectively. Investment A has a 30% return on odd years while B has a 30% return on even years. Over any two-year period, buying and holding either A or B will result in a 30% investment gain.
At first glance, most investors would think that, in this scenario, you could not do any better than a 30% return over the two years. But an asset allocation of half in investment A and half in investment B has a total return of 32.25% for the two years. The extra 2.25% return comes from rebalancing. The portfolio had a 15% return during the first year and then is rebalanced. Half of the profits from investment A are sold and put into investment B, where they appreciate the next year and receive a compounded return.
This is an example of rebalancing both reducing the volatility and boosting returns. In this example rebalancing smooths the returns to a consistent 15% each year and compounded returns adding a 2.25% bonus.
Unless You Can Predict Markets
Yes, it would be wonderful to invest everything in A the first year and everything in B the second year. If you had the precognition to do this, you’d earn 69%. But this type of return foresight is next to impossible. We are much more likely to chase returns than anticipate them. The worst scenario of this is investing everything in investment B the first year. Then, enticed by the returns of investment A, selling B and investing everything in A the next year.
In our example, this strategy of chasing returns results in no return at all. This strategy is sadly common because people wrongly believe that an investment will continue to go up just because it went up in the past. Although some people talk about “the momentum of the markets,” the stock markets are much more complex and volatile than such simplistic strategies.
The rebalancing bonus becomes clear when looking at many decades of historical data. For any one decade, one investment choice randomly has better returns and, with perfect hindsight, it appears that you should have put everything in that winner. But none of us has precognition. Instead, investing in non-correlated asset categories and then rebalancing to that asset allocation has the best chance of seeing the gains of one asset class compound in a different class the next year.
There is a complex formula to compute the bonus produced by the discipline of regularly rebalancing your portfolio. The bonus is increased when the correlation between the two investments is low and the volatility of each of the assets is high, as in our simple example.
The Rebalancing Bonus
Consider three investments which each year have annual returns of -16%, 7%, and 30%, but rotate which year each investment has each return. If you invest equally in each and rebalance every year, you receive an average return of 7%. But if you start invested equally and don’t rebalance, your return drops to 5.33%.
This is because if you don’t rebalance after a fund grows by 30%, then more money will show the -16% return in subsequent years. In the same way, not rebalancing the money that has a 16% drop means that less money receives the upcoming 30% return.
When an asset class has just dropped significantly, it is difficult to sell some of the best performing class and buy more of your worst performing category. However, the greater the difference between asset class returns, the higher the rebalancing bonus.
Rebalancing & Volatility
The markets are inherently volatile. They experience what is called “lumpy tails,” which means there are more returns outside of the normal bell curve. The stock market’s normal volatility (about 18% standard deviation) suggests a rebalancing bonus of about 1.6%.
What’s interesting, if the market were more stable, the rebalancing bonus would drop. At a 5% standard deviation for example, the bonus might only be 0.12%.
This is why rebalancing only bonds does not have as much of a rebalancing bonus. The normal volatility of the bond market is only 6.9% (standard deviation), which suggests a rebalancing bonus of 0.28%.
Rebalancing from stocks into bonds may reduce your returns on average since bonds have a lower average return. There are several articles suggesting that rebalancing does not boost returns, but these are about rebalancing out of stocks and into bonds.
Moving into bonds may be a part of rebalancing, but the goal of such movement is not to boost returns. Bond allocations are useful to support portfolio withdrawals and limit risk.
Rebalancing can increase returns because market volatility makes it difficult, if not impossible, to predict which asset class will perform well in the future. The asset that recently went down may be the next to go up, while the last to go up may be the next to go down. Thus, systematically rebalancing back to your asset allocation gives you the best chance of compounding and therefore boosting returns.
As always, an important aspect to investing is knowing what you own and why.
Investing can be stressful, but it doesn’t have to be. If you have a well-built portfolio, understand what you own, and have a plan, then you shouldn’t be too worried about market volatility and what the financial pundits are saying.
Here are a few tips to help you invest wisely and stay sane at the same time.
Hopefully, taking a step back from your investing life gives you greater peace of mind and lets you focus on family, friends, your personal goals and living a fulfilling life.
-Paul R. Rossi, CFA
First, let's ask, what is a Registered Investment Advisor?
And what makes this advisor different from a Registered Representative who works at my bank or a national brokerage firm? - A lot actually, keep reading.
A Registered Investment Advisor (RIA) is a professional independent advisory firm, that is held to the highest standard of care, the Fiduciary Standard - Registered Representatives at banks and brokerage firms are not. RIA's provide personalized financial advice to their clients, many of whom have complex financial needs. Because these advisors are independent, and are required to work in their client's best interest they are not tied to any particular family of funds or investment products, so they can use the investment that is best for the client.
On the other hand, If you've ever worked with a Registered Representative from one of the large firms (Wells Fargo, Morgan Stanley, Merrill Lynch, Edward Jones, etc.) you might have noticed that many of the investments (mutual fund or ETF) in your portfolio have the same names as where the advisor works. Coincidence? Nope. Morgan Stanley makes more money if a Morgan Stanley Registered Representative uses Morgan Stanley investments in their clients portfolios - to the detriment of their clients.
Most importantly, they don't have to work in your best interest. Huh, how is that you ask?
Well, it's the way the Wall Streets rules have been set up. They will work in their best interest, not yours and it's completely legal, and in my mind completely wrong. To make matters even more confusing, Registered Representatives at these large firms can have titles such as Advisor, Financial Advisor, Financial Planner...but in fact, legally they are just Registered Representatives of the firms they work for.
As a Independent RIA (Registered Investment Advisor) and working under the fiduciary standard, Rossi Financial Group is held to the highest standard of care—and we are required to act in the best interests of our clients at all times. Period.
So what are the benefits of working with an Independent Registered Investment Advisor?
These 5 distinct benefits can make a dramatic difference in your overall financial well being. While I have a strong opinion about what type of firm you should work with, it doesn’t change the facts. So read, research, and ask a lot of questions before you enter into any financial relationship. In fact, I would require anyone you work with to sign a Fiduciary Pledge that explicitly states they will always work in your best interest. We sign one for every client.
-Paul R. Rossi, CFA
Are you considered clairvoyant? Do you win an office football pool every year? Can you accurately and consistently predict 10 coin flips in a row? Are you a palm reader? Are you the sort of person who, while possessing no psychic abilities, does not mind spending hours crunching numbers and analyzing obscure data in hopes of discerning future trends?
If you failed to answer yes to any of these questions, then market timing may not be for you. The belief that you, or any particularly person, can foresee the direction of the stock market is a seductive one. Some investors are confident that, with proper research, they can make money by snapping up equities when prices are low, and shifting their investments into cash or bonds when the market hits its peak. But longitudinal studies have shown that most market timers not only fail to beat the market, they may actually earn less over time than buy-and hold investors.
However, many armchair investors persist in the belief that, by carefully following business news and trusting their “gut” instincts, they will be able to out-smart the market. Some study the stock tips in personal finance magazines, others hope to glean additional insight from analysts’ reports and specialized investment newsletters, and still others attempt to mine all the available data, crafting complex simulations of how the market is likely to behave in the future.
But if financial professionals who do this for a living struggle to accurately predict where the stock or bond market might go, private investors are even less likely to outfox the markets. As soon as a piece of business or economic news hits the airwaves and the Internet, analysts and brokers react immediately to the information (this is call "The Efficient Market Theory" in finance). Because of financial professionals acting quickly, the market mechanics create a situation where the stock market almost always reflects all the known information at any given moment in time. And even if an individual investor were able to develop an analytic model with some real predictive value, unexpected events—such as a terrorist attack, a natural disaster, or even a political scandal—typically leads to sudden and dramatic market fluctuations that no model based on historical data could have anticipated.
It is only natural that investors would want to find some way to sit out bear markets and get back just in time for the next bull run. It is useful to keep in mind, however, that even the slowest equity markets have some bright spots. A well-diversified portfolio will help you protect against loss and capture whatever gains might occur in a market downturn.
Investors run a big risk by selling when they believe stocks have reached their peak. They may turn a profit when cashing in their equity holdings, but they could also miss out on some of the market’s best cycles. Being absent from the market for only a few of the days or weeks with the highest percentage gains can decimate a portfolio’s returns over time. Market timers who sell frequently also lose money to transaction costs and taxes, and miss out to a large extent on the compounding effect that benefits investors who remain in the market consistently. The vast majority of investors are better off, instead of trying to time the market, just being in the market. Of course, investors need to be in the right investments that match their risk tolerance and time horizon.
Trying to pinpoint the right time to invest in the stock market is an exercise in futility. If you have a longer period to save, owning equities provides the most effective hedge against inflation and taxation available. Since it is impossible to know where the market might go from here, remember, that long-term investment success is achieved not by timing the market, but by time in the market.
-Paul R. Rossi, CFA
Television and radio business news reports lead with it almost daily. Serious financial discussions begin with it. Many economic discussions are often centered on it. The “it,” is the “Dow,” or more accurately, the Dow Jones Industrial Average, and it remains the most widely used measure of stock market performance by many main street pundits.
So what exactly is the Dow Jones Industrial Average?
The Dow is a price weighted “average” of some of the largest and well-known companies in the United States.
But how the Dow is measured, its history, and current holdings are typically not so well-known.
Let's take a brief look at market history, how the Dow has changed over time, and what the current companies that make up the Dow.
Charles Henry Dow first devised his market “average” in 1884. The first “Dow” average consisted of 11 stocks, nine of which were railroads--the large growth companies of that era. Not surprisingly, not one railroad company remains in the index today.
The Wall Street Journal first published the Dow in 1896, covering an average of 12 stocks. During the period from 1916 to 1928, the Dow average increased to 20 stocks and then in 1928, the now familiar 30-stock Industrial Average was born. All of the original names have disappeared after GE's removal in 2018; they have either merged, changed their name, been removed from the index, or gone out of business.
If we were to use an example Dow of 28,000, it would mean that the average share price of the 30 Dow stocks is $28,000, and, of course, no Dow stock sells for anything close to that level. How then, do we make sense of this “average”? Here’s how it works. The Dow average is constantly adjusted for stock splits, stock dividends, and changes in market valuations of the component stocks.
As an example, when a stock splits, the share price decreases and the number of shares increases proportionally, with total value to the shareholder unchanged. For example, a stock selling for $50 per share splits two-for-one. If you owned 100 shares, you now own 200 shares worth $25 per share. Overall, nothing has changed in terms of value.
You’re probably now seeing that this function is going to impact the average price because even though the price of the shares came down the value of the company remained unchanged. So, this is what creates some complexity.
While the impact of stock splits on individual investor holdings is straight forward, such changes in share price have an impact on the Dow. Consider the hypothetical Dow “average” of 28,000, and, on the same day, all of the stocks split two-for-one. If no adjustments were made to allow for the split, the Dow would “drop” to 14,000 overnight without any change in the underlying value. In order to compensate for these price changes which produce no effective change in total value, the Dow average is constantly adjusted by altering the “divisor” in the pricing formula. The divisor is simply that number when divided into the total share prices of the 30 component stocks, creates an equivalent basis on which to compare a current reading with any other historical reading since 1928. Each time a split occurs, the divisor must be adjusted downward; if this did not happen, the average share price of a Dow component stock (based on a Dow of 28,000) would really be $28,000. When the 30-stock Dow average was created in 1928, the divisor was 16.67. This number was derived to establish a price relationship to earlier averages so that historical comparisons would be meaningful. Over the years, the divisor has declined steadily, falling below 1.0 in 1986, at which time it effectively became a multiplier. (A quick review of the math will show the result of dividing a number by a number less than 1.0 becomes a larger number—that is, a divisor less than 1.0 effectively becomes a multiplier). The current multiplier is 0.152. So a $1 price move in any Dow component translates to a swing of 6.58 points to the Dow.
While many financial professionals use other broader measures of market activity such as Standard & Poor’s 500 Index (the S&P 500) or the Russell 2000, the Dow is still considered a reflection of the overall stock market is a testimony to how powerfully ingrained the Dow is to our collective thoughts.
Below is the current list of what makes up the Dow Jones Industrial Average, along with recent market values for each company along with their respective 5-year total return.
-Paul R. Rossi, CFA
The real value of a bear market may be that it gives investors, who are temporarily frozen within its grip, the opportunity to learn or relearn important lessons regarding risk and diversification. For savvy investors, a bear market also creates a period for looking beyond emotional headlines and studying the hard facts—facts that can ultimately place them in a position to take advantage of coming opportunities.
Periods of falling equity prices are a natural part of investing in the stock market. Bear markets follow bull markets, and vice versa. They are considered the “ebb and flow” of wealth accumulation.
Remaining Balanced Can Pay Off
Bear markets create apprehension in the minds of many people. That’s natural. However, any feelings of anxiety should be balanced with reason for anyone seeking financial success. Anyone dubious about the need for a stable outlook should consider that virtually every bear market during the twentieth century was followed by a better than average annual rate of return from the bull market.
Focus on Five Lessons
Instead of taking a “time out” from the market, and missing out on potential opportunities, investors should focus on five key lessons the market has repeatedly been trying to teach everyone during its naturally occurring economic cycles:
Remember that you’ll be inundated with all kinds of economic information during both bear and bull markets. There will be reports (and some of them scary sounding) about inflation, interest, and unemployment figures that may entice you to either give up on the stock market or invest in it to the exclusion of investments paying relatively smaller returns. To avoid being lured to either extreme, develop a financial strategy that accounts for risks you find comfortable.
Review your investments and know what you own to help ensure they are still relevant to your overall financial plan, and that you’re staying on track. Then trust yourself and stick with the plan. Also, remember that past performance does not guarantee future results.
Take Advantage of Bear Markets
Over the last 152 years, from 1869 to 2020 the U.S. has experienced 31 recessions (including the current recession), for a total of 43.8 years of economic contraction. And on average each recession lasted 17 months. Conversely, there have been 32 periods of expansion economic activity totaling over 108.2 years, with each one averaging 3.3 years. So, said another way, 71% of the time we are in an expansive economy and 29% we are in a contracting economy.
What is surprising, of these 31 recessions, 54% (17) of the time, the stock market actually went up. How is this possible?
Because the stock market is not the economy.
No one predicted this pandemic, it's impact on our economy, and the stock market's response over the last 6 months. The economy is down, the stock market is up. The world is complicated.
U.S. stock market peaks and troughs are often independent of the beginning and ending of recessions. In fact, the U.S. stock market many times peaks six months before the start of a recession.
The correlation between U.S. stock market returns and GDP over the 31 recessions is -0.1.
What does this mean? Correlation calculations and results can fall between -1.0 and +1.0. A correlation of +1.0 means two variables move in lock-step with each other, while a correlation of -1.0 means they move exactly opposite of each other. If one was up the other is down. Typically, a number between -0.3 and +0.3 can be understood to mean the two variables are not correlated with each other and basically move independent of one another.
What also might be surprising, the market tends to recover quickly, returning on average 23.5% in the 12-months following the end of a recession. As Warren Buffett has said, “Be fearful when others are greedy and be greedy when others are fearful.” An idea to keep in mind during the next recession and market downturn. Many times these downturns provide opportunities to purchase at a discount to intrinsic value.
It is difficult to time recessions, even more difficult to time the stock market.
Making predictions is easy...making accurate predictions is impossible.
The Stock Market is not the Economy.
Investing principles to provide you comfort during exuberant markets.
Your biggest question: How do you keep your head during what is an unprecedented time. It might seem the stock market and the economy are not reading the same news.
There’s an effective medium, though, between doing nothing and panicky trading. These guidelines can keep you level-headed even while the markets twist and turn and record new highs.
Revisit your ISP (Investment Policy Statement) and if you don't have one, now is the time to put one together. An IPS is a written planning document that describes your investment objectives and risk tolerance over a relevant time horizon, along with the constraints that apply to your portfolio. An IPS serves as your guardrail so you don’t veer all over, chasing investments or changing your strategy as markets ebb and flow.
This document should be designed, built, and discussed prior to constructing and implementing your investment portfolio. The IPS creates a link between your unique considerations and your strategic asset allocation. The IPS is also an operating manual, listing key ongoing management responsibilities. You and your financial advisor should review the IPS regularly and update it whenever changes occur either if your circumstances change or the capital markets environment changes.
Your ISP should include the following:
A well-constructed IPS has several powerful advantages.
One advantage is that the IPS encourages investment discipline and reinforces your commitment to follow the strategy. This advantage is particularly important during adverse market conditions, like we've just experienced recently.
A second advantage is that the IPS focuses on long-term goals rather than short-term performance.
Third, the IPS provides evidence of a professional, client-focused well thought-out investment management process, with the fulfillment of fiduciary responsibilities.
By having an IPS you’ll know what to do and exactly when to do it – not just when your emotions want to move you.
Exxon Mobile has been a part of the part of the Dow Jones Industrial Average in one form or another since 1928. It's one of the largest oil companies in the world and for 92 years was considered a stalwart. In 1994 Exxon was valued at over $446 billion dollars and was the most valuable company in the United States.
At one point, even Warren Buffett owned the stock.
From 1994 - 2013 Exxon generated an annualized return of 12.65%, a whopping total return of 985% return during this 20-year period. Exxon's performance completely dwarfed the overall stock markets total return of 471%.
What could go wrong?
Well, as most of us have come to learn, nothing is guaranteed in this world, and this definitely holds true on Wall Street.
The challenge for Exxon and one reason why the company is being removed from the Dow Jones Industrial Average today, actually began back in 2014. From Exxon's high in 2014, it's seen it's stock drop by -46%. Several years ago, the energy sector made up 16% of the S&P 500, today it makes up less than 3%. What does this mean? This means that the Energy sector and Exxon is not as an important part of the market as it used to be. The once mighty and most valuable company in the United States, Exxon is now worth just 8.5% of Apple or about 10% of Amazon.
Why did Exxon's mobile stock price drop by -46% over a period the time when the stock market is up 111% and so many technology company's stock prices have been soaring?
As I've written before, a company's stock price is a reflection of it's earnings and it's future growth prospects. The market cares little about the past.
And on this front, Exxon falls flat. Both it's earnings (see below) and it's future growth prospects do not look promising. Since 2014 Exxon's earnings per share are down a staggering -77%. And digging into the company's financial statements, the numbers do not look good, whether looking at their revenue, earnings, or the the company's balance sheet.
While I'm not predicting Exxon's emanant demise or that it will not survive, I think Exxon will do just fine. However, its future doesn't look as bright as its storied past.
What can we take from this?
Well, several ideas can be drawn from Exxon being dropped from the Dow Jones Industrial Average.
As we get closer to the US Presidential election, the chatter begins to build about who may or may not occupy the White House, which in turn leads investors to worry about how this might impact the stock market. I’d like to provide some information and historical perspective.
For years now, politics and investing have been spoken about in the same breath. Market pundits and even presidents themselves have linked the performance of the stock market as a sort of “barometer” of their administration’s policies. What's interesting, the data doesn’t support this connection.
Over the past 100+ years, the long-term performance of the market has shown almost no correlation with government policies.
Informed investors realize that the key drivers of stock market performance have been, and will continue to be, earnings and economic growth.
Much of our collective memory about the performance of the economy under various past presidents’ stems from incorrect historical narratives, not hard data.
Presidential Stock Market Returns vs. Economic Growth (1957 - present)
While we want to believe that this election season will be different than so many previous elections, it won't be. There will be vitriol on both sides. It will be a knock-down drag out fight, and it will not be pretty. But…the good news is, in spite of this, history has shown that investors have prospered even during the most difficult political times. In fact they done extremely well during all sorts of challenging times. There has never been a time when there was not something to be concerned about, whether it be, up-coming elections, trade-wars, inflation, social unrest, military wars, or anything else that grabs the medias' attention.
Several years ago, Invesco, a provider of financial products, coined a phrase that bears repeating: “Hating the government is not an investment strategy.” We agree.
While nobody can say with absolute certainty who will win in November 2020, we can say for most people staying the course has made the most sense for long-term investment success.
Here are some certainties during this uncertain election season.
6 Ideas to Keep in Mind No Matter Who Wins:
Many people attempt to use historical narratives to inform ourselves about the future, but do we get the history right?
The charts below show a metric for each president, in dark blue, compared with the long-term average growth rate for that metric since the end of World War II. Clearly, history is often remembered differently than the actual data. And you thought calculus was hard.
How about only investing when your particular party controls the Presidency?
“Partisan” portfolios – which would invest only when a Democrat or a Republican was in office – significantly underperformed the “bipartisan” portfolio that stayed invested regardless of who was in power.
The difference is a result of the fact that the US stock market rose fairly consistently over the past 120 years, even while enduring two world wars, many smaller wars, two major financial crises, several recessions, and now, not one, but two pandemics. The best-performing portfolio over the past 120 years was one that stayed fully invested through both Democratic and Republican administrations.
The more time in market, and not trying to time the market, the better investors have done. See below.
So what does all this mean?
It means if you have a well-designed investment portfolio, you can stop worrying about who's going to win the Presidential election and focus on what you can control and what I would argue is most important. Things like, the relationship with your family & friends, your health, the people you can positively impact, and your long-term goals.
Charts and data from Invesco.
Paul R. Rossi, CFA