I’m not convinced that we’re out of the woods yet. These markets still appear to be expensive. Here’s why:
- Midterm elections are around the corner. If the Democrats win, U.S. politics will be deadlocked for another two years.
- By next spring, earnings growth won’t have the benefit of tax cuts. From what I’ve seen so far, earnings growth for most U.S. companies is at 0 to 10 per cent when not accounting for tax cuts: That’s average at best and not as stunning as many analysts tout.
- Emerging market issues have reduced growth for U.S. multinational companies. This is especially those in the technology sector. The same thing occurred in 1997 during the Asian contagion which preceded the bursting of the tech bubble in 2000.
- The Federal Reserve should continue on its rate hike policy through December. Rising short-term rates pressure companies as they operate by borrowing in the short-term markets. This slows down their capacity to hire, innovate and acquire.
- Wages are quietly rising. The news today was that salaries rose just over 3 per cent. Rising wages is something else corporations have to deal with on the cost side of their businesses.
So what’s an investor to do?
- Stop trading and start investing. Share prices are only important when buying and selling. This is similar to your home: The only time its price is relevant is when you buy it or sell it. Since two-thirds of all long-term performance come from rising dividends and the re-investment of those dividends, investors should focus more on the rate of dividend increase, not the stock price or the current yield. Trading actively just pays for your broker’s retirement, not yours.
- Hold some cash and wait for better opportunities. In the past decade, it’s been a successful strategy to buy on the dips. But those investors haven’t seen markets like 2008, when buying on the dips could have bankrupted you because the market kept trending lower between December 2007 and March 2009. The cash-on-hand is to buy after a big correction (20 per cent or more), when valuations get cheap. While the market dropped significantly in October, it still hasn’t made it back to where it was at the end of September.
- Think about portfolio structure and have a plan in place. Now is the time to have a diversified portfolio to avoid correlation risk (too many names in the same sector) and concentration risk (too much ownership of one stock).
- Be patient and unemotional. Emotional investors sold at the bottom of the market in 2008 and never returned. They missed the best 10-year bull market in our lifetime. Be more practical instead, like Warren Buffett. Be an investor in a business, not a speculator, and let the dividends grow.
Given the market volatility of the past few weeks, it’s important for investors not to lose their heads. Here are some guidelines for getting through crucial market moments:
- We’re just entering earnings season. This should reveal if companies’ earnings are slowing because of tariffs and higher input prices. No need to do anything until we see the impact of earnings on stock prices.
- U.S. midterm elections are coming up. If the Democrats win the House and/or the Senate, the market could sell off violently as Washington would return to partisan politics and create a deadlock on any future legislation being passed. Again, no need to do anything until then.
- From a technical standpoint, the markets still aren’t oversold yet so we don’t really see any screaming opportunities.
- In our estimation, the market top on the S&P 500 Index would be 3,700, which would be similar in valuation to the 1929 and 2000 peaks. Conversely, we’d only be interested in adding to our positions with any significance if the S&P 500 fell to 2,200 (20 per cent lower than today) where valuations make more sense. Remember, Wall Street pushes “adjusted earnings,” which are artificial as they don’t include interest on debt, taxes and depreciation.
- Holding cash makes more sense than ever. The maximum needed is 20 per cent. There’s no need to go over that amount because you’ll then have to find the market bottom (which nobody has ever been able to do).
- Avoid correlation risk in your portfolios. Owning similar stocks would have sent your portfolio down further than most, especially if you’re heavily tech-weighted.
- Avoid concentration risk. We hold 30 stocks in our portfolios with an average weight of 3 per cent. If one of them becomes a 6 per cent holding, we automatically sell half. This rebalancing helps protect the downside.
- You haven’t lost any money unless you sell.
- Time and compounding is how you make money. Two-thirds of all stock market performance in history has come from rising dividends and the re-investment of those dividends. If you want to retire wealthy, you have to let the dividends grow.
- If you wish to buy stocks in this market, we suggest you buy only half positions to start and sit back and watch what happens next.
In the end, there’s no reason to try to be a hero in these heady markets. Instead, discipline will carry the day.
We expect increased volatility across all asset classes – stocks, bonds, commodities and real estate — meaning investors have to be patient and diligent to find buying opportunities. Stock valuations still appear to be stretched. The market could easily go sideways for the next two years until earnings catch up to current prices. Or, in the interim, the stock market could fall 20 per cent to return to proper equilibrium.
For investors, it’s important to:
- Hold cash to prepare for market corrections or to take advantage of buying opportunities. We currently hold 20 per cent cash times the client’s equity weighting. If the portfolio is 100 per cent equities, they’ll hold 20 per cent cash. If the asset mix is 50 per cent stocks and 50 per cent fixed income, they’ll hold 10 per cent cash (50 per cent multiplied by 20 per cent).
- Stop reaching for yield. A stock’s current yield isn’t as important as the dividend growth rate. The average dividend payer on the TSX Index increased its dividends by 9 per cent this year. For the S&P 500 Index, it was 11 per cent. Dividend growth is necessary to offset inflation. Buying a stock with a high yield but no dividend growth means that inflation eats away at an investor’s spending power and the value of the investment deteriorates over time. This is especially bad for retirees.
- Take advantage of opportunities. If a stock drops 20 per cent more than the overall market performance and there’s nothing wrong with the business model, this often presents buying opportunities.