The Stock Market – Be Cautious
The Scary Stock Market
Be greedy when others are fearful, be fearful when others are greedy. – Warren Buffett
You might think the title of this post is a little strange. For most people, the stock market over the last year has been anything but scary. We have seen a spectacular rally! The SP500 is up over 21% since this time last year. New records are being set almost every week. The dow pierced 21000 briefly before settling again slightly below that illustrious mark. Banks are flush with cash, Wall Street is happy, and everyone’s talking about the next hot stock that’s going to rocket them to riches.
There are some fundamental reasons why the market has seen a dramatic increase over the last year, and particularly over the last few months. We’ve finally seen a return to earning growth. Some folks think business-friendly taxes and regulatory changes are on the horizon. I’m not going to weigh in on those. I’m just here to pour a little water on the fire and turn the party music down by just a bit.
Trying to time the market is dumb
First, I just want to reiterate some advice I think is extremely prudent for all investors. TRYING TO TIME THE STOCK MARKET IS DUMB. Full stop. This is true both on the upside and on the downside. Time and time again, research has shown that the investors that do the best are those that stick through the ups and downs of the market, save consistently, and don’t try to hop in and out. Be patient and let the magic of compounding growth work. I would never advocate pulling out of the market just because a few ratios are higher than historic averages. Anyone screaming ‘THE MARKET IS OVERVALUED” is just as likely to be wrong and others right. I simply advocate caution.
Shiller SP500 and Grizzly Model Predictions
I don’t put a huge amount of faith in just watching ratios move around. But there is one that has a very good track record of predicting future returns. The Shiller PE ratio, which is basically the price of the SP500 over the average of the last 10 years of earnings. The reason they average it out is to show a bit more stability during the ups and downs of business cycles. When it gets really high you should start to get a little nervous, when it gets really low you should start to get a little greedy. Don’t follow it blindly, there are many caveats to this measure of value, but it is a good indication.
I tackled a few of those caveats in an article a few months back. Some of the caveats folks normally apply to the Shiller PE ratio is that it doesn’t take into accounts things like prevailing interest rates, dividend yields, or recent swings in earnings. In that article, I attempted to correct for those things when determining a good forward-looking Safe Withdrawal Rate for our portfolio. Using the same inputs – Shiller PE, 10-year treasury yield, dividend yield, and current PE ratio – the current SWR you can expect given the prevailing conditions is around 3.8%. Lower than it was when we first did the calculation last fall. Back then it was sitting around 4.2%. All of this simply indicates that the market is a little riskier than it was a few months ago. Be cautious.
My advice is to simply be cautious. I would not recommend pulling money out of the market but be wary of people telling you that now is the time to put extra money in. Many people you know will be talking about the ‘roaring stock market’. Many people will be talking about how they’re investing more to ‘catch the wave’. Many people will be telling you that you’re going to ‘miss out’. Don’t buy that crap. There is a lot of dumb money chasing the recent track record of high returns. Much of the recent rally has been driven by retail investors (i.e. folks like you and me). That doesn’t mean their wrong, just means that they probably don’t know anything special that you and I don’t have access to.
Don’t let the rally of the last few months throw your investment plans off. Remain consistent, follow your plan. No one knows exactly what the stock market is going to do. Everyone is as blind as you and me. The only thing I can say is that when I see massive rallies in the stock market I start getting nervous rather than greedy.