The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (16 page)

By contrast, in the prior period from 1928 to 1982, a time of huge growth of the U.S. economy, the Dow grew a more reasonable 300 percent in 54 years. And yet, in just 20 years during the 1980s and 1990s, the Dow shot up more than 1,000 percent. That is truly extraordinary!

It is also the quintessential definition of a bubble.

Like most bubbles, the stock bubble originally started to rise for good reasons. But as investors began to fall in love with the profits from stocks, those early gains just made them fall even deeper in love. And not just American investors were smitten; increasing numbers of foreign investors were joining the love-fest, as well. And not just individual investors. Big institutional investors who manage pensions, endowments, and life insurance funds fell in love, too.

But even love is not enough to keep a bubble going forever. Given enough time, economic gravity eventually kicks in and bubbles do pop. Knowing this is a bubble does not mean we have to exit it immediately because it is not going to pop today. But you must be aware that it is going to pop eventually, and if you choose to stay in this bubble a while longer, you will need to
actively manage
your portfolio.

There are big risks to staying in stocks and it’s not clear exactly how much upside is left, although there could be some. Since 2000 there has been little upside (overall, the Dow has barely risen in the last decade) and there has been a huge amount of volatility. For Nasdaq stocks, the past decade has been even worse, with almost a loss of up to 50 percent. The short-term future is hard to predict, but if you time it right and get out before the stock bubble pops, you could also lock in some larger gains. Even if you decide to move entirely or heavily out of the stock market, or move to a more defensive stock position, you will still need to actively manage your portfolio to protect yourself and still make reasonable returns.

To understand our view of stocks and how to actively manage an investment portfolio containing stocks, you need to understand the Conventional Wisdom (CW) view of stocks. To understand the CW view of stocks, it’s essential to understand the recent history of stocks. You don’t need to know how stock markets were formed and other ancient history, but you do need to understand the more recent history upon which current conventional wisdom is based.

Stocks were not always the popular investment they have been for the past several decades. Before stocks became the darlings of the investment community, bonds had a more favored status. And before bonds, it was gold. As each asset class proved its reliability over time, it became more popular. Only when stocks began growing across the board for decades at a time did they become impossible to ignore for all but the most risk-averse investors.

Originally, stocks were primarily valued for the dividend payments that came with them. Rather than hoping to benefit from rising share prices, investors looked at stocks essentially as bonds with greater yields—payments could be variable, of course, but investors paid close attention to earnings and gravitated toward blue chip stocks with a consistent record of dividend payments.

It was only in the 1920s that many investors began to see the value in buying stocks with the intention of earning capital gains by selling them later at a higher price. At that point, the stock market became more speculative in nature and trading activity increased. This sent stock prices soaring. In a six-year span, the Dow Jones Industrial Average would quadruple in value, but it would take only a few days for everything to come crashing down in October 1929. Although it’s worth noting that even after the crash ended the great speculation of the 1920s, it took several years for the stock market to fall during the Depression to its historic low point in 1932.

After the market crash and the Depression, stocks were naturally very unpopular. New Deal reforms, in particular the establishment of the Securities and Exchange Commission, sought to curb the unethical and manipulative behavior that had been rampant among publicly traded companies, and which had often left financially ruined stockholders in its wake. But it wasn’t until the 1950s that stocks regained popularity among the general public. By the 1960s, the stock market was booming again, though that boom turned into a mini-bust in the next decade due to recession, and particularly high inflation (the natural enemy of the stock market).

A stock is a certificate indicating that you own some small portion of a company. When you buy stock from a company, you are paying for part of everything owned by that company. If the company makes a profit in the future, the value of your stock goes up. As partial owners of the company, stockholders have the power to vote on decisions that may impact the future of the company. The more shares you own in a company, the more decision-making power you have.

Various types of stocks, mutual funds, and index funds are bought and sold on various stock markets around the world. Some readers may need or want more background on stocks, and some may not. So, in our attempt to keep the flow of the book moving, we have put some background material on stocks in the Appendix. Financial books can get a bit dull at times and we want to avoid that.

As we mentioned earlier, for most of the past few decades, an investor could make money in the stock market just by throwing darts at a dartboard and watching his portfolio grow. And in today’s era of 24-hour stock market analysis on TV and the Internet, there’s a temptation to divorce stocks as a commodity from the companies whose ownership they represent.

When investors are willing to pay more for assets than their inherent value justifies—particularly if that investment is fueled by debt—we have an asset bubble. But how do we assign an accurate, nonbubble value to a stock? It really comes down to earnings. But how to translate earnings into share price can be tricky. We’ll look at some of the traditional ways and then at the ways we think are more reflective of a company’s value.

Earnings, fundamentally, are what you are buying when you buy a stock. You’re usually not buying assets; you’re buying all of the company’s future earnings. Not just next year’s earnings but
all
its future earnings—forever. But how do you put a value on something so long term and something so unknowable? Well, that’s the trick. It is a bet you are making. You, of course, hope that bet is more than just a guess. At the very least, you want it to be an educated guess.

Before we can tell you about how we look at stocks, you have to understand the conventional wisdom approach to valuing stocks. Again, you have to know CW before you can understand any deviation.

One of the most commonly used methods to value earnings is to determine a price-to-earnings ratio (P/E ratio or just P/E). This is basically a measure of how many years’ worth of earnings you are willing to pay for the company’s stock. For example, a P/E of 10 to 1 (often shortened to just 10 by financial writers) means you are willing to pay 10 times the company’s current annual earnings for the stock. So if the company’s annual earnings (not revenues) are $10 million, the company is worth $100 million at a P/E of 10. If you want to calculate the price of a share of stock, you just use the earnings per share. So if the earnings per share is $10 and the P/E is 10, a share of stock is worth $100.

There is no magic rule as to how many years’ worth of earnings investors should pay for a stock. For S&P 500 stocks the P/E has varied from 8 in 1980 to 22 in 2000. Generally, P/Es are higher for companies with higher growth.

Although the ratio is simple, what goes into determining the correct ratio can be very complex. One of the key issues that has to be considered is the cost of capital. You’re paying now for earnings coming later. Those earnings in the future are not worth as much as the same amount of cash now (the time value of money).

Also, there is uncertainty regarding those earnings. What if the company’s earnings decline quite a bit in the next few years? What if it goes out of business? What if revenues grow but earnings decline? Lots of things can happen to a company’s earnings over a period of 10 or 20 years. Hence, the more years’ worth of earnings you are willing to pay, the greater your risk because the likelihood of bad things happening to a company’s earnings are much greater over a 20-year period than a 10-year period.

Finally, what if the stock market values those earnings less in the next few years? Your company may have exactly the earnings you hoped for, but the market values them less and, hence, your stock is worth less.

Valuing uncertain future earnings in an uncertain stock market is a very tricky game. That’s part of the reason why valuations can vary so much over time. There’s no certainty in the calculations.

Most importantly, partly because of all this uncertainty, psychology plays a huge role. Some people may see fewer risks in a company’s future than others. Some people may see fewer risks in the future economy than others. Who knows who’s right and what the right P/E should be.

However, if the economy slows, expect P/Es to decline. Some of that decline may have been anticipated, but lately, stock market analysts have been none too good in predicting economic slowdowns. Hence, the P/Es fall only when the economy has proven to be in a slowdown. That also means that P/Es could fall a lot if the economy slows down a lot.

Of course, in a down economy not just P/Es are falling, but the actual earnings are often falling as well. This will cause further damage to a stock’s price. In addition, earnings can fall substantially if interest rates rise substantially. These are two key vulnerabilities that the stock market faces in the future as we near the Aftershock. We will talk more about these issues later in the chapter.

It’s easy to see how psychology can enter the stock valuation game. There’s a lot of uncertainty and judgment that are a key part of valuing stocks. In addition, if bubble psychology enters the game, it often doesn’t matter what the “correct” P/E should be. All that matters is that stocks have been going up in price and investors want to get on board that rising boat. Earnings valuation and analysis is needed only to make investors feel good about their decision to jump on the bubble boat.

To make matters even worse, earnings themselves are not always easy to define and therefore the correct P/E is not a certainty. Hence, different people look at the history of P/Es differently. Robert Shiller, the person who helped create the Case/Shiller Home Price Index and did great work in tracking real historical home prices, has also done a good job in tracking historical P/Es. His historical chart of P/Es is presented in
Figure 4.1
.

Figure 4.1
Historical Price-to-Earnings Ratios

Notice the high points were right before the crashes of 1929 and 2008.

Source
: Robert Shiller, Yale University.