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Perspective NewsletterIf I had told you in the Fall of 2016 – not even five years ago – that Elon Musk would be the richest man in the world, a global pandemic would virtually shut down the entire world, and a US president would be impeached (for the second time) for inciting an insurrection against his own country’s legislature, you would have questioned my sanity – or at least asked what I was smoking.

Despite these and many other system shocks over the last half decade, the stock market seems to be powering through on its way to ‘infinity and beyond’ based on easy money from central banks around the world and recovering economies. It’s always been said that ‘markets climb a wall of worry’ and that seems to be true again.

My experience – and history, of course – tells me that natural consequences and mean reversion tend to correct excesses (in almost all areas of life, actually) over the long term. Unfortunately, these setbacks often come with pain, and there is always the risk that you miss the chance to make changes before it is too late.

In his January 5, 2021 article “Waiting for the Last Dance: The Hazards of Asset Allocation in a Late-Stage Major Bubble”, GMO founder Jeremy Grantham argues that markets are extremely frothy and on the verge of a drop. He is clearly on the bearish side of the continuum of prognosticators and has been negative for a while — and is all too familiar with the old saying that ‘the market can often stay irrational longer than the investor can stay solvent.’

He exited the Japanese market entirely in 1987 when the market was selling at a very ‘bubbly’ 40x earnings and accounted for 40% of the EAFE index (Europe, Australasia, Far East). Unfortunately for him, the Nikkei index kept going up for another three years to trade at 65x earnings and account for 60% of EAFE, before tumbling and then languishing for over 30 years. It still hasn’t recovered to its 1989-90 peak levels.

The current market, he argues, particularly US growth stocks, is similarly in bubble territory. One poster child, Tesla, has a market capitalization of $600 billion – or $1.25 million per car sold vs. $9,000 per car sold for GM; small retail buyers are back in the stock market with a vengeance, the Buffett indicator (market vs. GDP) is at new highs, and the IPO market is on fire again. The six FAANGM stocks [Facebook, Apple, Amazon, Netflix, Alphabet (Google), Microsoft,] now account for almost 25% of the market capitalization of the S&P 500 index and trade at 40.1x forward earnings vs. 19.8x for all of the other stocks in the index.1

Who knows how long this will continue? Even if Tesla turns out to be a great and profitable business over the long term, how long will investors pay 130x earnings, except perhaps to sell it at a higher price to a ‘greater fool’ if the price keeps rising? The one thing we know is that excesses do ultimately get corrected, either by price drops or a long wait for earnings to catch up to the price you paid.

As author Morgan Housel explains (in his excellent article, “The Three Sides of Risk” from August 2020), there are three components of risk that investors need to take into consideration:

  • The odds you will get hit (e.g. how often should you expect a significant decline in the overall market or a certain sector)
  • The average consequences of getting hit (e.g. how deep does a market decline typically go)
  • The tail-end consequences of getting hit (e.g. what happens if there is a low-probability, high-impact event that is catastrophic)

“The first two are easy to grasp. It’s the third that’s hardest to learn and can often only be learned through experience.”2

So, what’s a person to do?

The very long-term charts show that equities are the far and away best investment vs. bonds and cash. In round numbers, $100 invested in cash in 1926 would be worth about $2,500 today, $17,500 if invested in bonds, and almost $1,000,000 million if invested in equities.3

One option is to stay in the equity markets and ride out the ups and downs hoping for a payoff in the very long term. Unfortunately, many people can’t withstand the volatility and end up changing horses at the wrong time.

Another idea is to try to catch the market’s ups, but not its downs. In other words, you want to be there for the good times, get out before the bad times come, then get back in again for the inevitable market recovery. All sorts of historical and behavioral evidence suggest that correctly timing the market is very difficult to do successfully, even for the experts.

I have found that the best approach is to find ways to soften the ride so you can stay in over the long term. Not all of these strategies are possible or even appropriate for every investor, but they can all help mitigate volatility of participating in equity markets and the risk of not having the funds when you need them.

  • Have a clear financial plan for your cash flow and assets, including a personal balance sheet that outlines all of the goals that need to be funded.
  • Match your assets to your liabilities. Near term and high priority items should be funded with cash and fixed income; longer term or lower priority assets can be funded with riskier or less liquid assets.
  • Use conservative expectations for investment returns. Upside surprises are ok, downside surprises aren’t.
  • Hold sufficient cash to cover a couple of years of living expenses so you don’t need to touch your risk investments (such as equities) when they are down.
  • Avoid or pay down debt.
  • Own high-quality investments, diversified by asset class, region, style and sector. Don’t overreach for higher returns.
  • Choose investment managers that have demonstrated good risk-adjusted performance and low downside capture (i.e. are likely to decline less than the market in bad times) to help preserve capital and stay the course emotionally when markets correct.
  • Take advantage of any tax and fee savings you can.

No one has a crystal ball, so it is important to make sure you are focusing on the things you can control, both to participate in good markets and protect yourself from bad ones.

3 (Includes dividend re-investment)

Northwood Family Office

Tom McCullough

Tom McCullough is Chairman and CEO of Northwood Family Office, which looks after the investments and integrated financial affairs of wealthy families with $10 million or more. He teaches ‘The Management of Private Wealth’ in the MBA program at the University of Toronto’s Rotman School of Management, and is also co-author of the books, Family Wealth Management and Wealth of Wisdom: The Top 50 Questions Wealthy Families Ask.

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