Many have inquired as to my opinion on the upcoming presidential election. Sadly, when I attempt to formulate an educated response, I am left speechless. In addition to being a small business owner and investment manager, I find myself with the incredible task of leading three young boys as they slowly mature into young men. My primary goal for these boys is to teach the importance of character and integrity. While life will be wrought with challenges and mistakes will be made, it is how one handles these mistakes that defines character. I try to teach this through my own actions and the actions of others. When I struggle to discuss the particulars of either candidate with my children, I’m at a loss to even begin to articulate an opinion on the race as a whole.
Fortunately, it is not my job to be a political commentator but rather a financial adviser and investment manager. To that end, there is no question it has been a difficult time these last few years. The market has experienced quite a few ups and downs, with the net result being zilch. When you understand the backdrop of market cycles, this stagnation is not all that surprising. After recouping the market decline of 2008 and 2009, the market advanced approximately 30% and has been digesting this advance over the last two years. The question one has to ask is, if this is the start of the next leg higher or a top that will usher in the next bear market.
While there is not a single person who can predict with 100% certainty what the future will hold, it is our job to evaluate the environment and work towards formulating an educated plan.
Valuation is always one of the best places to begin when looking at the general market environment. In simple terms, the best question to ask is ‘are stocks cheap?’ Unfortunately, the answer is not all that simple. Most pundits will simply relay a valuation based on a price multiple and compare this to a historic average. For example, one of the most popular forms of valuation is Robert Shiller’s 10-year average, inflation adjusted P/E multiple which can be found HERE. According to this metric, the current S&P 500 P/E of 23.99 is above the average of 15.62. While this data set may ‘sound smart’, it is quite misleading. For example, in January of 1992, the P/E multiple was approaching 26. If someone would have avoided the stock market, due simply to valuation at that time, they would have missed one of the greatest bull markets in history.
In addition, it is important to understand that P/E is, in fact, a ratio taking two variables to derive a final multiple. For example, if Price = 10 and Earnings = 2 this P/E would be 5. Within the context of our previous discussion, if we assumed that 5 was historically a high number it is immediately assumed that price must come down in order for this multiple to shrink. For example, if Price declined from 10 to 8, and earnings remained constant at 2, the P/E would therefore be reduced to 4. (8/2= 4)
While it is assumed that it only takes a price drop to see a P/E multiple decline, what is neglected is the potential for earnings to increase to accomplish the same thing. For example, if price remained at 10 and yet earnings increased from 2 to 5. Our P/E would have a reduction from 5 to 2 (10/5). All of a sudden, without the price moving at all, an increase in earnings resulted in a reduced P/E multiple or valuation. I think it important to mention that while this is not my opinion of what will happen, it is a more informed approach to the valuation argument.
In addition to the way in which valuation may change, I think it germane to discuss the composition of the S&P 500 as well. At present there are eleven sectors which make up the S&P 500. These sectors have different weightings. For example, the largest sector currently within the S&P 500 is technology, making up 21.44%. Following technology is healthcare, representing 14%, then financials at 13%.
What I find interesting, when evaluating this breakdown, is how an overall index may become skewed towards one sector and its valuation over another. For example, in 2008 the energy sector represented 13% which was an equal weighting with the financials. Since the S&P is a market cap weighted index, as the energy and financial stocks struggled, their weighting in the overall index was reduced. Conversely, as technology stocks moved higher, they secured a greater spot within this market.
Over the last few years, the two areas that have come under great pressure, energy and financials, saw their earnings erode as well as their price. Financial stocks have rebounded to a level that has normalized their earnings’ multiples; however, the Energy sector has not. As a result, the current earnings’ multiple or P/E of the Energy sector stands at 112.13.
I mention this only to once again relay how complex the valuation argument is and one that cannot simply be taken at face value. In my opinion, it is not enough to say that the S&P multiple is 23.99 and therefore too expensive.
Basic economics states that supply and demand will dictate price. This is as true as gravity; however, economists extrapolate this to infer that, as the money supply increases or decreases, inflation will adjust accordingly. This is precisely why so many predicted a US dollar demise incorrectly, I should add, when the US Federal Reserve began its unending rounds of quantitative easing. The theory was quite simple. If the Fed is lowering interest rates by adding money to the system, the value of the dollar should decrease. Inflation would be the result and therefore a great investment would be gold or other tangible assets. What those predicting this failed to realize was, that rather than actually adding money into the system, it was more of an electronic swap as the government bought the tainted securities held by banks and credited their deposit accounts. In reality, this added no more money to the system and therefore the value of the US currency did not decline.
We now are faced with a direct opposite situation; whereby, the Fed is preparing to raise rates as they did last December and many are predicting that when this happens the dollar will strengthen and inflation will stall. My problem with this theory goes back to some common sense and the unprecedented time period in which we find ourselves. Rather than this curbing inflation, I am of the idea that this will actually spark inflation and have the direct opposite of basic economic understanding. Let me explain.
Most commercial loans are held with variable mortgage debt. Let’s say that the owner of an apartment complex is faced with a higher mortgage payment once the Fed raises rates. Will this entrepreneur simply accept this higher cost and decreased cash flow? Absolutely not. In short order, this owner will raise rents to compensate for the increased carry cost. Once this happens, the tenants will be forced to approach their employers seeking a raise in pay or seek employment elsewhere. Whether this individual receives an increased rate in pay or is forced to find a new job, the end result will be higher employment costs for the employer. Like the owner of the real estate, will this employer eat these higher expenses? Of course not. This employer will raise prices to compensate for the higher labor costs. The result will be a natural path of inflation for the everyday goods and services you buy. Once this transpires, the data will reflect this result giving the Fed even more ammunition to raise rates – which they will be fully justified in doing. The result of this…..well, just run through the above scenario again and again and again.
While I have expressed this opinion before, I am often berated for what is perceived as a general ‘lack of understanding’ of basic economics. I find this ironic, since this same ‘ignorance’ kept me away from the conventional wisdom of a dollar crash and hyperinflation; which, of course, never happened.
Our job at Tatro Capital is to work with folks to lay out a longer term plan to reach their financial goals. Once we develop this plan, our job is to invest funds in order to achieve these objectives. While we are at an unprecedented time within our country, I also feel very strongly that we will soon be ushering in a new wave of inflation resulting in an erosion of purchasing power. The only way to combat this is by positioning investments in areas that will advance in the face of this.
For those of you who are clients, you have already seen from the construct of your portfolios an emphasis on the areas that should benefit if this hypothesis comes to fruition. In the coming months, we will continue to allocate should this thesis begin to develop and be proven correct.
Tuesday’s election will come and go. Wednesday, barring some ‘hanging chad’ issue, we will awake to the reality of a new president. Regardless of the short term market gyrations as a result, the general economic conditions of our country will not change and the path forward is quite clear. While there will certainly be some challenges, there will always be opportunity.