When the fit hits the shan
The S&P 500 and the NASDAQ both hit a new high this month, before heading down over the past couple of weeks. Valuations of some US stocks are at near record highs with many of the techie stocks selling at nose bleed prices. For example, Amazon is selling at a Price to Earnings ratio (P/E) of 160. Netflix is selling at a P/E ratio of 116. That means that at current earnings levels, it would take 116 years to earn back your investment in the stock ! Compare that to the S&P 500 historical average P/E of about 17 and the current P/E ratio of about 20. Investors piled into crypto currencies and lost billions over the past 12 months. Now they are doing the same to pot stocks which have zero earnings. Canopy Growth (symbol WEED) now has a valuation of $14.7 billion, greater than Canadian Tire ($9.8 Billion), despite never having made a cent of profit. The dream of money for nothing never fails to arouse speculative frenzies. For a very good explanation of valuations today please listen to this podcast from ETF Expert: http://www.etfexpert.com/september-2-2018-etf-expert-radio-podcast/.
But in short, someday in the foreseeable future, the “fit will hit the shan” and these valuations will come back down to earth. With Trumpski as President, who knows what might trigger a major correction or worse? Iran, China, outrageous deficits, higher interest rates ?
This time it ain’t different.
As happens seemingly every time the US stock market gets to these rarified levels, various pundits appear to explain how “this time it’s different”. Those are the most expensive words in investing. There are a variety of reasons – low interest rates and new technology are the favorites. I would rather take the lead from a well experienced and successful investor, Warren Buffett, whose Berkshire Hathaway is currently holding over $100 billion in cash, 20% of its total value, because he says he can’t find enough well priced investments. It is clear that Buffett thinks that stocks are over valued, and he is waiting for a significant pull back in order to buy in. Remember his famous line:
“Be fearful when others are greedy, and greedy when others are fearful”. Interestingly, in 2000 just before the last tech crash, the pundits were claiming that Buffett had lost his ability to pick the winning industries. Then, the S&P 500 P/E ratio hit 40+. But in 2002 and again in 2008, it was Buffett who had bags of cash that he used to bail out such blue chip companies as Goldman Sachs and Bank of America, for immense profit.
Too late to the stock market party
It is clear that after a nine-year run of stock prices increasing 150%, there are a lot of people who were too fearful after the markets tanked in 2008 and missed out on the ensuing mega rally. They have seen other braver souls make big bucks and are now finally greedy enough to buy in at these stratospheric stock price levels. Inflows to US index tracking Exchange Traded Funds have been at record levels over the past year. But as usual, the amateur is too late to the party. See the following graph comparing the VFV ETF (S&P 500 in C$) to XIC (TSX300) over the past ten years (which also underlines the benefit of diversification, but that is another issue).
So, what should the retired investor do? Obviously, everyone is different, but for an income focussed investor, here are some ideas that I am personally putting into practice:
1. Keep your allocation to stocks within a range that will allow you to sleep at night when, not if, the stock market declines by 20, 30 % or more. Interestingly, research has shown that retail investors are affected much more by a 20% decline than a 20% increase in the value of their investments. Ask yourself, if I have $200,000 invested and I lose $40,000 or $60,000 of it, how will I feel? For me, the comfort limit for stocks is 60% of my total investments BUT with the following 3 major caveats.
2. Hold a significant portion of your stocks as high dividend payers and even better, dividend growers. Then, even if the value of the stocks decline significantly, your income will remain the same or even increase. You can afford to wait out the market decline and even buy more stocks at cheaper prices. The market always, always eventually rebounds, but that can take up to 10 years so it is nice in the waiting period to be earning those dividends. A number of ETFs offer high dividend payers. Check out XDV, XDIV, VDY, ZDV,HAL amongst others. They pay between 4.2-4.8% dividends.
3. Hold a major portion of your non stock portfolio in fixed income producing investments that will keep on paying, no matter what. I prefer preferred dividends because of the Canadian dividend tax credit. Reminder – in Ontario you can have a taxable income of up to $75,000 and pay 9% tax or less on Canadian dividends. You might pay 3 times that on interest income, depending on your taxable income. ETFs that hold preferred shares include ZPR and HPR and yield about 4% plus there may be some capital gain as interest rates increase.
4. Keep some cash on hand to buy the bargains when they will surely appear. It may be difficult to give up 10% per year growth for the next year or two (or maybe less, who knows?), but think of it this way. If you buy after a 30% drop in the index and it goes back to where it was before the drop, you have made 42.8% (100 -30% = 70. 100/70 = 142.8%). So the profit from having cash to invest after a major market correction is far more than holding on to all stocks and seeing them increase by the average of 10% per year. How much cash? Right now, I am holding 6% cash and I would like to increase that. Buffett is holding almost 20% cash. Warren Buffett is not worth US$ 85 billion because he is a dummy.
Note: Before making any investing decisions, you must perform your own due diligence. This site does not provide personal investing advice and each investor must determine what are the right investments for their particular situation.