There are a few problems with (financial) forecasts and forecasters. In regards to the former, they’re almost always wrong. In regards to the later, their incentives are not aligned with yours, they have (almost) no repercussions for being wrong, they often only regurgitate what others feed them, and they’re insanely celebrated when occasionally right yet simply forgotten when wrong. Despite this, humans live by them, swear by them, and mindlessly repeat their soothsaying often without realizing it.
We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.
What Are You Buying?
Imagine someone offers you their business. It’s a good business, though not a great business. It’s somewhat cyclical – not as economically dependent as selling RV’s and not as smooth-sailing as selling deodorant. The seller tells you that over time and on average, the business returns about 7% per year due to the growth of its earnings. Over the past 12 months, the business made a profit of about $5,400. His asking price is $100,000. So buying today gives you a yield of 5.4% ($5,400/$100,000). With that much information, would you buy it?
Fast forward three or four years. This same seller has another business identical to the one above. The seller again tells you that over time the business grows about 7% on average, though for the last four years the earnings of this business haven’t grown at all. Despite that, he’s more optimistic this time and wants $127,000 for his business. So buying today gives you a yield of 4.2% ($5400/$127,000). In other words, pony up an extra $27,000 or 27% for an identical business that’s had flat earnings for the past few years. With that much information, would you buy it?
I bet you would. I bet you are.
Where Are We?
Here are the most recent annual prospectus’ for two of Vanguard’s popular funds: The Growth Index Fund and the S&P 500:
On the left is the Growth Index Fund at 27x earnings and 4.7x book – all I’m qualified to say here is let’s hope there’s a lot of growth coming.
For today’s purposes, let’s look at the page on the right – the S&P 500 (VFINX).
Since year-end 2013, forward earnings forecasts for the S&P 500 have consistently predicted earnings growth of between 5-12% for the coming year. In reality, earnings growth has looked like this: (you can find the raw data here. Click on Additional Info, then Index Earnings)
|QUARTER END||AS REPORTED EARNINGS|
Prefer it in a chart?
Almost exactly flat.
Let’s return to the two businesses for sale. The two businesses presented in the previous section are none other than the S&P 500. The first business for sale is simply the S&P 500 circa 2013, the second is the S&P 500 today (2017).
Notice the actual returns vs. the returns of the professional forecasters. Earnings started at about $100. They ended at about $100. If, on our original purchase in 2013, we took the low end of the growth forecasts (5%) and applied that for the next 4 years, we’d have over $120 in earnings today.
So, did we overpay? Those who bought in 2013 for $100,000 certainly don’t think so. They could sell their stake for $127,000 today. So the real question is: are the underlying business worth $27,000 more today than in 2013 considering they earn almost the exact same amount as they did in 2013?
I don’t know. My wonder and my suspicion is that not many people on the journey to financial independence think in depth about the economics behind their indexed returns and when it may be more or less prudent to automatically contribute capital for indexation month after month.
Yes, earnings could all change tomorrow and the future could be very bright and hence worth buying today. Though to assume forecasters will be right this time is interesting (They’re currently forecasting 8% growth for the coming year).
Into The Numbers!
The increase in the S&P 500’s price from 1,848 at year end 2013 to 2,362 at the end of Q1 2017 has been on investors believing the forecasts (or rather becoming more optimistic about them). PE’s (the price one pays for 1 year of earnings or price/earnings) have moved from 18.4 to 23.6x as the price of these businesses has risen, though their earnings have been steady. Sure, you could say it’s energy or oil’s “fault” as the pain felt in their industry has hurt a lot and offset the gains in the more healthy sectors of the S&P 500 – but for the indexers, 401k buyers, pensioners, and Bogleheads (indexers unite!) that doesn’t matter. When one is buying the index – they are buying good and bad (the Vanguard 500 isn’t the Vanguard 500 Ex-energy). And for you purists who think that reported earnings are continuously bogus and understate earnings to a considerable degree, operating earnings have grown from $107.3 to $111.11 – a 1% CAGR. Nothing to dance about and far below the forecaster’s predictions.
I bring this up because I see a lot of posts, conversations, and arguments for continually investing no matter what. Arguments are coming up more and more frequently saying idle cash and emergency funds are a waste of time, and that being continually invested (indexed) is the (only) way to go. Anecdotally it may be getting too one-sided. Perhaps the pendulum has overswung. Buffett says indexing is best and therefore he must be right. Right?
I don’t know the answer, and I own some index funds. I’m not a cheerleader for active managers who hopelessly fights indexers or vice-versa. My only goal is to do what makes sense. I have begun to think more deeply about this stuff as I’m not convinced people know (or care) what they’re buying (indexing). I would be interested in how many indexers actually have 1) looked at, and then 2) understand the above earnings data taken from S&P. How many have taken into account corporate earnings growth rates? How many even understand or care that they’re buying an earnings yield of 4.2% (1/23.6 or inverse PE)? How many understand that they are buying the S&P’s 17% ROE (return on equity) for 2.9x book and therefore buying a 5.8% return on their personal equity? The return on capital of the S&P 500 net of cash was about 6.3% at year end, but capital to American businesses isn’t free. So what’s their cost of capital? If their cost of capital is anywhere near that 6.3% (combined equity and debt) then the investor should not count on continued multiple expansion for that going-in yield to be bailed out by reinvestment growth unless you’re pretty confident at predicting macro market movements or trends. Yes, CURRENTLY there is a spread between the cost of capital to American businesses and their return on capital but it’s not a giant spread. The question is whether the spread is adequate or not.
An investor needs to be relatively confident that going-in yield (earnings/purchase price) provides them with enough margin of safety to account for the cyclical nature of markets and economies. Or the investor ought to be relatively confident in their ability to extrapolate or predict macro economic trends.
Thoughts For Thought
Beyond the numbers, how many think about or have a sense for where we stand? Economies are inherently cyclical. Have cycles stopped cycling or is it different this time? Currently, the economy is vibrant, the outlook is positive, lenders are eager, capital markets are loose, capital is plentiful, terms are easy, interest rates are low, spreads are narrow, investors are sanguine and eager to buy, there are few sellers and lots of buyers, markets are crowded, new funds open up daily and have little difficulty raising money, asset prices are high, recent returns have been strong, prospective returns are likely low, businesses can raise money without stating a purpose, businesses are focusing on EBITDA vs cash flow and earnings, companies are issuing debt to fund buybacks and dividends, there are bidding wars in the M&A market, volatility is low, and in general there is too much money chasing too few deals.
To offset all this, there is no explicit euphoria and there exists some pessimism.
How many investors consciously weigh these aspects?
Perhaps if one has an idea for where we stand, slowing the all-out index dollar-cost-averaging could make sense. Again, not saying it does, just simply saying that perhaps it’s worth thinking hard about. Maybe cash could provide some option value for those willing to think and look. For those who desire safety and have some time horizon, it could be thought of as a call option on anything that will probably cost you 4% p.a. (opportunity cost) for the time being. More importantly, think of how cash has performed during times when there are historically high valuations. When CAPE ratio is above 25x, cash has outperformed in the subsequent rolling 5-year periods 77% of the time. The CAPE ratio is 29x today. For the past ~25 years, cash has outperformed the market almost half the time over rolling 5-year periods. Having cash when assets are priced to perfection generally has not been a bad idea, although it may not serve one well over the near-term. And then again, maybe CAPE doesn’t matter anymore.
I’m not saying bubble, I’m not predicting a dumpster fire, I’m not anti-indexing, and I don’t know the solutions to all of my assertations. I simply wonder how many investors are willing to think hard through this type of reasoning before deploying their capital instead of just blindly follow the forecasters, cheerleaders, and trusting recent trends. How many people are asking the investment question that matters: How much? (How much risk for reward, How much return for this price, How much time do I have, How much downside vs. upside)