Row, Don’t Sail: A Closer Look at Unexpected Returns

Adding a sail to a watercraft enables it to harness the wind for power. All the boatman has to do is position the sail, direct the vessel, and ride.

But what if there is no wind? That’s when the boatman has to engage other modes of power such as a paddle or oars. It’s important for the skilled sailor to retain a secondary mode of power in case the wind stops blowing.

It’s the same with investing. When markets are on the upswing, it’s relatively easy to ride the momentum, especially for those with traditional stock and bond portfolios. Most investors profit during rising markets. But what happens when bull market winds cease blowing or shift to a secular bear market? That’s when you have to row. That’s the time to sell-off overvalued stocks, hunt for undervalued securities, exploit temporary mis-pricings and market inefficiencies, and align your holdings with your purpose.  

Separating Emotions, Cyclical, and Secular Trends

When market winds are favorable, portfolios can increase in value rapidly. Likewise, when these winds stall, losses can accumulate just as briskly.

Conventional wisdom says there are only two emotions on Wall Street: fear and greed. But I’d add a third to that equation: envy.

In 1999 when I was a young financial advisor in California surrounded by booming tech companies, Wall Street fundamentals were tossed aside. It was a time of — in former Fed Chairman Alan Greenspan’s words — irrational exuberance. Everyone wanted in on the tech gold rush. Everyone, including my taxi driver, was day-trading and schooling me on stocks and index funds. The tech-wreck followed that exuberance, brining everyone back to earth.

I saw this same movie play out again in 2007–2008, and most recently in 2019. I had stepped in that pothole before, and I swore I’d learn from those harsh lessons and never step into it again. My experience led me to place high value on discipline, purpose, and perspective. These truths have revealed to me like-minded veterans, such as Ed Easterling, author and founder and president of Crestmont Holdings LLC, an Oregon-based investment management and research firm. Easterling was the first to introduce me to the distinction between secular and cyclical market trends and how to understand and leverage them.

Cyclical trends happen over a period of quarters. Secular trends transpire over periods of years or decades. There are large secular uptrends and downtrends that savvy investors need to be aware of. They need to understand where we are at a particular point in time, and what the context of the market is. They need to boil it down to the essentials.

What are these? Valuations, P/E ratios, and understanding where the highs and lows are and what they mean. What mattered in 2007 and what should we be watching for now that might be similar? Were those the same things present in 1999?  

Bull and Bear Markets

Great bull markets usually start off when average P/E ratios are at 7 to 10 times earnings. That’s when valuations are cheap, and conditions are primed for earnings expansion. Prices surge. But these bull markets generally peter out when average P/E ratios creep above 20 times earnings. Bear markets flex their deflating muscle when ratios rise above 25 times earnings.

In 1999 we peaked at 42 times earnings, far above the previous high of 25. Equities were significantly overvalued. But you wouldn’t know it. Nobody cared. Investors believed we had transcended traditional market rules and benchmarks. It was widely accepted that companies didn’t even have to produce revenue to be valuable, and there were examples of tech companies with zero revenue trading at $300 a share. We forgot that it’s impossible to have a P/E ratio without the E.

Today’s Risk Landscape

Where are P&E ratios now? Today, we’re at 33 times earnings. Optimism is high. Employment numbers are at record lows. Every company is competitive. But don’t be fooled into thinking this is a bull market. Bull markets collapse when ratios as high as they are now. Yet if you were to ask the average investor, they’d tell you there’s nothing but more upswings on the horizon. The S&P 500 was up 29% in 2019 and PE Ratio is currently, as of January 24, 2020, 28x trailing 5-year earnings.

When you present this context to executives with 80% of their net worth tied up in concentrated stock positions in their own companies, it raises the question: Given the current state of the market, is this smart? Does it make sense to have a portfolio that is heavily invested in one thing and is largely illiquid? Probably not.

Brace for Dying Winds

I am not saying a recession is coming, or that the market is on the verge of a steep slide. I’m simply saying that now is the time to take stock and define your What and Why. Why are your hard work and earnings important to you? What do you want to achieve with your accumulated holdings? I strongly advise executives to assess their purpose and align their assets and capital accordingly. Be disciplined about building your team of professionals and in designing and executing your strategy to generate the measured results you want.

There are large secular forces at work. That’s why I believe it’s risky to carry unnecessary debt loads at this time. These should be reduced. Now is the time to be in the best financial position possible to maximize and align your assets with your priorities so you’ll be ready no matter what happens.  

Think about why your wealth and investments are important to you. What can they do for you and your family? How will they support your values and legacy? Define these things now. When this market loses momentum, it can be stalled for a decade or more if history is any guide. And that’s not the time to be up a creek without a paddle.

To learn more, set up a meeting with me.