Broker Check

The Voting Machine vs. The Weighing Machine

| December 27, 2018
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As we close out the year, it's hard to describe 2018 as anything other than A Year to Forget

Investors have enjoyed a long, and generally interrupted bull market since the financial crisis, and it's easy to forget that there are always corrections and bear phases in the midst of them.  The fourth quarter has been a painful reminder.

Remembering why we invest in stocks

At those more difficult times, like last week when the S&P500 lost seven percent, or this week, when we lost another three percent on Christmas Eve, we have to remind ourselves why we own stocks in the first place...  And the answer is not a short-term phenomenon, but a very long-term one.  The reason is all about compounding:  Companies grow.  Their earnings and dividends grow.  Eventually, their share prices reflect this. 

Benjamin Graham, the "father of value investing", once said that in the short term the market is a voting machine (tallying up which firms are popular and unpopular), but in the long term it is a weighing machine (assessing the substance of a company).  This also applies to the markets as a whole, with investors alternating between optimism about the long term and pessimism over the short term.  

To survive the inevitable volatility, one needs to remember that market action doesn't necessarily reflect truth, but instead, it reflects our collective fears, the human need to "protect" and to take action -- whether or not that is in our long-term best interest. In the long run, we are wise to focus on the readings of the weighing machine.

What is the right allocation?

Another famous investor once said that tolerating volatility is the price we pay for earning returns that are greater than a CD rate. Of course, CDs don't really help many investors to meet their financial goals, (but at least no one loses sleep over them.) 

For investors to meet their growth goals over time, stocks are usually part of a portfolio.  Yet excessive sleeplessness over a market decline means that one's portfolio is likely too risky.  Investors can try to head this off with "Stress Tests" that simulate the affect of bear markets and financial crises on their portfolio.  This can help each investor to determine their maximum risk tolerance, and position their portfolio accordingly 

(Access a stress test here. )

What has investors so worried?  And are these long-term or short-term issues?

Many issues are mentioned as the "cause" of recent market declines:

  1. Trade wars.  Investors are right to worry about these as they tend to slow economic activity in the short term. 
  2. Government shutdowns have unsettled markets historically, but they have had little long-term impact on anything over the longer term. 
  3. Rising rates diminish economic activity (that's precisely the idea) and make bonds a more attractive alternative to stocks.  

These factors have all been at work for well over a year.  And while short term rates are rising, the Federal Reserve's job is to walk a fine line, slowing but not inhibiting economic growth.  We're likely close to the end of the tightening cycle.  And nothing seems to be actually signalling a recession.  The Fed appears to be doing its job correctly.

When one looks at the US market in aggregate, there are things to like, too:

  1. Earnings should grow around 7% next year. 
  2. Valuations:  Recent index declines, combined with growing earnings, have made stocks cheap by some measures. The forward (2019) P/E of 14 times earnings is below historical averages.
  3. The economy should grow 2-3% next year. 
  4. Inflation remains under control at the present. 

Surely things could deteriorate.  But for now, these are not a bad set of conditions.

Final Thoughts

We have seen this drill before, and it hurts.  Sharp corrections (and even bear markets) happen with unfortunate regularity. Year-end selling often exacerbates any negative trends. We're in the midst of that for a bit longer.

Meanwhile, policy makers aren't totally deaf to the market's cries as it says, "Negotiate those trade deals", "Get back to work" and "Take it slow on further rate increases."  Eventually, this negative period will pass. And company fundamentals will likely be pretty much the same as they already were.

We may not remember 2018 fondly. But we can't really say, "This time it's different."  Because '18 was just another year when the Voting Machine, and not the Weighing Machine, was heard most loudly.

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