My Opinions About Last Year’s Market Performance

In the last three weeks I posted various financial and stock market charts. I chose data I found interesting and reflective of the markets and views I have. Obviously, there are many other metrics, but I want to center in on what I posted.

The stock market as a whole, using any one of the four indexes I follow as the benchmarks, increased considerably over the last ten years. The S&P500, DJIA and Nasdaq are all large caps, while the Russell 2000 is a small-cap index. I did not provide data for mid-cap or foreign stocks. You can draw a conclusion about mid-cap by looking at the ranges of the S&P500 and the Russell 2000 and likely assume something in between. I do not think owning foreign stocks makes sense since there is considerable foreign exposure, with 40% of the S&P500 company sales coming from outside the U.S. Accordingly, I do not see the need to increase it by adding specifically foreign stocks. However, there might be certain instances where some foreign investments might be appropriate, and that should be covered with your financial advisor.

COMMENT: All opinions here are mine and are intended for educational and instructional purposes and should not be considered as any sort of recommendation for any investments or any investment actions in any manner.

Last year the major stock markets were all up. The Russell 2000 was up the least at 13.67% and the S&P500 up almost double that at 26.89%. These are high numbers and they indicate market strength and optimism for the future. Buying stocks indicate expectations that there will be a sustainability of current profitability, growth and dividend payout trends. My personal attitude and advice is based on a long-term outlook for the economy and that this growth will be reflected in the values of a broad-based well-diversified stock portfolio. When you use a 10-year lens, things appear differently than when near-term blemishes are magnified.

The stock market strength is borne out by the increases in dividends and pretty steady price to earnings and dividend payout ratios. Right now, fixed-income yields are at very low amounts while dividend yields are pretty steady with yield dips (but not dollar payment dips) only when there are sharp increases in the stock values. Analysts refer to dividends plus stock price changes (either increases or decreases) as total return. If a stock pays a 2% dividend and increases 10% in value for the year, the total return is 12%. A 10% loss gives a negative 8% total return. This is important when evaluating stocks since an important reason for investing in stocks is to have the stocks increase in value. In fact, some stocks do not pay dividends since the expectations are that all of the “total return” would result in an increase in the stock’s price. However, my opinion is that earnings drive values, and if I am right about that, then at some point all stock values will be based on the earnings. REMEMBER this is my opinion.

While my contention is that the earnings drive value, the “earnings” could be current or projected, and could be the reported net income, net cash flow, free cash flow or calculated any number of ways. For many companies, the “projected” would be for the next year or two. However, with some companies, the projected is what is hoped for many years after the initial or current “start-up” stage is normalized. For some companies, this start-up stage could be 10 or 20 years, as it might have been for Amazon.com or Tesla. For more established companies, this “start-up” stage could be with entry into new areas of business such as Ford and GM expanding into electric vehicles. But at some point, and as each person supplies their own judgment, there will be a normalization of cash flow and earnings and the stocks’ “values” will settle into being based on earnings. That “value” is determined by the price to earnings or P/E ratio. A high P/E represents optimism of better than average growth while a low P/E represents either stability or pessimism, and that would be different for each company, each sector or the market as a whole. The P/E ratios are included in my charts and except for aberrations for some years, they have been pretty steady with upward slopes. Nothing with investing is simple or easy. For instance, the price of a stock and its P/E is affected by many things including inflation and interest rates and overall economy which are independent of the company, and desire for stability and safety, which is a personal feeling.

I mentioned the concept of total return. I believe this is a valid measure for stocks. However, I believe it is spurious for investing in and owning bonds and, in particular, bond funds. My clients and the audience for my blogs are basically long-term investors with the goal of securing their financial future. When they buy bonds they are doing so to get a fixed cash flow for the period they invest for and to not have any risk if they hold the bond until maturity (except they will have a default risk with any bonds other than from the U.S. Treasury). This means they expect a determinable steady cash flow and that the bonds will not lose value. This is definitely the situation with individual bonds that are intended to, and are able to, be held until maturity. However this is not the situation should they need to sell the bonds before maturity. In that situation, the value of the bonds would be determined by market rates for interest and not the face value of the bonds. When you invest in bond mutual funds, there is no fixed maturity date and at some point, whenever that is, the fund shares will be disposed of, and at that point, the proceeds will be based on fluctuating market rates. This means you will never ever get back the principal you invested. You will get something, and it could even be more than you invested, but you will not get back what you invested. However, didn’t you buy that fund thinking it was secure and safe because you wanted the steady interest payments? You will get the interest payments, but as to the safety and security of the principal, fuhgeddaboudit! I can easily prove this. Look at any bond fund to see what the interest payment was for the last year and you won’t be able to find it. You will be given the “total return” for that period. Well, total return includes the change in the value of the fund’s shares. Where is the interest payment? If you are investing for that, isn’t that information that should be easily available? If you own bond funds, think about this carefully!

A word about inflation. We have it! It exists! The only thing we do not know is the future amount. Further, if you looked up the amount for last year you would get some conflicting amounts. A better gauge is what it costs every week to fill up your shopping cart. If it is higher this week than last week, you have inflation, and you can even guess its percentage amount. Also inflation is cumulative. For instance, if inflation goes up 10% this year and 1% in each of the next 9 years, your buying power would have eroded by about 20% at the end of that 10-year period. Compare this to a 2% inflation rate for each of the next ten years. Your buying power would be eroded about 22%, which is pretty close to the other illustration. However with the 10% increase the first year, you would feel pretty lousy, with the 1% increase for the next nine years or with the steady 2% increases, you would hardly notice the annual increases. However, if you are in this for the long haul, then you need to consider the effects of inflation since, except for right now, it is a hidden increase in your costs.

There is a lot going on and there is a lot more I could write about, but this is a good spot to stop for now. I will add comments in future posts, so stay tuned.