Simply Begin Again

Table of Contents

1. Start the Year with a Wide Perspective
2. Buffett Indicator
3. Shiller P/E Ratio
4. Other Sources
5. Now, Forget All of the Above
6. Let’s Get Practical

1. Start the Year with a Wide Perspective

I stole the title of this issue from Brad Feld, a venture capitalist and former neighbor of mine who has been writing a great blog for many years now. Simply begin again. Whatever it is you feel you’ve failed at, you regret, you’re angry about: simply begin again.

What a wonderful new year this is going to be. More on this at the end and in the Let’s Get Practical section, below.

But, for this issue, as promised in my week off letter, let’s look at the market overall. To follow up on the recent InvestED Podcast episodes #247 and #248, in which we talked extensively about the market still being ridiculously high compared to historical values, I looked up the charts myself.

When I first started this investing thing, I was completely freaked out by the world of finance and markets because it felt so horribly BIG and uncontrolled. How would anyone have any perspective on what was happening, I wondered? Well, guess what? I’m not the only one to ever have that question. So, smart people created tools to get some perspective on the markets overall, and the two ratios my dad pointed me to are great places to start: (1) the Buffett Indicator, and (2) the Shiller Price-to-Earnings Ratio.

2. Buffett Indicator

The Buffett Indicator represents the overall US market capitalization (the price of the entire US market put together, as represented by an index called the Wilshire 5000) to the Gross Domestic Product (GDP) of the US. The Buffett Indicator is so-called because Buffett has said he refers to this chart for perspective on the market. The St. Louis Federal Reserve publishes the data and a nice chart, which we can look at for free right here on their website: Wilshire 5000 Total Market Full Cap Index/Gross Domestic Product.

The last two times it crossed 100%, the market crashed.

It’s at an all-time high of about 170% as of Q3 2019, which is their most recent data. According to this particular metric, we are in la-la-land in which the US stock market has suffered a psychotic break and completely departed from reality. No one knows if it will stay above 100% from now on, or if it will crash in a way we’ve perhaps not seen since 1929. THIS is why people keep saying, “maybe this is a new normal in economics.”

If we expand Buffett’s definition and look at the same ratio, but using global numbers – global stock market capitalization to global gross product – it looks slightly less perilous. I don’t have a primary source for that ratio because I don’t have a Bloomberg account, but here’s an article about it with a photo someone tweeted from their Bloomberg (part of my ongoing series entitled Sources and How To Get Them For Free!). Because I didn’t run that chart myself, I take it with a huge grain of salt, but still, it is informative as we try to put the pieces of this stock market perspective puzzle together.

Let’s look at some other, less doomsday-predicting, data.

3. Shiller P/E Ratio

The second ratio was created by the Nobel Prize winning economist Robert Shiller. It’s the price-to-earnings ratio of the S&P 500 index, adjusted for inflation and market cycles so that multiple years can be compared to each other in an apples-to-apples kind of way. It averages earnings over a rolling 10 year period, which eliminates some of the short-term volatility of each market cycle. It’s also called the CAPE Ratio (Cyclically Adjusted Price-to-Earnings, or CAPE for short).

Professor Shiller kindly puts his data up on a website for us to download and use. When I went to check the latest data, I discovered he has also been thinking a lot about the effect rampant stock buybacks are having on inflating the prices of stocks. To adjust his ratio for the buybacks, he created an adjusted CAPE ratio by reinvesting dividends into the stock price. If you click this link, it will download an Excel file from Professor Shiller’s website, and you can see the comparison: click here for the Excel download.

The adjusted ratio is even higher than the regular ratio. It’s nuts.

4. Other Sources

The regular (non-adjusted) average P/E Ratio of the S&P 500 is about 16. I did a bunch of clicking around the internet trying to find a good chart of the non-adjusted P/E ratio over time, and found a lot that are not updated and some with wrong numbers that even I could tell were wrong, so user beware on these random websites. As you know, I obsessively go to primary sources when it comes to numbers because I’ve seen them be wrong on secondary sources many times. (If you’re an Excel-oriented person and want to play directly with S&P Earnings numbers, you can go to the S&P website, click on “Additional Info” on the left side, and click on “Index Earnings” and you’ll get an Excel file filled with data for your spreadsheeting pleasure.)

For a secondary source I do trust, the Wall Street Journal publishes the P/E of major indexes with current numbers (available to non-subscribers as well). As of this writing, it has the S&P 500 P/E at about 25. Average is 16, and it’s now at 25.

Another metric of the overall market that was interesting for me to read about is Nobel Prize winner in Economics James Tobin, who came up with the Q Ratio. The Q Ratio measures the market price of a company to its “replacement cost” (in quotes because what that means exactly is hard to measure). Because replacement cost doesn’t have an easy answer, some people use Book Value instead. Here’s an Investopedia article explaining it and that it hasn’t particularly predicted investing results all that well.

I’ve talked to some very smart investors about their perspective on the market, and have heard a few times that, intriguingly, they don’t think the market is overheated at all. Why? Interest rates are still at historical lows, which makes investment options other than the stock market (such as bonds) less attractive. As a result, more and more money has been piled into the stock market, and these investors believe P/E ratios can go even higher without much worry. However, I wonder, if interest rates rise, wouldn’t that encourage investors to sell their stock and move to other kinds of investments – which could cause a perhaps dramatic stock market event? I think it would, and I think that is exactly why, when the Federal Reserve discusses raising rates, President Trump, who has a strong interest in a strong stock market going into the next election, gets so upset.

More thoughts from smart people:

Thoughts from Fred Wilson, one of the godfathers of the venture capital world:

We can’t predict the market. “We’d also be better off spending less time reading market news and drinking from the firehose of financial and economic data (which is mostly noise), and more time reading books about investing (which are more likely to contain wisdom).”

Brad Feld says to simply begin again.

5. Now, Forget All of the Above

With all of this said, you won’t hear much, if anything, from me about these predictors for the rest of the year. The beautiful thing about long-term investing focused on the fundamentals of a given company is that I don’t have to predict anything about the market overall, so I don’t have to choose which of these predictors I think is right. I only have to be confident in my prediction for a given company. The market overall will affect that company’s stock price, most likely, but all I have to do is watch what happens and buy some (or more) if the price drops.

Having all of this information at our fingertips isn’t necessarily a useful thing for our investing practices. As Barry Schwartz says in his excellent book The Paradox of Choice, “the fact that some choice is good doesn’t necessarily mean that more choice is better.” To extrapolate from his idea, the fact that some information is good doesn’t necessarily mean that more information is better. Sometimes it’s just more. When it becomes distracting from real investing practice of learning and enjoying and, most of all, deepening our circles of competence, then it’s just more.

So, I don’t really have to care about all these guesses in the slightest. And THAT is a wonderful feeling of peace of mind. Who knew investing could be like that?

(Um obviously WE DID, peace of mind and joyfulness is the whole point of our investing practices!)

Welcome to year 2020 of The Invested Practice.