The Saga Of Destruction For Small Investors

There are generally two ingredients to the formula that cause someone to walk around saying something like, “The stock market is rigged.” First, they generally buy stocks at prices that could be considered a bit higher than average. And secondly, they tend to sell during times when stock prices have become low, because they are focusing on the fact that $10,000 of hard work can only be redeemed for $7,000 (or whatever the low turns out to be) at a particular moment in time.

It seems that the first condition is now being met. The Wall Street Journal reports that small investors are becoming increasingly comfortable with investing in the stock market again (I would link to it, but I understand that a number of you have become irritated at clicking on links that lead to a paywall, so I’ll take a breather for now). And secondly, the price of the S&P 500, in aggregate is a little bit higher than normal. Today, the S&P 500 closed at 1,924. Over the past 12 months, the collection of these five hundred businesses have pumped out $101.93 in total profit. So if you wanted to buy a share of America’s 500 leading businesses, you would be paying 18.87x current profits for a current earnings yield of 5.29%.

I think Buffett has been calling this price point “within the zone of reasonableness” for stock market prices, which, put another way, indicates that a good chunk of businesses in the United States are trading on the high end of fair pricing or the low end of expensive, depending on the vantage point you prefer. What is the implication of this, over say the next ten years? My guess would be this: if, say, the S&P 500 grew earnings per share at around 8% annually for the next ten years, the capital appreciation would probably be on the 7-8% side (plus you’d get whatever dividends are thrown in).

You don't want your stock portfolio to turn into this.

You don’t want your stock portfolio to turn into this.

If someone chooses to purchase the S&P 500 today, they are buying stocks without a margin of safety in terms of price. That’s not the end of the world—you now have your money invested in some of the world’s most productive assets—that S&P 500 Index Fund means you are selling the world iPhones, Big Macs, GE light bulbs, oil and gas, Colgate toothpaste, Iams dog food, Tylenol medicine, and an almost perpetually long list of economic goods. But it does have this implication: something like a 25-35% stock market decline isn’t necessarily out of the question because about a third of that loss would be the result of the S&P 500 coming down to fair value, and the other two-thirds would be the result of stocks becoming cheap (the general rule with American stocks is that you have a significant down year every three years—we’re working our way through consecutive year number five on the climb upward).

Please note, this is not a stock market prediction, but rather, a stock market characterization. In March of 2009, when the S&P 500 hit its low, there was nothing stopping it from falling another 30%. If that happened, though, it would have meant that stock market valuations had gone from excessively cheap to once-in-a-century cheap (mirroring only the Great Depression 1933 type of prices). On the other hand, if we experienced a 30% decline now, it would represent stocks going from slightly expensive/high fair prices to moderate undervaluation. That would be a garden-variety correction that you’ll probably see about a dozen or so times over the course of your investing life. In other words, there’s nothing all that surprising about a correction once stock prices get a tad bit on the frothy side.

I don’t think, though, that the average person who is getting automatically enrolled in their 401(k) plan at work (or whatever that situation may be) is understanding the implications of current valuations. That’s not a moral judgment—this kind of stuff does not naturally interest 99% of the population in an intense way, but unfortunately for those to whom investing is not a hobby, the wise stewardship of capital has a huge bearing on the material quality of the second half of their lives. If you knew nothing about money, it would be very counterintuitive to think that you should buy stocks during and after 20%, 30%, 40% declines. At that particular point in time, paper wealth is being destroyed as those continuing to invest appear to resemble Sisyphus rolling the same boulder up and down the mountain: you keep putting hundreds of dollars per month into a 401(k) account that only seems to be treading water with your constant additions.

Of course, as the price goes down, that’s when the time to invest gets more intelligent because long-term returns are dominated by two variables in addition to the dividend payout: your starting earnings yield and the future earnings per share growth. You want those two figures to be as high as possible. When the S&P 500 falls 50%, you are usually doubling your earnings yield (unless profits are actually declining like the 1930s bear market, 1973-1974 market, or the banking sector in 2008-2009) when you make a new purchase. And usually, the long-term growth prospects of the S&P 500 stay more or less the same (six percentage points above the rate of inflation).

What is the best defense against allowing yourself to become one of those people that participate in the same cycle of buying high and selling low that seems to be gently starting to unfold again right now? Know what you own and why. Speaking strictly about the long-term prospects for American businesses, the future is very bright. S&P 500 companies are earning very nice profits relative to the amount of capital they invest, and they are also possessing the ability to give you 2% or so in dividends while also reducing the share count by 2-3% as well. Ask yourself the question: “How could I deal with seeing every $1,000 I invest turn into $700, every $10,000 into $7,000, every $100,000 into $70,000 and not bat an eye?”

Everyone has their own way they can play this to their advantage—my advantage is that, even though I do write about money all the time, I don’t take it all that seriously. If money gets lost, I can always do something to make it back up: it’s a fun task for me to make that happen. I’m wired that way because my dad got it into my head early on that you shouldn’t let money trouble affect your mood—you should save your grief for things like burying a child or a failed marriage—things you can recover from, but never truly be the same. The key is to think prospectively—think proactively. Swings in stock prices are inevitable, and if you have a plan in place ahead of time, then weirdly enough—those 30% declines are tinged with an almost welcome feeling because you get the opportunity for your preparation to pay off. Preparation, accompanied by an honest internal reflection about what you can and cannot handle, is the best way to insulate yourself from the periods of economic darkness.