With near certainty, philosopher Schopenhauer was not pondering the nature of investing when stating that “only loss teaches us about the value of things,” but there is certainly some relevance to financial markets. After all, what investor does not remember the (likely painful) lessons learned during the invalidating crashes of 2000/2001 (Dotcom Bust) and 2008/2009 (Credit Crisis)? In both instances, excessiveness became fashionable, purely on the basis of a collectively distorted perception of value and the consequent willingness to lead prices ever higher – especially for stocks of internet-based sales outlets with no earnings (ever), real estate and select commodities. Today, we may very well be heading down the same road again, but with one important and difficult-to-grasp twist: we are not only “playing” off of each other’s mutual distortion, but are also at the mercy of a far more powerful player – the collective of central banks and, more importantly, their shared dedication to continued accommodative policy.
For the analytical and logical mind, nearly every absolute and relative valuation model for stocks is “screaming” danger and yet, we are willing to bet on another round of improvements to our value proposition, e.g., deregulation, fiscal stimulus, improved earnings (despite a less open world for trade), etc. Thinking about equity valuations in far simpler terms, however, I was reminded of my early lessons in the industry: we buy equities to protect from inflation (meaning to secure our purchasing power) as every stock represents a piece of real value. With this seemingly acceptable logic in mind, our approach to equity valuations reveals surprising results.
To set the stage: there is little benefit of measuring purchasing power against the official rate of inflation – since it is skewed – in that it does not capture price increases due to asset-price inflation (think real estate), and computation methods have been changed whenever convenient. With the objective of assessing the purchasing power of one unit of equities (think of the S&P 500 at the index level of 2,350 as being equal to $2,350), I composed a theoretical “inflation basket” of four equally-weighted, essential, “better-to-have-than-not” assets: 1) Gold as a historically accepted store of value/tender; 2) Oil as a representation of energy to move the internal/external economy; 3) Poultry capturing the price of food/protein, including cost of feed; and 4) Timber as an asset and/or material building component.
The index level of the S&P 500 was subsequently used for a monthly purchase of my theoretical “essential basket,” beginning in January of 1988. By this measure, the S&P 500 (as a purchasing power unit) peaked in June of 1999, when it bought nearly three units (2.94) of the basket. Today, the purchasing power of the S&P 500 is only about 70 percent of the all-time high, even though the index level is nearly 1,000 points higher. Therefore, the purchasing power of stocks has eroded materially, and only when including dividends (i.e., total return) has the S&P 500 recently regained the same purchasing power as back in 1999 (but this still excludes taxes and investment costs).
Monetary policy, seemingly, has changed the rules of the game, with a material decline in purchasing power having occurred after massive stimulus was introduced by then-Fed-Chairman Alan Greenspan to aid the Dotcom Bust and Y2K concerns. With this in mind, stocks may not be too expensive on a price basis, but at the same time, their value proposition may not hold true any longer, unless investors can “hang around” for extended periods. The only teacher may be time, after all, with losses largely being a function of one’s investment timeframe. At this point, we should plan for the long-term in U.S. stocks, as the shorter-term investor will likely be disappointed.
Matthias Paul Kuhlmey is a partner and head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to high net worth and ultra high net worth individuals, family offices and institutions.