OK, Investor: What Do You Want?
What do you want? Yes, you want the market to engage in a ferocious upside rally, but that won’t happen quite yet. Here’s why.
To put it succinctly there is a best time to make profits and a worst time to make profits. We’re in the latter phase. It’s quite simple. Would you rather invest when earnings and price-to-earnings multiples are rising or when earnings are declining, and price-to-earnings multiples are falling? We’re in the latter phase. Let’s not talk about why this is happening so much as recognize that all economic cycles deliver both periods to investors. The good news is that there’s something called the equity-risk premium that rewards long-term investors. Let’s talk about how it all works by way of a dollar.
To illustrate: one dollar of earnings from a company you own can be exciting or disappointing. We’ve left the exciting phase of earnings. We’ve entered the disappointing phase. So, what caused the change in enthusiasm and the introduction of greater market volatility?
Inflation can create the disappointment phase. Why? It’s basic. When interest rates go up, price-to-earnings multiples go down. Why? Think of price-to-earnings multiples as a measure of how easy it is to make a profit. During periods of inflation companies facing labor shortages must pay higher wages and other expenses, labor is the single largest expense facing companies. So, when labor costs rise, profits commonly fall. Rising material costs can also squeeze profits. So can the cost of capital, but the cost of labor must be accounted for even as supply-chain issues abate. There is growing fear that just as supply-chain problems decrease, consumer demand will die off due to higher gasoline prices and food prices, leaving companies with high labor costs and lower unit volume of demand. This can be very disappointing to the short-term investor.
Here’s the simple math; stock prices are tightly connected to two things (1) earnings and (2) price-to-earnings multiples. Multiply one number by the other. That’s it. So, $1.00 of earnings times a number called the price-to-earnings multiple, delivers the price of a stock. Wait. It can’t be that simple.
Yep. A number times a number. If the number on the left of the X is $1 and the number on the right side of the X is 20 then the price of the stock is $20 per share.
Inflation, however, changes both numbers.
During periods of inflation price-to-earnings multiples tend to fall. Let’s say they fall from 20 to 16. In this case we multiple $1 of earnings X 16. This produces a stock price of $16. But you bought the stock at $20. What do you do now as you look at a loss of $4.00 per share? Well, if the company, in time, grows its earnings to $1.25, this $1.25 in earnings X a 16 multiple produces a $20 per share. All good, though no profit. However, if inflation declines, price-to-earnings multiples should rise, accounting for a period in which both earnings and price-to-earnings multiples are rising together. This is the best of all worlds for investors. It begins after the periods when both earnings and price-to-earnings multiples decline in tandem.
So, let’s look at this one paragraph to understand. Earnings decline. Your anticipated profits from company X disappoints. Instead of earnings coming in at $1.00, the company reports just 90 cents. Worse, multiples decline. Once supporting a multiple of 20, now the stock market supports only $.90 X 16 and produces a price per share of $14.40. You paid $20. This is the opposite of the best of both worlds when earnings are surprising to the upside and price-to-earnings multiples are rising. In that world, $1.25 times 20 produces a price of ($1.25 X 20) $25 per share.
Now here’s the good news. After the final worst-case phase of the economic cycle is completed, things flip. The best-case phase begins. This is the period of the economic cycle when both earnings and price-to-earnings rise simultaneously. This phase continues until the market becomes overvalued, corrections occur, and additional advances occur. This is a long, multi-year phase.
So, this is how economic cycles work. The worst-case phase of stock values leaves 90 cents at a price of ($.90 X 16) or $14.40. Whereas the best case of stock values leaves $1.25 at a price of ($1.25 X 20) $25. The difference between the $14.40 stock and the $25 price is 73.6%. Yet, the world did not come to an end as much as the stock price may have shaken the confidence of the novice investor. Patience, therefore, benefits the long-term investor. This brings us to the equity-risk premium.
The equity-risk premium is the return you get from stock investing over the economic cycle. Recessions tend to last some 6 to 36 months. Economic expansions last much longer, roughly between five to nine years. Yes, some people will use strategies to get in and out at the best time; however, I use these strategies sparingly as using too much timing has been shown to reduce returns.
I urge you to go back and read my last newsletter as asset allocation does allow for deployment of opportunities to outperform the market.
I trust you find this breakdown of economic cycles and the pricing of stocks helpful. Explaining economic cycles and stock valuations can provide investors with sufficient understanding to become a better investor. Monitoring and managing your portfolio every day over the years has hopefully given me the writing skills to confidently talk about economic cycles and strategic alternatives for you.
Thank you for your continued trust in all we do for you. It’s never dull keeping up with world activities and how they affect asset allocation and investment values.
Sincerely,
Vaughn L. Woods, CFP, MBA
Vaughn Woods Financial Group, Inc.
2226 Avenida De La Playa
La Jolla, CA 92037
858-454-6900
www.vaughnwoods.com
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0273.