As the new year begins, I think many of us do a lot of reflecting over the past 12 months and evaluate how successful of a year it has been (or not been) based on initiatives stated earlier in the year.
As I reflect on my own progress towards Financial Independence, the success of my side hustles, and the overall direction my life is headed, it has never been clearer to me that I am indeed making progress – slowly, but surely. I began investing in March 2017 (the same time I started this blog) and my investments in the stock market have done amazingly well for me this year.
In 2017, the S&P 500 (the biggest 500 companies in the US based on market cap) increased by %28! If you missed out on this record-breaking year in the market you may be feeling some FOMO right about now. Or maybe you missed the %1400+ jump in Bitcoin or the %10,000+ increase in Ethereum. I definitely missed much of the cryptocurrency wave in 2017, but my analysis on cryptocurrencies and blockchains are for another article.
In this article, I will lay out my current perspective of the stock market, the reason I think why the market has been defying gravity, and whether or not we should invest in 2018 (I bet you can guess my suggestion).
Current State of The Market
In the “Intelligent Investor” by Benjamin Graham (Warren Buffet’s #1 recommended reading), Graham suggests that the intelligent investor pay no more than 15-20 price to earnings (P/E) ratio for any given stock and to be especially wary of stocks that have soared to lofty valuations as the reality of an underlying company’s true earnings will catch up to the stock’s valuations. Today, there are several companies with disproportionally large P/E valuations that have never existed before.
For example, look at Amazon (AMZN) that has a P/E ratio of 200+, Netflix (NFLX) with a P/E ratio of 200+, or Chipotle and Shake Shack with P/E ratios over 60+. All of these companies have valuations that traditional investors look at and have mild panic attacks about. Even though the average company in the S&P 500 index has an average P/E of 25, the index still manages to create new record highs every day.
Amazon, more specifically, Jeff Bezos, has no appetite for profit in the traditional sense but is completely focused on growth. This focus on growth as compared to profits is why the current valuations make very little sense from a more traditional perspective. As Amazon has redefined the rules around profits not being the main priority, the stock market has seen many non-profitable IPOs in the recent years. Think about Blue Apron (APRN), Snapchat (SNAP), or Trip Advisor (TRIP) when you think about companies that have IPO’d into the market with minimal or zero profits.
Being the company that focuses on growth instead of profits seems to be a growing trend in companies that IPO into the market. Just think about how strange this is though – if someone asked you to invest $100 in their company that does not make any money or has some strategy that is unclear to you, would you really be willing to give that person your $100?
There is no denying that some of these overpriced companies (or companies with no earnings) are the future of America, but at the same time, the numbers do not lie. At a certain point there must be a mass market correction – but when?
Big Dumb Money – 401k and Index Investing
Before we answer the when, let’s take a look at why is the stock market defying gravity. Warren Buffett, The Oracle of Omaha, believes that this historic rally in the market is due to low-interest rates on the federal treasury bonds. As the Feds establish the going interest rate on Government bonds, they also control the entire incentive for investors to buy stocks or bonds. With interest rates intentionally suppressed by the Feds, it makes the stock market more attractive as the potential gains would far outperform the %2.25 gain the Feds offer.
The argument that stocks are more favorable compared to bonds due to low-interest rates is definitely one valid reason for a rising stock market.
However, I propose another reason: BIG. DUMB. MONEY.
What I am referring to is the huge movement into passive investments through 401Ks, mutual funds, or index funds (a.k.a. ETFs). Workers used to have pension funds that their companies would offer and allow the employees to have a safe and secure retirement fund. As companies have moved away from the pension model, 401Ks and IRAs have become increasingly more popular.
If you have a 401K that is a date targeted fund (which is typically the default setting based on age) somewhere 30+ years into the future, then you are investing into one of the most historically ‘overpriced’ markets without even realizing it every time you receive a paycheck. Every two weeks, Americans are contributing a portion of their pre-tax income straight into the stock market through these target date retirement funds. The structure of a targeted date fund that is far into the future is more heavily weighted in stocks than in bonds as these funds assume people have more appetite for risk as they are young, and will less appetite for risk as you approach retirement age (moving the asset allocation to be more weighted in bonds than in stocks).
Even if you don’t have a 401K, investing through simplified apps or services have become increasingly more popular. Apps like Stash, Acorns, or WealthSimple do not allow investors to invest in individual stocks, instead, they bundle every persons’ investment into these index funds that track the market.
Jack Bogle, the found of Vanguard and creator of the index fund, has made everyone’s life easier in terms of investing and mitigating specific risk. Index funds have helped the common investor in a fantastic way by making the entire investing ecosystem much easier to navigate by giving your average investor the ability to be immediately diversified. Instead of doing extensive research about which company in healthcare will make the latest and greatest product, you can now buy a basket of biggest 50 healthcare companies and hedge your bets across the entire market. I cannot stress enough how great this is for your average investor.
However, the problem is that people do not fully understand how they are contributing to the greatest market rally in history with BIG DUMB MONEY.
Stop Waiting For The Recession
As people put this money blindly into the stock market through their 401K retirement accounts, passive investing apps, or index funds, it seems like the market will have enough wood to keep the fire burning.
My take is that there has to be a catastrophe so large that institutional investors simultaneously lose confidence (but with the corporate tax cut, I doubt there will be a loss of confidence any time soon) or a catastrophic event that makes people reallocate their 401K to be more in bonds/cash funds and less in stocks/mutual funds. I am not saying that such a catastrophe does not exist, but it would have to be pretty significant to make a majority of investors lose confidence all at the same time. Based on that fact alone, I would always bet money on there not being a recession in any given year.
Typically, the last couple years of the bull market have some of the best historical returns. There is definitely some risk in investing in the stock market in 2018, but there are also plenty of reasons to be optimistic even with the high valuations of the stock market.
On average, the stock market goes up every 2 out of 3 years, which is a pretty good record over 100+ years. So, being an optimist, it only makes sense that 2018 will be another good year for stocks.
Not to mention – the corporate tax cut from %35 to %20 will only help shareholders and corporate executives. Most of us have slim or no chance of ever becoming a corporate executive on the board of a Fortune 500 company, therefore I suggest that we all get a part of the American Pie by participating in the market.
If you plan to sit on the sidelines in 2018 like you did in 2017, then you are letting the world pass you by. So many of us let fear immobilize us from taking action. Instead, utilize the fear of never accumulating a significant amount of wealth be the driver that begins your investing journey.
Thanks for reading.
P.S. – In 2018, I will be coming out with weekly content every Wednesday, so stay tuned!
P.S.S – I am explicitly stating my opinion in this article and this should not be taken as explicit investing advice as I do not know your specific situation or risk tolerance. I may or may not have personal interests in the stocks mentioned above.