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Don't Be Surprised By The Next Move

Today is one of those days; not fun. Not that our job is supposed to be fun. Or, that investing is supposed to be fun -- it's not. 

To put today in perspective - The Dow dropped 370 points --sounds terrible, right? Or, 1.78%. (We'll talk more about that in a bit) 

That being said, a big and very real part of our job is managing your expectations as an investor.

As part of that job I've been a bit of a broken record in sharing the narrative we've been seeing for the last year, and six months in particular, "US stocks are getting expensive."

Today, we thought you might benefit from a more visual and concrete perspective. 

Over the long haul stocks have provided about a 10% return annually. As investors, we've been trained to expect this too.

The problem with this pavlovian expectation is that over the long-term, stocks course-correct along the way (and can and do crash). These corrections along the way are a healthy and necessary part of the path as investors in being rewarded with that 10% return; re-valuing the future along the way. Not fun, but necessary.

Think of it like this -- if stocks only went up, they'd eventually grow too expensive to continue to be able to pay you that 10% expectation (because not even Apple or Amazon are perfect at predicting and producing future products you'll want and can afford in the chaotic, random world that is ours).

Yet -- it does happen; markets do get expensive. Markets do price themselves for a perfect utopian iFuture. And broadly speaking, that's arguably happening in the US right now.

Today we're paying a premium price to invest in US Stocks; almost 29 times, using the 10-year average PE ratio - also known as Cyclically Adjusted Price to Earning Ratio, or CAPE ratio for short.

To give you an idea of what's "normal" -- we generally consider stocks fully valued in a low-inflation environment at around 16-20 (CAPE). So, at 29 we're expensive. Are we in bubble territory? No. Just expensive with other historically expensive bedfellows too; not unprecedented by any stretch. 

But, for US stocks to offer us that 10% expectation from here, over the next 10 years, that would mean stocks would need to become more expensive still. And, if we do assume stocks will produce 10% a year from here, today, then they'd actually need to become more expensive than they've ever been. In case you missed that -- more expensive than EVER.

Will that happen? Not likely (but they could), and here's an idea of what historically you can expect on the return-front going forward from what we know about stocks being this expensive. 

So, as expensive as we are today, going forward we'd better be prepared for more muted returns if history is our guide (and we don't course-correct at some point in the future). 

Think about it like this; stocks right now are like that kid in your sixth-grade class who was already six-feet tall and didn't grow again until high school -- that's where we are right now (and I was not that kid). Or put another way, the premium we are paying today is for future returns we haven't yet received -- today's market prices are like opening all of your birthday presents the day before, rewrapping them, and then acting surprised the next day when you open them again.  

Possible -- just not logical. So, that leaves us to explore the other possible outcomes from here.

1) Stocks do a whole lot of nothing.

There's precedent for periods like this. Namely the most recent decade in the 2000s, where the total return of the S&P 500 for that decade was -1.0%. And in the 1930s we saw the same (read: after bubbles pop). Are we doomed to be in a lost decade? No. Is it possible? Sure. Barring the market dropping, and revaluing from here, we simply cannot sustainably continue to expect stocks to go up and up and up -- without an almost inevitable day of reckoning.

2) Stocks drop from here.

That's the nature of the investing beast. There's an old adage on Wall Street that you'd be wise to remember -- Stocks take the stairs up and the elevator down. And here's how often those down days can happen.

5% Market Corrections
How often on average has the stock market experienced 5% corrections over the last 110 years from 1900 – 2010? Three times per year!

10% Market Corrections
How often on average has the stock market experienced 10% corrections over the last 110 years from 1900 – 2010? Once per year!

20% Market Corrections
How often on average has the stock market experienced 20% corrections over the last 110 years from 1900 – 2010? Once every 3.5 years!

Right now the S&P 500 has gone 215 days without a 5% drawdown, which is the longest streak since 1996. Today would be only the second 1%+ down day of 2017.

So, it would be good to remind yourself of this fact while you're watching the news tonight. What happened today is normal. 

Does this mean that because we're expensive today, we're doomed as investors and a "crash" is coming? No. The reality is that the world is a big place. I will say though, yesterday I was reminded of how small the world is too.

We met with one of our favorite clients, who lives in Italy. Her oldest son lives in the UK and found us online from some of our writing... small world. Toward the end of the meeting, her other son, who lives in Santa Barbara and was coming to meet us for the "first time" since we started working for their family -- he realized he had met me almost over a decade ago through a mutual friend. The world is a VERY small place, indeed!

I digress.

My "the world is a big place" point is this: outside of the US, stocks are not expensive. They're pretty darn cheap; relatively and historically. This is why we preach global diversification. Many of those other countries outside of the US still have not appreciated much above (or above at all) their pre-crash 2007 levels, and that is an interesting development, to say the least. Especially when the world does seem so small and so connected. This is also why we preach having bonds (even when bonds look "dumb").

So naturally, now that you know all of this, you want to know: "What do we think happens from here?" Stocks will either go higher or lower or do nothing :)

What's more likely? We don't know, frankly - but I'd be more apt to tell you to be prepared mentally for a whole lot of nothing or a drop from here or somewhere a bit further down the road, at least here in the US.  

We'll never know the how, when, or why, but we do know this, if you mix your assets well, using the history we have as our guide, we can be fairly certain about what mood swings you can expect along the path of high, low, and nothing.

If you're feeling concerned or would like a fresh look at the risk in your portfolio, please feel free to reach out us here.