Investing when Euphoric
“to be carried away with amazingly good feelings”
“intensely happy or confident”
To be clear, I’m not. Euphoric that is. But the spirit of the age, particularly in entrepreneurship and investing, is euphoric at levels only experienced a couple of times in the past 100 years. That makes it really difficult to answer a question I’m often asked: “How should I be investing today?” As a consultant to a multi-billion dollar investment firm and the manager of a private hedge fund, it’s a question I spend most of my working hours trying to answer. This year I believe investors face the exact opposite problem of eight years ago. Back in March 2009, famed value investor Jeremy Grantham wrote one of the best-timed investment articles ever, Reinvesting when Terrified. Markets had fallen 50%, investors were shell-shocked, and the economy looked incredibly bleak. Just a short time before, Grantham was seen as hopelessly outdated when he warned about the bubble and raised cash while the bull market continued. But things changed, and in 2009 his article encouraged investors to have a plan and start buying. He didn’t “call” the bottom, but he knew that conditions had turned massively favorable. The rest is history. Eight years later, markets are at new highs and investors are riding a growing wave of euphoria. Today investors are overconfident, forgetting the consistent lesson of history — market gains don’t matter until you convert to cash, and bear markets tend to wipe out at least half of the previous bull advance (in the case of ’00 and ’07, it wiped out all excess gains back to 1996!). So how do we invest to make (or preserve) the most in the coming years?
First, recognize the underlying conditions of the times and what’s at stake. We’ll discuss this at a number of levels in the sections that follow, but for the moment, consider investor sentiment. This can be measured by surveys, investment flows, investors using debt, and of course prices themselves. Below are three charts that I’ve picked out of dozens that can be used to measure investor sentiment—note that none of these are surveys. These are the measurable actions that speak at least as loud as words.
Chart 1: Using borrowed money to buy investments
Chart 2: Record low volatility in the stock market
Chart 3: Money flowing into stocks as opposed to bonds, cash
When investors are optimistic, they tend to buy everything with growth potential. And throughout history, every single time, there comes a moment when prices are too high as the world changes. Sometimes there’s an obvious trigger, but often not. Prices decline as investors get pessimistic until they eventually bottom at prices that seem incredibly low compared to the peaks. Every single time in history. During the bear markets, investors typically give up half of the previous bull market gains. When things get really excessive, as we are witnessing today, investors give up decades of gains.
Like the great companies of the “Nifty Fifty” era back in the late ‘60s, I suspect Amazon will be a case study for how this dynamic plays out. It’s a great business. But what’s it worth? Investors are buying like there is no tomorrow and no price too high. The stock is up 33% just since the start of the year. In January, Amazon was valued at 172 times normalized earnings per share. 172 times! Now it trades at 195 times normalized earnings. Fantastic business, and it will still be a fantastic business if the price of the stock drops 75%. We’ve actually seen this before. Take Cisco Systems, a fine business that gushes billions in actual free cash flow and dividends today. Roll back the clock to the last time no price was too high for growth tech companies — 2000. Cisco wasn’t paying dividends at the time; it was in growth mode. Sound familiar? Selling everything necessary for the technology new era. And its stock was priced at…wait for it…156 times normalized earnings. Then the music stopped. One year later, Cisco stock had plummeted almost 80%. It was still a fine business and revenue kept growing! Here’s the kicker: if you owned Cisco at the peak ($67.50/shr) and still hold it today, seventeen years later, you’ve lost almost 50% (today’s price is $34.39/shr). Dividends in recent years have added about $4.50/shr, in aggregate, since the collapse. And Cisco is still a good company. But you’ve lost almost half of your money, seventeen years later. When investors are buying at any price, the underlying conditions are dangerous and the stakes are getting higher. As we approach the midpoint of 2017, it is interesting to note that five stocks (Amazon, Facebook, Apple, Google, Microsoft) have generated around 40% of the total return of the S&P 500 year to date. Followed closely by another handful like Netflix and Tesla. Pricing is getting more and more euphoric.
The idea of investor euphoria may be hard to reconcile with the political rancor, social tension, and geopolitical flashpoints that capture the news headlines. In fact, I suspect the general mood of the average person is nowhere near euphoric. However, the financial behavior of investors as a group has grown intensely euphoric, in practice if not words, for the past several years. That’s what those charts showed. Prior to the presidential election, investors were forced buyers as Fed policy suppressed interest rates and there has been a desperate search for yield and any hope of growth to beat low rates. Since the election, hope for pro-business policies, tax cuts, and accelerating economic growth has captured the imagination. Money has poured into technology and index-based investments at the fastest pace in years. Largely price-insensitive buying. Obviously this buying pressure acts as its own catalyst for a while. Stocks with rising prices draw additional investment which makes them go up more.
Euphoric investors pay a lot for hopeful futures. They pay it in advance. When no price is too high, eventually no future can be bright enough to pay it off. Start by being aware of underlying conditions.
Next, think about your investment mix from a cash flow perspective. I prioritize cash flow needs because that’s where the rubber meets the road—whatever your investment results have been up to the moment you convert to cash to buy something (living expenses, vacation, new car, etc) or invest elsewhere. Keep in mind that the general discussion below is just that. General. Your specific situation could require a different approach, but I’ve found the overall framework is a good starter at least 90% of the time. Also, if you’re working and plan to continue for at least the next ten years, your cash needs from your investment portfolio may be almost nothing and you can have most of your portfolio positioned for growth in Level 3.
Level 1. Money needed in the next year or two
Cash in the bank, short term CDs, money under the mattress. Keep it very liquid. Feel free to complain about the fact that you’re not earning anything. Write to your Congressperson. Vent to your friends. But stay liquid for money you’ll need in the near term. Anything else is foolishness, and the worst possible investment decisions are forced when there is a “liquidity mismatch” related to timing (i.e. you need the money now, but it’s not a good time to take it out of longer duration investments).
Level 2. Money needed for years 3-7 years
Fixed income. This is where bonds play a central role. Specifically, medium duration bonds (3-7 year). If you are a U.S. citizen spending primarily in dollars, I’m partial to U.S. corporate and government bonds. Because of current government policy and global deflationary conditions, bond rates are really low. If done prudently, this part of your investment portfolio currently yields 2-3%. Live with it and adjust your cash flow needs accordingly. Don’t be suckered into the “reach for yield” that can make this an inappropriately risky part of your portfolio. Widows and orphans are currently buying junk bonds because they yield 5% without realizing those bonds can drop 50% in value during a recession! It’s fine to have a professionally-managed fixed income portfolio that includes high yield, international, and emerging markets as a small piece. However, the overwhelming objective for money needed in the 3-7 year horizon is that it retains its value versus inflation and buffers you from selling your growthier assets in a down market. Money invested in Level 2 needs to be reasonably liquid—in a bad scenario, you may very well have to convert it to cash to spend in year six. That’s why I’d prefer not to include an asset like rental real estate in this category. Dial in your expectations to the reality of the current low-yield environment. It will eventually change, and as time goes by, you can expect future tranches of your Level 2 money will get invested at higher yields. To be clear, I’m not suggesting that most investors have enough fixed income so that the yield alone covers all their cash flow. That’s nice if you can do it without needing the growth from Level 3 assets to cover your longer term needs, but not practical for most. I’m suggesting that the total amount you maintain in fixed income equal at least the cash flow you expect to spend in years 3-7. So, if you expect to need $150,000 per year from your investments, you might want at least $750,000 in your fixed income portfolio. Today, after many years of a bull market in stocks, you might want to bump up your Level 2 investments by adding cash needs for years 8-10. The incremental gains you give up in the short term by shifting down from Level 3 will probably be immaterial, and the peace of mind could be invaluable in the future. Also, assuming it fits your longer term plan as regards investment returns, there’s nothing wrong with having an even bigger chunk of your investments in Level 2. It will be less volatile and could allow you to sleep better at night with less worry. Just make sure the math works based on your annual cash needs, reasonable expected return, and your life expectancy (joint if married).
Level 3. Money needed starting 8 years and beyond
Growth investments. Publicly-traded stocks, private businesses, real estate, commodities, and all the “packaged” versions of these assets (mutual funds, ETFs, partnerships, PE and hedge funds) fit in this category. This is where you prudently allocate the money you need to be compounding at growth rates over time (say 8% and higher). IMPORTANT: it is ok to count a conservative yield from Level 3 assets in your cash inflows to determine your money needs for Level 1 and 2. The principal amounts, however, are generally less liquid and more volatile in bad times. The principal is Level 3 money.
In my experience through multiple bull and bear markets, one of the most important steps for an investor is understanding cash flow needs and matching up the investment strategy to the extent and timing of those needs. If you are in your prime working years and plan to keep at it, cash needs from your investments over the next ten years may be zero. In that case, it can be fine to have a year or two of emergency cash set aside and the rest of your investments in Level 3. (Assuming, of course, you are willing to be patient and sit through volatile bear markets as they occur.) On the other extreme, if you plan to retire and live off your portfolio, do the simple math—ten times your pre-tax annual cashflow need is probably the minimum you should have in conservative cash and fixed-income type securities. Particularly at this point in the cycle, do not assume the riskier strategies and higher expected returns of Level 3 investments will bail you out. Dial down cash flow needs or keep your job. Otherwise the math just isn’t going to work.
In the next article I’ll give some thoughts on investment strategy for Level 3 assets, but the first step is getting clear on how much of your portfolio should be invested for growth at all. It’s easy when markets always go up to put more and more in Level 3. Now is the time, as the euphoria of investor action becomes more clear, to dial it into what you’re going to be willing to live with through the inevitable bear market that follows.
Alan Gotthardt is the Chief Investment Officer of TriniD, a private investment company, and is the author of a comprehensive work on Christian philanthropy, The Eternity Portfolio, Illuminated.