How do you invest when we are 8 years into this current cycle?
We get this question a lot, from friends and family, from clients, from colleagues and fellow investors. Unfortunately this is such an open-ended question that we have take a careful assessment to have a reliable answer.
First of all, does number of years in a cycle have anything to do with overvaluation or undervaluation of securities? Logically it is not the case. In 2004, although it was just 2 years into recovery from Dot.com bubble burst, one couldn’t make a confident conclusion that stocks were undervalued. In 2014, although we were 4 years into recovery, lots of stocks were still undervalued or fairly valued, especially given the record low interest rate at that time. A bull market does not die of old age. It dies of overvaluation.
In the most recent economic expansion/recovery cycle, the employment growth was extremely low in the early years of the cycle. Therefore people put a term called “jobless recovery” to this cycle. The growth rate was also anchored down by various forces: low job creation; lots of new regulations and taxes; concerns on Central Bank’s tapering; European debt crisis; worries on China slowdown etc. The real economy “wasted” several years worrying about general economic environment until end of 2016, when they saw a pro-business Republican President was elected office. Since then, the business confidence climbed to record high, together with consumer sentiments. Always remember, consumption is 67% of the GDP. If you have a large group of optimistic small business owners and consumers, you can count on a strong showing in GDP growth in 2018 and 2019. Then you have a much stronger push with historic passing of tax reform that cut corporation’s tax rate to 21%.
Based on my observation, current S&P 500 hasn’t really fully appreciated the full positive impact from this drastic change of corporate tax reform. Indeed, the 2017 annual results for Berkshire Hathaway showed that $29 billion of the $65 billion gain in book value came from new tax law. And the lower tax expenses are going to be repeated in future!
If S&P 500 companies collectively have a long-term after tax return rate of 8%. The pretax return rate was then approximately 12.3% (8%/(1-35%), assuming 35% average corporate tax rate). Under the new tax law, such 12.3% pre-tax return will deliver instead a 9.7% after tax return (12.3% * (1-21%), assuming 21% average corporate tax rate). That means every $100 dollars in S&P 500, it will earn $9.7 in return, $1.7 higher than that $8 return in 2017. Applying that $1.7 additional earning to a discount rate of 8%, we will have a present value of approximately $21.25, benefit from this change to a lower tax rate. That implies a 21.25% gain in S&P 500’s intrinsic value. All these did not take into account that with strong capital expenditure from new tax law. And with the overall optimistic sentiment from business owners and consumers, the pre-tax return has a fair chance to grow even higher than before.
**********
From the first section, you probably will conclude that there is still some room for this cycle. However, that’s only true if we assume the $100 value assigned to S&P 500 today is not already overvalued. According to Morningstar, S&P 500 total return averaged around 9.68% annually in the past 10 years, a period in which the GDP of USA only averaged around 3% (from St Louis Federal Reserve). We can’t say S&P 500 is definitely overvalued now but it does not look particularly cheap related to fundamental growth at the same period.
What is your suggestion then, you may ask.
Strong caution should be applied in today’s market. However, we can still find opportunity to invest. Mr. Buffett can’t deploy his $110 billion dry powder effectively because the size of the capital he manages. For individuals, whose investment probably doesn’t require a 13-D filing to SEC, there are still plenty of opportunities around, particularly in retail industry. We made the major call recently to one of such companies, and we are planting seeds in a couple of more. If you think independently from the panic and euphoria of Mr. Market, you will be able to buy some decent business at a very sensible price.
In summary, we have two recommendations to two types of investors:
- For passive investors, please make a programmatic investment plan to deploy a fixed amount of capital into low cost S&P index fund every month. This way if there is a major pullback, your same amount of capital can buy your more shares in the index fund. One thing is extremely important however, never use borrowed money to make sure purchase.
- For investors who are more enterprising and active, you can either do a careful stock selection by yourself or you can hire a reliable manager to do it for you. If you are doing the work yourself, make sure you don’t leverage your position and you are confident of your mental strength and financial analysis skillsets. Make sure you can live the life the same if your positions declined 50% over next month. If you think it is beyond your mental comfort zone or expertise area, give it to a manager to manage. If you give the discretion of managing your money to a manager, make sure their interests are aligned with yours. At Fuji Investment Corporation, we charge no asset management fee (except trading commissions or expenses that are applied to investing in this account). We earn our entire fee from the profit we make for our partners. We earn $0 if we fail to meet the return hurdle. (I don’t think any other professional manager out there can claim the same).
Important Note: the statement above is not a solicitation or advertisement of investment with us. We are not open to admitting any investors.