My Latest Thoughts on the Market

Back in January, I posted a blog titled “Don’t Expect Much from the Stock Market”.  Since that time the S&P 500 is up 4.8% and the Dow Jones Industrial Average is up 2.5%.  I was projecting 10-year annual returns of 2.1% and today I expect about the same.  In my opinion, this is not a great time to be “all in” the U.S. market.

I often hear that the market has been doing so well so why not be fully invested so we don’t miss out.  This is what I like to call FOMO (Fear of Missing Out).  It can be a powerful force and we saw a lot of it in 1999 and 2007 just before the 50%+ declines.  If you are investing simply because stocks have gone up a lot recently and therefore you think they will go even higher, then you are speculating, not investing.  Investing is all about weighing risk and return.

When 10%+ annual returns are projected for the market, it makes sense to take on potential downside risk.  However, if future long-term returns are in the low single digits, it may not be worth the risk.  This also depends on your age, risk tolerance etc.

The framework I use goes back to basic financial theory.  If you are taking on added risk to be in the stock market, you should be compensated for it.  Whether you are investing in stocks, bonds, real estate or a family business, you are assessing a level of risk compared to the alternatives. 

The 10-Year Treasury Bond is generally considered the safest of investments.  Us Finance types refer to it as the risk-free rate of return.  It is risk-free because the Government has the ability to print money to pay its debts.  All potential investment returns should be compared to this rate. 

Currently, the 10-Year Treasury is yielding 3.0%.  When I consider how exposed I want to be to the stock market I need to be confident I can earn more than 3.0% per year.  Otherwise, why not just invest in risk-free Treasuries.  So how much additional return should we demand to invest in stocks?  (Equity Risk Premium).  Over the past several decades, the Equity Risk Premium has been in a range of 3-6% and as long as I can remember college professors and investment analysts have been debating what the exact amount should be.  Personally, I use 4% when looking at most individual stocks.

Let’s be generous and assume an equity risk premium of 3% (the low end of the historical range).  If we take the risk-free rate of 3.0% plus the equity risk premium of 3.0% we get a “required” return of 6.0% for equities.  In other words, we want confidence we can earn at least 6.0% per year in the stock market.

Now, it’s just a matter of calculating the market price level needed to support a 6.0% annual return.  Currently, the S&P 500 is at 2,930.  From this level, I’m projecting approximately 2% annual returns.  To get to projected returns of 6.0%, the S&P 500 would need to trade at 2175 or 26% below today’s close.  At that point, I would increase exposure to the market in a meaningful way.  Until then, my exposure remains close to zero.      

Scary thought…to get back to our historical average of 10% annual returns, we would need a 45% correction in the market!