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Betting on the Status Quo

Author: Sam Maness, JD CFP®

“Buy stocks for the long run. Diversify. Watch your dollars grow.” We believe this investing mantra remains true, but it sure doesn’t feel easy right now. A lot of us are worried – about our jobs, our investments, our health, and our families. And it feels like this uncertainty arrived without warning.

The challenge is that humans are wired to plan and predict. We generally believe tomorrow will look like today. Over long stretches, this works well because life moves in patterns. We should plant crops based on seasonal cycles. We should develop tools and equipment so that the next time we do a job, life is a little easier. And we should invest our financial capital in businesses that continue to improve our world. But this last one gets difficult when we don’t know what the future will look like over the next few months, or maybe even the next few years. And for me this highlights a big idea worth discussing: betting on the status quo.

“Progress happens too slowly for people to notice; setbacks happen too fast for people to ignore. There are lots of overnight tragedies. There are rarely overnight miracles.” Morgan Housel, Five Lessons from History

Investing is hard because we mentally bet on continuation. Over time, markets go up. We believe that is the status quo, so bear markets feel surprising even when history shows us that major declines - mixed into the longer upward trajectory - are routine. A portfolio may have an average annual return of 7% with a standard deviation of 10%, meaning if you invest long enough the returns average about 7% per year, but over shorter time horizons you could easily range between 27% and negative 13%!* When we experience those negative returns, the status quo changes. Behavioral ticks beyond our control produce a strong negative reaction to the loss. Fear sets in and we want, more than anything, to protect against additional losses. It is easy to predict that our five percent loss will continue snowballing to ten, and then twenty, until eventually we go broke.

The challenge with investing is recognizing a meaningful change in the status quo versus a surprising yet arguably routine change in prices. The status quo is that investments provide positive returns over time but experience significant price swings. Stock portfolios go through bouts of severe loss, but the losses have always proven temporary. So far in 2020, this looks much the same, even if it feels different. We might recover in a few months; it might take a few years and more gut-wrenching losses. The big decision is setting goals and adopting a portfolio that provides adequate returns, and risk levels you can live with. Buying stocks means buying ownership stakes in companies. Over time, it has proven profitable and I don’t see this changing any time soon. But even if this crisis presents ’nothing new’ in terms of long-term investment strategy, it has potential to shake up how our world works, and how we interact with one another, in very real ways. Here are some areas I’m thinking about when it comes to the ‘status quo’ going forward.

Value v. Growth

A common stock valuation method is the price to earnings ratio (“P/E”). Since the early 1970s, the market has traded at an average P/E of around 19 or 20 – in other words you pay $19 for stocks offering annual business earnings of $1. Generally, value stocks trade at lower P/E ratios and growth stocks trade at higher P/E ratios. As of May 2, 2020, JP Morgan trades at a P/E of about 10.53; Google trades at a P/E of 26.79. Some believe the affordability of JP Morgan would make it a lower risk bet, but on the year JPM is down over 33% and Google is down less than 2% (source: https://finviz.com/). We are seeing this on a broader scale as well; growth stocks, with heavy technology representation, have so far proven more resilient during the March 2020 decline. Is this temporary or part of a bigger change that is just starting to play itself out?

Technology is changing how humans work and could be breaking down the classic ideas we have around value vs. growth. The changes will be amplified if Covid-19 and other global pandemics fundamentally shift the way we interact as a society. Being an industry leader may soon require digital and cloud-based solutions, remote access, and service without borders. “Asset lite” business models, companies that don’t require significant capital investment in people or production, may also be better positioned to weather financial and other storms like the one we are currently experiencing. Even a high P/E ratio looks attractive if the growth of earnings, and resiliency of those earnings, appears secure. A tech company may trade at a premium to the market, but if it doubles earnings, the P/E is cut in half. The inverse is also true, so if a value stock fails to maintain earnings in a rapidly changing world, the “cheap” price tag starts looking very expensive very fast. Other value stocks may be looked over by investors for this reason and may make interesting investment opportunities!

We design portfolios, and try to partner with fund managers, with these ideas in mind. And we are open to talking with you about funds and companies that may do well in the future, regardless of how things shake out with the current pandemic.

The “Everybody Wins” Game of Poker

Covid-19 has created widespread fear and uncertainty, so it makes sense that the stock market has reacted negatively. This pattern appears throughout history. But we often expect conservative bond funds to maintain value, or in some cases provide a positive return, when stocks decline. In early 2020 most bond funds fell in lockstep with stocks. Many suggest this was less about the quality of the bonds and more about a need for cash. Sellers rushed to raise cash and this drove down the price of bond funds.

As this was all happening, government stimulus efforts moved quickly. Among other things, the Federal Reserve ramped up asset purchases (“quantitative easing”). The Fed started buying bonds in the open market to provide liquidity, lower interest rates, and encourage borrowing. This began during the Great Recession and in the past focused more on safe treasury bonds and government-backed mortgage bonds. But on April 9th this program expanded to include corporate bond fund ETFs and even high yield or “junk” debt. In other words, the Fed is buying the debt of American businesses to help prop up the markets.

The good news is that bonds started to recover. But it seems like a game of poker where everybody wins. Maybe it proves temporary, but what does it mean to have this backstop in place during challenging times? In a world with financial derivatives and other liquidity traps, do guard rails on the potential losses faced by private business help reduce economic damage? Or do they create the wrong incentives for companies if it appears no one can lose, with the ‘house’ invested in the players at the table, even the players making riskier bets? This seems like a big development, and one that will take time to better understand. For more reading, I suggest the following articles:

The Shortest Path to Living Wealthy

Most of my recent thoughts and discussions have centered on the direction of the markets, the best investment opportunities, and how we can preserve capital and limit losses. I’ve shared a few ideas here on investments, but the hard truth is that thousands if not millions of smart people are looking at these same opportunities, vetting the risks, and moving stock prices to better match those expectations. There are few if any “home run” ideas out there, and a lot of smart people fighting over the same pitches. In a changing environment, even our best laid plans may fall short. This reminds me of a valuable idea that we hear so often, one that is easy in theory but much harder in practice: giving energy and attention to what is within our control.

This year shows us how fast things can change, and in ways we previously never imagined. It feels like things are happening beyond our control, and in many ways that is true. But our balanced approach to financial planning and investment portfolios prepares us for these tough times. It is within our control to stick to the game plan. It is within our control to adjust and make changes. And it is within our control to define for ourselves what living wealthy means.

We have control over how we approach these days. If our emotions and personal well-being are set by stock market performance, the daily news cycle, or radical Facebook posts, we effectively relinquish control of our own happiness. We take back control by directing our attention to loved ones, our good health, time spent outdoors, and the food on our plates. Outside of our borders, many don’t have those luxuries right now. Would things for us look different if the stock market goes up or down? Sure, but maybe not by as much as we think. The shortest path to living wealthy remains being content with what we have. With the right mindset, living ‘wealthy’ is always within our reach.

*This is a hypothetical example for illustration purposes only and does not represent an actual investment. 

Opinions expressed are those of the author and not necessarily those of Raymond James Financial, Services. Links are provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed web sites or their respective sponsors. Securities offered through Raymond James Financial, Inc. Services Member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. McLaren Wealth Strategies is not a registered broker/dealer and is independent of Raymond James Financial Services, Inc. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. 

This is not a recommendation to purchase or sell the stocks of the companies mentioned. Holding stocks for the long-term does not insure a profitable outcome. Investing in stocks always involves risk, including the possibility of losing one’s entire investment.