Truly generational buying opportunities coincide with a moment of panic.
It’s tough to time a bottom, and honestly, we don’t need to. I’ll almost never make an outright prediction regarding a market turn on this letter. I don’t need to be a hero, and I would rather get the big picture right for the next decade rather than trying to be something that I’m not - a swing trader. My priorities are as follows.
Priority 1: Don’t blow myself up.
Priority 2: Get the big stuff right.
Priority 3: Make opportunistic investment decisions that have a chance to improve long run returns, reduce risk exposure, or both.
Priority 2 simply means following a Bogleheads philosophy - save a lot, invest for the future, and own different stuff (i.e., diversify). Getting the big-picture stuff right does 90% of the heavy lifting. Everything else gives us the opportunity (but not the privilege) to get there a little quicker or a little richer.
To figure out next steps, let’s take an assessment of where we are.
Taking Inventory
As I write this, the Shiller PE is above 31. Bonds are still yielding almost 4%, and cash is still spitting out 4.5%. The question we should be asking ourselves is knowing nothing else, will I mad at myself for holding fixed income given these starting valuations?
My preferred valuation heuristic is still reading -70 basis points. This has improved from the -200 basis point gap at certain points during the last year. Bonds have now outperformed stocks by 9% over the trailing twelve months. Relative valuations have climbed from the worst quartile valuation levels to the 2nd worst. Historically, even these levels haven’t presented very good expected excess returns for stocks over bonds.
So while valuations have improved, they’re still not screaming “buying opportunity of a lifetime”…not yet.
Already, I think I’m fine still holding a mix of assets.
That’s before we consider the implications of current economic policy.
Tariffs, whether you believe in the strategy or not, will lead to some combination of higher prices or tighter corporate profit margins. Full Stop. If tariffs are passed to the consumer, consumers will consume less. That’s just how demand dynamics work. If car prices go up $10k, more people will opt for maintaining older vehicles, and fewer new cars will be sold.
There’s only one scenario where earnings aren’t coming down, and that’s if foreign suppliers eat the tariff impact, in full. But, just because a business is based in China doesn’t mean that the laws of capitalism don’t apply…they have to turn a profit too.
So we’re left with almost no scenario where earnings aren’t coming down. And if future earnings are impaired, we need to incorporate that into our valuation. Trailing PE ratios don’t do us much good, if future earnings are permanently impaired. If future earnings come down, valuations aren’t as attractive as they look.
I was already on the fence about increasing stock allocation. This just cements it.
Quick Note on Asset Allocation
Before we continue. It’s worth remembering that stocks go up - over the very long term. The very nature of asset pricing defines that any cash producing asset will have some positive return - over the long term. Owning U.S. equities in 2000 had a positive return - over the long term. Japanese stocks, during their height with PE ratios in the 50s, will have offered 2-5% returns - over the long term. This is true as long as earnings and cash flows aren’t permanently impaired. And I tend to lean on the belief that capital markets are more resilient than one administrations agenda.
While markets were frothy leading into this year, they weren’t anywhere near dotcom levels (both on an absolute or relative basis). The most richly valued companies in the world are also of the highest quality. The balance sheets of the Mag7 are nothing short of sterling. Cash flow and earnings power for these companies are, have been, and will likely continue to be “magnificent”.
We may be staring down short to intermediate term market turmoil, but I wouldn’t use this as an opportunity to move away from equities if you already haven’t. And, for those that are decades away from retirement, this presents the perfect opportunity to continue contributions at better entry points. Stocks may or may not be at attractive valuations relative to intrinsic value, but they sure as hell are cheaper now than they were a month ago.
To reiterate Priority 2, above: Get the big stuff right.
Finding a Bottom
Valuations are obviously the ultimate arbiter for forecasting future long run returns. The first tell, for me, will be relative valuations. In order to climb above the median historic levels, US equities would have to fall another 30% from here. Alternatively, bond yields could fall to 2.6% to get us in that range. Some combination of these two is most likely. At either rate, we’d see bonds outperform stocks enroute to more attractive stock valuations.
I don’t necessarily expect this to happen. This is just the scenario, or something close to it, that would need to play out for me to begin overweighting stocks again (moving away from my current neutral-weight posture).
For us to reach truly generational valuations, we’d have to see both - stocks prices falling and bond prices rising as investors run for the hills.
Signs of a Market Bottom
I’m already seeing people declaring now as a great buying opportunity. I’ve seen other posts about “Being Fearful When Others Are Greedy” and “Blood In The Streets”. And while this may actually be a market bottom, I don’t think we’ve started seeing the markers for a truly “blood in the streets” moment.
Here’s what we should look out for.
Things tend to get a little “screwy” at market bottoms.
Frauds come to light
Bankruptcies Spike
This isn’t an exhaustive list. We’d probably also see unemployment spike, credit spreads widening, and yield curve un-inversion as monetary policymakers step in to stop the bleeding.
Bottom Line
Every burst has it’s own spin. Companies are currently in pretty decent financial shape. Even a lot of “crappy” or very high risk companies are strapped with cash. Peloton (PTON) has $750 million in net cash. One of my favs, Quantumscape (QS), has a billion dollars in cash and no debt. I have many worries about Quantumscape; having enough liquidity to make it through the next 2-3 years isn’t one of them.
There’s a lot of debt floating out there, but for the most part, I suspect most companies can weather short term economic bumps. This isn’t something that I’ve explored in great depth, however.
I also don’t think we’ll have a subprime moment. Having gone through the underwriting process during covid for a new mortgage, I was under no impression that corners were skipped, and I certainly wasn’t able to put my dog’s name on the application. Underwriters were checking every piece of paper I submitted.
To conclude, my plan is to let valuations be my guide. And when valuations look attractive AND no one is left buying stocks is when truly great buying opportunities emerge.
We currently have neither. And, we may never get there. And that’s okay. I’m perfectly happy holding a heavily diversified portfolio with very decent forward expected returns.