Are you getting paid enough to risk your money in the stock market?
A recent article in Business Insider interviews a "famous" Wall Street Bear, John Hussman, who argues that we are not only due for a recession, but a doozy of one. He argues that investors are looking backwards too much, thinking about how the market gains over time, historically, and not looking at the present picture.
He makes a compelling argument, that you should buy in times of financial discomfort, and sell in times of financial comfort. Buy low, sell high. And right now, things are high. Which is why I have sold off a lot of stocks (but not all). The other reason, of course, is that I am retired and need the money. So I keep enough for the next 5-10 years in FDIC insured accounts. Oddly enough, some of those are earning more money than my stocks!
I recently raked Sirius XM over the coals once again, and what startled me was not that the company was foundering and losing money, but that it was making money. But what was interesting to me was that the market had bid up the price of the stock to the point where it was not such a great deal for investors.
Oh, sure, if you are one of those people who only looks at share price, and not P/E ratios, dividends, and other "metrics" it may seem like it - and the greater market - are doing well. After all, if you bought at 11 cents a share a decade ago, it is now worth over $6 today! Whoo-wee! But of course, eventually, this era of low interest and low "risk premiums" will come to an end.
Risk Premiums is an interesting term used by Mr. Hussman, and one which investors don't often think about. We want to know what our return on investment will be, but we fail to appreciate what risks are involved. For example, you buy stock in WillGrowCo, and it goes up 5% per annum. That's swell, of course, but then the next year, it goes bankrupt and leaves you with nothing. Having experienced this firsthand with General Motors (and others), I can tell you it ain't pretty. It leaves you with that pit in your stomach.
In short, when you invest, you are taking a risk, not only that the stock may go down in price, that the company may not make profits and may not pay dividends, but also that it may drop down to nothing in price and leave you with zilch. The reason why investors make profits, is that they are taking risks. The higher the risk, the higher the profit should be. Low-risk investments have low profits.
This is a point missed by the far lefties who think "profits are evil, man!" and that there should be no profit for risk-taking. And they think this, because they don't appreciate that people are indeed taking risks with their money, and there should be a reward for that - otherwise, why invest money or loan it out? But I digress, but not too far.
In this era of low inflation and negative-to-zero interest rates, a company with earning of 2.5% and a dividend ratio of 0.65% (as is the case for SiriusXM) doesn't seem all that bad, right? After all, your savings account is paying only fractional interest, and even "money market" accounts are struggling to break 1%. So a low "risk premium" is acceptable, right?
Maybe. Maybe not. The fact that other investments are lower doesn't take the risk away from a risky equity investment. And I am not saying that SiriusXM is particularly risky, only that like all equities, there is a risk involved. And as I noted in my earlier posting, you have to wonder where the company is going with its 8-track technology. Can they jump on the streaming bandwagon or something? We'll see. But getting a lousy 2.5% profit doesn't seem like much of a premium for the risk.
Now to be sure, risk premiums can be adjusted for inflation, and today inflation is at an all-time low. If you are investing in a market where inflation is at 5%, then a company making a 5% profit is really just breaking even, isn't it? But traditionally, companies have made better profits than they are in the present. A P/E ratio of 20 or so (a 5% profit) was, until recent years, considered the benchmark of a company that was doing well. And a dividend ratio of a few percent was considered pretty standard for a company that paid dividends. What changed?
Well, we have the 401(k) generation trying to find places to invest. Suddenly, we are all investors, and we all want to "beat the market" by buying equities and bonds and whatever else promises to make us money. And some folks, who under-saved their whole lives, want to make spectacular returns, and are willing to throw money at junk bonds and junk investments, on the promise of a spectacular return. So the market is overheated - people are bidding up the prices on equities to the point where they are "meh" deals - much as the housing market has been bid up, yet again.
And I guess that illustrates the point - we've been through this before, not ten years ago. Usually the market cycles every 18 years or so, but it seems today, it is cycling faster and faster between boom and bust.
There are, however, some caveats. The current price of stocks represent only what the "last guy in" paid. So, for example, if you bought SiriusXM back in 2009 for 11 cents a share, the earnings-per-share today of 20 cents seems fantastic - even accounting for the inflation-adjusted cost of what you paid for those shares. Once again, old people win. I hang on to some stocks, not because their current P/E ratio or EPS or dividend ratio is all that great, but because based on what I paid for the stock a few years back, it is a rock star. The fact the market over-values the stock today is really not that important. If the stock drops to half its value, it still is a gain for me.
(And maybe that is how it always is. Young people, being new to the market, have to buy at higher prices and take more risks - which they can afford to do, as time is on their side. Older people, having bought in years ago, are in a less risky situation, as their "risk premium" relative to what they paid for a stock, adjusted for inflation, is much higher).
Of course, you could make the argument that there is an "opportunity cost" to this - I could sell the stock with the current low P/E ratio and buy something more attractive. But again, in this economy, what would that stock be? Everything, to me, seems quite overpriced right now. Why would I risk losing my life-support-system in retirement for a paltry 2-3% gain?
And that was the point of the article - that when market conditions change, what is deemed a "good return on investment" can change overnight:
"A market crash is nothing more than a period where low risk premiums are pushed abruptly higher," Hussman wrote. "For that reason, the combination of thin risk premiums, increasing risk-aversion, and upward yield pressures is the single most negative set of conditions an investor can face. Ignore this paragraph to your detriment."
So, rising interest rates, rising inflation, and rising T-bill rates could cause investors to demand better returns on their investment - to maintain the same "risk premium" as before. Why risk your money in stocks for a paltry 2.5% return when a T-bill is doing as well or better?
We'll have to see how this plays out. But I suspect the era of low rates-of-return and low risk premiums may come to an end shortly.