“When you arrive at a fork in the road, take it.”
Yogi Berra could have been recommending an investment strategy. Everyone is desperately trying to collect some yield while they watch from the sidelines, uncertain which fork in the road to follow.
Despite how funny Yogi’s quote is, we also know it is darn good advice. Uncertain about which way to go, we also know that in order to move along we must choose. With little or no intelligence about what lies beyond each option, there’s at least a 50% probability we might not like where we end up. Worse, both options might turn out really bad. Optimistically either fork might miraculously take you where you’d like to go.
Frequently, but especially right now the investment community will find itself confronted by a fork in the road ahead. There are more sophisticated models (maps) designed to help determine investment strategy than there are armpits in the world, but alas most of them will arrive at the same useless result (“take it”) as my simple back-of-the-envelope model.
A ridiculous simplification I admit, but isn’t the stock market just a bunch of businesses that earn money? And by far the most influential variable is the expense (rate) you must pay to use money, which then is invested in labour, plant and equipment etc. (You know the drill).
Let’s assume (remember the quote from Siege 2? “Assumption is the mother of all….”) that the trailing earnings for the S&P 500 for the last 12 months will not grow or decline. The question one might pose is how much would you pay for those earnings if you knew with certainty they’ll remain the same over every one-year period forever? It would depend on the rate of return you’d expect is reasonable (based on the cost of using money). After all, you could do other things with your cash.
Below is a table of values for the S&P (and the S&P/TSX for the Canadian market) that summarize what I’m getting at.
The bottom table reflects the change (from current levels) in the potential price indexes (gain or loss) depending upon what rate prevails as the ‘cost’ of using money.
If the general level of interest rates began to rise, despite promises by governments that interest rates will be held steady, equity risk is certainly skewed to the downside.
The fork in the road?
- LEFT: If financial turmoil continues unabated and rates remain extremely low, things could go very well for the stock markets, especially if earnings growth were to surprise on the upside (remember, we assumed no earnings growth).
- RIGHT: Even a modest rise in rates will create havoc. Earnings would be dampened which would likely make matters even worse.
So take it!
Helpful story? I was asked to do a forecast at a Chartered Financial Analyst society dinner years ago. In order to make it entertaining, I asked the audience to put their hand up if they believed the market (sluggish at the time) would go up? One hand only was raised (mine). However all the hands went up when I asked if the stock market would end the year lower. A diehard contrarian, I sensed the consensus must be wrong and predicted a strong market for the year (+20%) – and it turned out correct within a few points. Moral of the story? If everyone is bearish, which seems to be the case at present…..take the other fork. Tends to work better than any model I’ve ever come across.
And besides, there’s plenty of reason to expect interest rates to remain where they are (the fork on the LEFT) especially in the U.S. where all the action will be:
I just have to add a comment I received from Chris Ford (a very bright Associate Investment Advisor) that uses another Yogi quote to express the same sentiment I babbled about in a prior posting (Is the end near? For yield it just might be!):
“My favourite Yogiism could be applied to the fixed income market: “No one goes there nowadays, it’s too crowded.”
Here’s proof that as ugly as I am, I do clean up real good…
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