Fear is the most powerful weapon in war. Hitler deployed buzz bombs against London in an attempt to destroy resolve and heighten fear during World War II. It nearly worked, if not for the even greater resolve of the British people and their leader, Winston Churchill. 

Fear is such a powerful weapon that nations will go to great lengths in war to manipulate the news reaching the people. During World War I, only Spain had a reliable free press reporting the deadly flu ravaging troops and populations. No army wanted the world to know they were taking heavy causalities from what would later be called the Spanish Flu. Yet every nation, on the battlefield and at home, were taking a hard hit from the disease. The U.S. was particularly hard hit. But when the absence of daily news on the deadly flu was only to be found in Spain, it was felt it the virus originating there. The truth was far from it.

Today we are facing a similar, though less deadly, threat, and the disinformation machine is in high gear. This time the media seems to want fear cranked to the highest level.

 

Washing your hands with soapy water for 20 seconds or longer is the most effective way to prevent the spread of the flu virus, even better than hand sanitizers.

 

Since I have no formal medical training I will leave the medical advice to those qualified to give it. What I can do, as an accountant, is reveal the truth behind the never-ending statistics and how they have been manipulated to scare us at the highest level. COVID-19 is a serious health issue without a doubt. It spreads easy and fast with a heightened risk of death. These simple facts make it easy to scare people into clearing their savings account to stock up on toilet paper and other essentials. 

The level of fear has filled my email box from clients and readers worried about the state of affairs and how it will affect their finances. I have worked hard on social media to provide a steady voice in the whirlwind of conflicting data. It is time I issued a formalized response here to the elevated levels of fear people are experiencing and the risks people face with their investments and personal finances.

Understand, this post is not about specific advice: buy this, sell that. Rather, my goal is to help you control your emotions and control your response to fear mongering and market unrest. That is where real wealth creation finds a home. Buying the right investment does no good if you panic sell before value has been realized. Buying high to sell at a panic low is the surest path to poverty. With new feeds bloated with coronavirus articles it is easy to start thinking the world is about to end. I will show you below, nothing is further from the truth. This has happened before and we know how it ends. (SPOILER ALERT: It will pass and most people will be unharmed. Even the economic damage will be less than expected and will return to normal in a matter of time. It will later be determined that fear caused more damage than COVID-19 did.)

 

A Short History of Pandemics

Human history is filled with pandemics. Until modern times, diseases ran their course with little effective intervention from doctors. Illnesses ran their course and eventually died out. 

The common cold, flu and similar illnesses are also common throughout history. The 1918-19 Spanish Flu was a particularly nasty one. As many as 50 million people died. 

Things were different in 1918-19. World War I was coming to an end. Governments involved in The War to End All Wars kept the flu numbers a secret so as not to encourage the enemy or demoralize their soldiers in the field and the folks back home. Only the free press in Spain reported on the people getting sick and the number dying. That is why some thought it started in Spain, hence the Spanish Flu designation. (It didn’t. It probably started in northern China in 1917.) 

Pandemics of the past, even those from less than 100 years ago, had less economic impact than today. Supply chains now span the globe. Never before have businesses been so integrated and international in scope. Pandemics of the past killed and sickened people; COVID-19 is also wrecking havoc on the world economy.

Until recently, a nasty flu season was the only way anyone knew something was afoot. Modern medicine gives us a jump start on what to expect. We knew COVID-19 was headed our way because China alerted the world to the pending virus. SARS, the Swine Flu and the H1N1 variety of flu in 2009 are modern examples of pandemic scares. Most of these viruses never circumnavigated the globe, dying somewhere along the way.

And we come back to the Spanish Flu. Somewhere between 20 – 50 million people died from that flu. It came in three waves with the second being the worst. Then it just disappeared. Nobody knows exactly what happened, but the flu virus probably mutated again to a less deadly form. Doctors didn’t discover a cure, social distancing wasn’t a thing and unless you were sick in a hospital it was unlikely you were even quarantined.

The Spanish Flu did have one nasty trait that put it into the history books. Normally the seasonal flu kills the old, very young and those with a compromised immune system. The Spanish Flu killed adults in their prime; the people who usually get sick for a week or so at worst during flu season, but almost always recover. 

And that is the first problem with the fear surrounding COVID-19: it generally kills older people, similar to the normal seasonal flu. The very young are spared with only a few healthy adults susceptible. Those over age 60 are at most risk.

 

Unfounded Fears?

COVID-19 is a nasty flu bug for sure. It spreads very easy and has managed to circle the globe rather quickly. It also makes people very sick that normally only get mildly sick from the flu. Older people face a very high risk of death if they contract COVID-19.

The fears are not unfounded, but are exaggerated. The response has been way overblown compared to the risk profile of the disease. Let’s place this into perspective:

As of this writing, 7,158 have died with COVID-19. Read that last sentence very closely as it will be important in a bit. Here are the current numbers

No one is advocating clearing the roads due to the risks of driving. Many still smoke tobacco and eat an unhealthy diet that increases the risk of cancer, heart disease and stroke. Yet, one of the smallest risks of dying to-date is causing a panic.

HIV/AIDS caused fear, but no panic. All the mortality risks listed above are a concern, but not at a level that should be disruptive. So what is causing COVID-19 to create such disruptive panic?

First, when the seasonal flu is with us every year and tens of thousand die from it we adjust to the risk as a normal part of life. COVID-19 is new, novel. Novel in this case means people do not have a natural immunity to the virus yet. 

Second, COVID-19 spreads fast and very easy. People have not had time to adjust.

Third, people who normally do not die from the flu are. Not like the Spanish Flu, but an elevated percentage of healthy middle age people are dying from COVID-19. 

All three combined has caused rampant fear. New, fast and potentially deadly to people who normally do not fear the flu has generated panic. Then people extrapolate the numbers to the entire world population and get dizzy. Except it is a massive misrepresentation of the facts.

 

Misleading Numbers

News reports and press releases from world health organizations are very careful how they word their press releases. Mortality rates are extrapolated by the public from the fancy representation of the numbers, but the extrapolations are far from truth. 

People dying with COVID-19 are reportedly as high as 3.84%. When people read this they think it is the mortality rate. It isn’t.

Not everyone is tested for the virus. Those most ill are more likely to be tested and all people who are reported to have died with COVOD-19 have been tested. (Otherwise how would they know they died with the virus?) This leads to a misrepresentation. If only sick, or potentially sick, people are tested, the number that die from the virus is pulled from a population likely to have contracted the disease. That is like using a test from people likely to have cancer as a representation of the entire population’s cancer mortality risk. The mortality rate for COVID-19 is likely under 1% and even lower for the population at large. Only time will give us an exact, or close to exact, number. Using the data available, COVID-19 is more deadly that the seasonal flu most years, but not anywhere near as deadly as the Spanish Flu.

Another misleading statistic comes from the wording in news reports and press releases from health organizations. They are careful to say someone has died “with” COVID-19 rather than “from” or “because of” COVID-19. This is a serious reporting issue.

Think of it this way. If someone is healthy and contracts COVID-19 they might have mild or no symptoms. But if they die in a car accident before the virus is cleared from their body they died “with” COVID-19. The virus had nothing to do with the death, but is recorded as a disease that the person had when they died. 

It is not uncommon for someone to have several contributing factors to their death. Rarely, if ever, do we medically say someone dies of old age. Instead, we list a variety of ailments that contribute to the final cause of death. Cancer and pneumonia  are common causes of death in people over 80. The flu is also a big contributor. Somehow we can’t bring ourselves to say they just got old and died. We need a reason. And that can lead to problems at times like these.

This counting of every death where COVID-19 is present misrepresents the full facts. The patient may have died from other causes at the same relative time anyway. This happens when people get old, and COVID-19 strikes hard at the old, as do many flu strains. This misrepresentation allows for an inflation of the COVID-19 numbers which heightens public fears.

 

Emotions in Check

People at risk need to take precautions. Because young people can carry COVID-19 without getting seriously ill, it is important to take steps to prevent the virus from infecting older family members inadvertently. That is the real risk with COVID-19; the unknown causing fear.

It is proper to take a break from all but necessary gatherings. The economy will take a short-term hit. It is scary, but not as bad as the media would have us believe. Social media blows it up even worse that the traditional press. Shame on us!

In the modern world this means supply chains will be disrupted. Business will slow and some industries will be very hard hit. The stock market is predicting a doomsday scenario.  It isn’t that bad! For those who are patient and control their emotions, now and in the near future is a good time to increase equity holdings. Keep adding to your retirement plan at work. Dollar cost averaging only works if you keep the regular investments going when the market is down, too.

I know it looks bad right now. Not everyone will contract COVID-19. Most who do will only experience mild illness. The older you are the more important it is to seek medical attention as your mortality risk increases rapidly with age. 

The way the numbers are playing out the number of deaths from COVID-19 will be somewhat higher than a normal flu season. However, the fear it induces will keep more people at home and off the road. It is possible the fewer number of people who die in road accidents as a result may be more than all the deaths attributable to COVID-19. 

That would make this the first flu strain to reduce the number of deaths by a greater number from other causes than those who die from the virus. Technically, a negative death rate. Again, technically, all factors combined, it could be the least deadly flu strain since the invention of the automobile.

It’s all a matter of perspective.

 


 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

There is an adage on Wall Street many have repeated over the years and more so in the last month:

BUY THE DIP.

What so many forget is another Wall Street adage similar to the first:

BUYING THE DIP WORKS UNTIL IT DOESN’T.

I have warned this is not over yet so don’t get too excited about buying the first decline.

My opinion is unchanged. Unless something drastic changes, the events put in motion will play out until their logical end (the end all panics end in).

Most readers of my blog have never experienced a prolonged decline in many markets at once. It has been 12 long years since things were really ugly. This will be the first REAL test of the FI and FIRE communities. Unfortunately, most leaders in these communities have also never experienced a real market panic when they had meaningful money invested.

By now I hope I convinced all of you to never invest with borrowed money. If you followed this advice it will only be a time thing before normalcy returns. Before the clouds clear, however, the news feeds will be littered with end of the world predictions. Unemployment will rise, markets will fall, the economy will slow or even decline. This has all happened many times before.

My advice to you, kind readers, is turn off the news feeds. The coronavirus will be fine without you watching its every move. Oil prices are going to decline heavily. Enjoy even cheaper gasoline prices in the interim.

If you didn’t sell at the high (you didn’t) don’t try to out guess the market now. Stand pat. Let the world around you panic as it always does. You, my good friends, are smarter than that. You will not be moved by a decline in your investment account balance. That is only a temporary thing unless you lock in the loss.

I was beginning to believe the coronavirus was the black swan event that would finally trip up this long bull run. It seemed strange because the coronavirus is bad, but not that bad. The economic damage could be sharp, but short lived.

The oil price war between OPEC (mostly Saudi Arabia) and Russia is the real black swan event I was waiting for. This has a real risk of causing serious damage.

If oil prices stay where they have fallen to (I’m writing this Sunday night, March 8th, 2020 when oil prices dropped into the upper 20s and gasoline futures dropped over 20 cents a gallon), U.S. shale companies are in deep trouble with massive debt and no way to work out of the problem. 700,000 jobs are on the line and several million more in halo industries serving the U.S shale oil industry.

Not all these jobs will be lost. But if even a reasonable percentage are lost the decade long economic expansion will come to an end.

Remember, the end of one economic expansion only paves the way for the next leg up.

I don’t know where the next economic advance comes from, but there are some strong indications. In 2008-09 shale oil was the one bright spot in the economy as oil prices were high. Oil will be an economic drag this time around.

Where will the next massive spike in economic growth come from? I have several guesses. Elon Musk made EVs cool and reliable. I expect the next economic surge will include a massive transition from ICE vehicles to EVs.

Solar, wind and other alternative sources of energy have the promise of huge economic growth. Even larger economically is storage technology. Batteries and other storage technologies for solar and wind will be nice areas to watch in the decade ahead.

After all this time the final frontier might be the biggest source of economic growth going forward. Virgin Galactic, SpaceX and Blue Origin will compete for space travel dollars. Space holds the promise of opening an economic boom never witnessed before.

So when the news feeds tell you the world is coming to an end, don’t believe it. None of this is new. Old guys like me have seen this before. The history books go even further back with stories of boom and collapse. It is the nature of a capitalist system. You have to take risk to build a better tomorrow and sometimes that leads to some short-term pain.

Stay well, my friends. And vigilant. Fear will rule in the weeks and months ahead. Do not allow your emotions to rule your common sense.

 

Note: I originally wrote this for a Facebook post for my followers. I removed that post shortly thereafter and pasted it into this post. I felt it was too important to leave this as a social media post that will gallop into the distance rapidly. 

You can read more about past market panic in this book. 

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Summary

  • 50% gains possible according to Buffett in arbitrage situations Altria potentially has.
  • Scott Gottlieb has a conflict of interest when it comes to Juul.
  • Altria has a large arbitrage situation currently overlooked by many investors.
  • A Peter Lynch style analysis reveals unrealized value in Altria.
  • Earnings should provide more clarity on how fast this unrealized value is reflected in the stock price.

Warren Buffett made one of those extraordinary claims that require extraordinary proof in a 1999 interview with BusinessWeek. He said investing large sums is a lot harder than investing, say, a million dollars, where he felt he could generate 50% annual returns. Then he corrected himself and said he guaranteed he could do it.

Fast forward to modern times where Buffett has passed at least one rein to younger people to help him invest the massive pile of cash at Berkshire Hathaway (BRK.A). He said he didn’t place any significant restrictions on their investments as long as they didn’t get him in trouble, like buying Microsoft (MSFT) or tobacco companies like Altria (MO). (Buffett is a personal friend of Bill Gates, founder of Microsoft, and could have a conflict of interest if he invested in Microsoft. Buffett worries an investment in a tobacco company would harm his reputation.)

Buffett’s wisdom is legendary. In an interview I once heard him say when asked about tobacco companies: The product costs a penny to make and it’s addictive; What’s not to like?

Indeed! I believe Buffett avoids Altria mostly for reputation reasons. Most readers here, however, are interested in maximizing wealth and are unconcerned with owning oil, automotive, chemical or tobacco companies, as long as they are conducting business in a legal manner.

 

50% Gains

So how would Buffett achieve 50% gains with wealth levels readers here actually possess? 

Buffett said he would look for arbitrage situations to capitalize on. This would mean scouring small companies with hidden value. Of course, this would be a full-time job. But hey, if you can pull a clean half mill a year it might be worth the effort.

If you are allergic to those levels of research there is an easier way if you are willing to earn an above market average, but probably less than 50% annually.

The market is at lofty levels as I write. Most listed companies are trading at nosebleed levels. Unless you are willing to consider the damaged (Boeing (BA) might be on your watch list) or the hated, you are stuck doing the research or accepting market returns, wherever that leads from this market level.

Altria has been a portfolio holding for me for a very long time and it has served me well. Before Buffett asked, What’s not to like? I already knew I liked the company, even if I never use the products. 

Holding Altria for such a long time means I have spent considerable time researching the company. I was there when the world was coming to an end for tobacco in the 1990s due to the massive settlement. 

It seems Altria (and tobacco in general) loves to go into a tizzy every so often. It makes for awesome buying opportunities where the stock price is lower and the dividend yield is higher. Rumors of tobacco’s death are greatly exaggerated. 

Altria is starting to exit one of these “end of the world” scenarios again. The Juul/vaping scare was worse than the damage done in the 1990s when there was a real existential risk.

Of course, there is plenty to worry about. Juul isn’t working as planned. (When does business go as planned?) And cigarette volumes are in a long-term decline. 

Altria does have something Buffett salivates about: pricing power. Altria is likely to increase prices faster than consumption declines. That means more dividends for patient investors.

Juul isn’t dead either! Yes, there are serious problems with getting the Juul transactions approved and Juul is dealing with litigation issues and a declining market share and increased regulations. The Juul approval is more a matter of time and what changes to the deal the government will require rather than a deal that will end up in court or unwound. 

Vaping isn’t dead either! Growth in vaping has slowed. But if you looked at the vaping growth rates a year ago it was obvious growth rates had to slow. Juul was on pace a year ago to be bigger than the entire U.S. tobacco industry in less than 7 years. Reference Stein’s Law: Anything that cannot go on forever, doesn’t.

Health issues surrounding vaping was not due to Juul products. Illegal street vaping pods, usually involving THC, were the chief culprit and maybe the entire culprit.

Juul’s market share has declined from over 80% to ~60%. However, vaping has continued to grow so Juul is getting a smaller piece of a larger market. Like it or not, vaping is the future of nicotine consumption.

 

Scott Gottlieb’s Conflict of Interest

Scott Gottlieb, the former commissioner of the FDA, has managed to get himself a cushy job at Pfizer (PFE). Gottlieb has made it his mission to bad mouth tobacco, but has a special hate for vaping and Juul, the leader in the industry. Now why is that?

Well, vaping has the real possibility of reducing tobacco use and is partly responsible to the increased rate of decline in cigarette use. Gottlieb should be happy with that, but seems to hate the good news. What gives? First, Gottlieb works for Pfizer now, which sells the leading smoking cessation product, Chantix. It becomes clear quickly why Gottlieb is more addicted tobacco than an 84-year-old chain smoker once you realize his income stream is at risk if smoking rates decline too much or too fast.

Second, Chantix is reported to be no better than nicotine patches. Nicotine patches are cheaper than Chantix with fewer side effects. Gottlieb doesn’t seem to want to address this issue during public interviews. 

Third, Pfizer has been busting tail to get a serious warning label removed from boxes of Chantix. Gottlieb took care of that problem promptly once he was working for Pfizer. I’m not saying Gottlieb did anything illegal or unethical. I’m just saying the circumstances does lead one to wonder.

Once you consider Gottlieb’s past with his comments, it becomes clear he likely has an agenda that might not jib with reduced cigarette smoking rates. When regulators and investors realize Gottlieb seems to be encouraging more tobacco use to benefit his employer’s bottom line, his crusade against vaping declines.

 

Hidden Treasure in Altria

I don’t know if Warren Buffett could actually deliver on his promise of 50% annual gains. I do know that arbitrage is an excellent way to spike your investment returns.

A Peter Lynch style review of Altria reveals massive unrealized value. It is easy to forget Altria is more than cigarettes. There is a dash of wine in the portfolio, non-combustible tobacco products, Juul, Anheuser Busch inbev NV (BUD), Cronos (CRON) and on! Nicotine Pouches in the product line as well. 

Let’s take an impossibly negative approach to Altria and see if the company survives or is loaded with large hidden treasures. 

For starters, let’s value Juul at zero. I know, I know. It is worth at least something, but we take no prisoners around here when we tally up a business’s valuation under a worst case scenario. 

Next we gut Cronos’s value and place it at zero, as well. In fact, let’s just value everything outside tobacco at zero, with the exception of BUD.

Altria owns 10.1% of BUD, with a valuation of ~$14 billion as I write. 

Altria has a market cap of ~$95 billion. If everything they own is worth nothing, except for the investment in BUD, which has no restriction on the holding starting in 2021, Altria has a core valuation of ~$81 billion. 

This valuation is for a company kicking out over $7 billion in cash flow without help from Juul! 

And let’s be honest, all that other stuff Altria owns has some value. How much is still to be determined. That is how it works with businesses. Value has to be created to be realized. (Remember the formula for value creation: Return on Invested Capital (ROIC) minus Cost of Capital (COC). A positive number is value creation.)

What we do know is Altria’s core business is kicking out loads of cash to pay down debt (on the 3rd quarter earnings call Chairman Howard A. Willard stated Altria paid down $1 billion of debt in the 3rd quarter and planned on paying down a similar amount in the 4th quarter of 2019), buy back stock, pay dividends and grow the business. 

 

Earnings Report

Altria’s upcoming 4th quarter 2019 earnings report will clarify some of these issues. I am interested to see how much debt was actually reduced. I also want to see how cigarette volumes are holding up and if we will have two or three price increases in 2020. 

Juul is the unknown. Will more write-down be in the cards? My gut tells me things are stabilizing at Juul, but gut is not an acceptable investment tool and has a poor track record. Cronos still has a lot of work to do to reach profitability.

A bright spot is the non-combustible tobacco products. Chew has been growing, but is still a relatively small part of the business.

What interests me more than any other product is iQOS — the heat, not burn product — licensed from Philip Morris International (PM). FDA conditional approval is a significant advantage Altria received in 2019. iQOS is rolling out in a measured fashion as you read.

The future of tobacco is in the non-combustible, reduced-risk products. Wouldn’t it be a kick if Altria found serious value in iQOS instead of Juul?

Either way, I think there is massive hidden value in Altria. With such a diverse mix of products, Altria is well situated to keep pumping out large, growing dividends for a long time to come. 

Unless you have a convincing argument people will quite smoking tobacco and using weed, chewing, vaping and drinking beer and wine, I think Altria has a bright future.

 

* Notes: As longtime readers of this blog know, I own shares in Altria and use it as an investing test model. Originally written for Seeking Alpha, this post provides an update on my reading of the tea leaves. I still own and plan on continuing to own shares in MO and PM. I own a small amount of BA and MSFT as part of my watch list. I do not own shares of other companies mentioned in this post at this time with no plans to open a position either.

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Find under-valued stocks for high profits. Use the most hated stocks for the best investment returns.Jack Bogle gave us the index fund. Warren Buffett has said most people should put their money into index funds.

Personal finance bloggers—especially in the FIRE* community—spout “index fund” like it’s a nervous tick. And you might have noticed this blogger has the same nervous tick.

Some are worried about all this index fund investing. The concern is index funds will control so much of the market that it will lose its efficiency. I remember the same concerns in the 1990s, when I was a stock broker, about mutual funds in general, most of which were actively managed.

Index funds will not break the market any more than actively managed mutual funds did. For one, there will still be plenty of people investing in individual stocks. And the hedge fund guys will do their share providing liquidity.

Index funds are automatic investing. All mutual funds and ETFs for that matter. You drop in your money (dollar cost averaging is suggested) and let time perform its magic. The broader based the index fund, the better your chances of enjoying the stellar performance of the market averages.

But some people don’t like “average”. And even the most hardened index fund investor periodically finds a company she would like to own a piece of directly.

That is where we come in today.  Finding a gem that can add to your portfolio’s performance isn’t easy, but possible if you know where to dig. Many have made a career out of beating the market with thoughtful investments. 

Index funds should be the home for a good chunk of your money. However, you might have a mad money account or even a serious money account for investing in businesses you feel are under-priced while possessing future growth potential.

Investing in individual companies can be very rewarding, but carry significant risks. I’ve been fortunate in finding great businesses that have performed well over the decades. My individual stock investments have outperformed the market. I’ve also noticed I think differently about an investment than most. 

Today I will share why I buy what I buy, and more importantly, why I pass on so many opportunities that seem so obvious. 

 

Buy the Hated, Be Leary of the Loved

Most people buy the hot stock because everyone is doing it and the recent price action has been tilted steeply up. These are the loved stocks. In the early 1970s they were called the Nifty Fifty; we now call them FANG (Facebook, Apple, Netflix and Google, the parent company of Alphabet) today. 

Buying hot stocks is easy because everyone is doing it. That always causes me to pause. 

For disclosure, I own one share of Facebook and a modest amount of Apple. I never owned any Google stock, but had a brief fling with Netflix.

Most loved stocks are priced accordingly. While I do own some shares of FANG companies, they are not predominant in my portfolio. 

Let’s do a brief rundown of the list. Netflix is sporting a 134 price/earning (p/e) ratio as I write. While NFLX has a dominant market share and there are reasonable barriers to entry from competition, NFLX faces stiff competition from Apple and more importantly, Disney. NFLX doesn’t have to fail to drop significantly. If Disney captures even a small slice of NFLX’s business the stock is in trouble.

Google is also richly valued at over 40 times earnings. Facebook is a company I want to own, but management is concerning. FB has a dominant platform and not much in the way of competition. When FB dropped below 130 in December, the margin of safety was large enough for me to buy. But it was a modest investment. 

Apple is a story we’ll address shortly.

I’m not saying there is never value in popular businesses. What I am saying is they tend to be over-priced. Warren Buffet once said he preferred a great company at a good price than a good company at a great price. Think about that for a moment.

NFLX and GOOG are excellent businesses, but are difficult investments to make at the current price. You don’t buy a great company at any price! You want to buy great businesses at a good price (or better) with plenty of margin for safety. Things do go wrong, you know.

Another area I tend to avoid are the socially acceptable investments. Everybody wants to invest in green companies these days. As a result, all that extra money is pushing these investments to levels too rich for this accountant’s blood. There can be select quality investments in this area, but none of it is cheap.

Since investing is about making money and not some ethical or moral statement, I seek value where others tend to avoid. Think of the most hated stocks: oil, coal, tobacco, processed foods.

I don’t own Exxon-Mobile (XOM), but I did take a look-see. As longtime readers are well aware, I own a lot of Altria stock, one of the largest tobacco companies on the planet. This is a good place to start our research on what makes a business worth buying.

 

Anatomy of a Good Investment

I think it was Warren Buffett who said, “It costs a penny to make and it’s addictive. What’s not to like,” about Altria (MO). In my opinion, Buffett would own a large slice of MO if he didn’t have a reputation to uphold.

Peter Lynch, in his book Beating the Street, shared his wisdom with a set of principles. Peter Principle #14 said: If you like the store, chances are you’ll love the stock. While Lynch is a legend in the investing world with a whopping 29.2% average annual return (better than Warren Buffett’s) when he managed Fidelity’s Magellan Fund from 1977 to 1990, there are times his principles are not hard and fast.

Use the secrets of hedge fund managers to find hidden gems in the stock market. Buy before the stock moves higher.Take, for example, Amazon. AMZN is a great company with great management. I love the company and buy plenty of stuff from the platform. Unfortunately, the stock price is not so great. Buying even a great company with great management at nearly 100 times earning is a serious risk. AMZN is a great company, but probably not the best investment for me.

Which illustrates a point. I don’t smoke. Never smoked. But I do love MO as an investment. Their track record is unbelievable and they are doing it in a shrinking industry. 

Still, my purchases of MO slowed these past few years. The price was a bit high for the situation and the 30 years of a declining cigarette market was starting to look problematic. True, MO has the world’s leading cigarette brand in Marlboro and are one of the best managed companies publicly traded. Management loves rewarding shareholders which is also a good sign.

The declining market size didn’t concern me the most; competition did. Peter’s Principle #16 says: In business, competition is never as healthy as total domination. I agree. And MO was facing serious competition for the first time in decades from a new foe: Juul.

Vaping isn’t exactly the most loved industry either. However, vaping was taking market share from MO and it was starting to move the needle. MO made attempts with their Nu Mark product to no avail. Juul was taking over the vaping market the way MO took over the cigarette market. And the regulatory environment creates plenty of barrier to new entrants.

What turned me the most positive on MO in my life was the 35% purchase of Juul. And the best part is vaping costs less than a penny to make and is also addictive. (MO also invested in a Canadian marijuana company.)

My greatest excitement with Altria is the potential size of the vaping market. When you review the numbers it is not hard to see Juul could be a larger company than MO. And more profitable due to the lower taxes on vaping products. 

Excitement is not a good thing when investing! Boring is best because this is going to be a long slog. Patience is the most important quality when investing. I bought my first shares of the now Altria in the early 1980s. If you reinvested the dividends, MO was one of the best performing stocks of the last 30 years. And you enjoyed a couple of profitable spin-offs along the way. 

Here are the things I looked at when purchasing more MO in December and earlier this year:

Is there an existential threat? 

The massive investments MO made in late 2018 required review. The question has to be asked: If the government shut down Juul today would if put MO at risk of collapse? 

After researching the issues it became clear the answer was “No”. If Juul went out of business MO would lose their $12.8 billion investment. But(!), this would not be enough to cause a dividend cut. Dividends would climb slower, no doubt, but the enterprise would continue. Also, if Juul disappeared, the people using the vaping products would probably turn to cigarettes for their nicotine fix, which MO has a dominant share of the market.

What about debt?

All else equal, I prefer companies with less debt. MO certainly has debt. The debt they issued to buy Juul will increase interest expenses. MO management said cost-cutting would be enough to offset the entire additional interest expense. Very encouraging. 

An over-leveraged company should be avoided as the risks are too high. The balance sheet should provide all you need to determine the debt level the business has.

Everybody hates it!

MO’s stock took it on the chin as investors hated the Juul investment, at first. For a brief moment I was able to buy a great company in a hated industry that was hated by even its own investors. And there was nothing to warrant such a response. Yes, MO paid plenty for Juul. However, looking at Juul’s growth, the price will look like the steal of the century in less than a few years. So I backed up the truck. Now my dividends are even higher.

Financials?

You do not need to be an accountant or tax professional to read a public company’s financials. But you do have to read them. Let’s take a look at MO’s balance sheet.

 

 

The balance sheet is the most important financial to review. (The cash-flow statement is a close second.) Income statements can be cooked, if you will. The balance sheet tells me how solvent the firm is. It also tells me if a recent investment creates an existential threat. 

As you can see, MO has reasonable amount in cash and investments in other companies. If MO sold all investments in other companies they own for the price they paid they would have enough to retire all debt. MO investments in Juul and ABInBev are solid investments so they probably could sell these investment holdings at a profit. But we’ll discount some of these investments anyway to pad our safety margin.

When you review MO’s cash and investments against it’s debt and consider the shareholder’s equity, it is easy to see MO is not facing an existential threat due to their Juul investment.

One thing to note. The reason for the large negative number for Treasury Stock is due to share buybacks.  This is not unusual.

 

A Few More Investments

As I noted in the beginning, I have a large share of my liquid investments in index funds. My retirement funds are almost 100% index funds or cash. My non-qualified monies (money in non-retirement accounts) are partially in index funds; a large portion is also in individual stocks. Buying good companies and holding them for a long time by default will increase the percentage not in index funds.

Apple is one of my newer investments. I will not provide financials as I did for MO. You can see Apple’s financials at CNBC

I prefer buying when a company is on sale. December last year when the market was down ~20% had me buying heavily. APPL has been in my portfolio for years and I added to it. I never used their products so I didn’t know if I’d love them or not, but I am fully aware of the cult status Apple users feel about their Apple products.

APPL is a popular FANG stock so it might be something to avoid. Except, the stock price increase was accompanied by increasing earning, low debt, loads of cash and stellar management. Of all the FANG stocks, APPL has the best management team. 

If you take the cash and subtract all debt, APPL still has ~$35 per share in cash! This means the p/e ratio is lower than listed. In other words, the enterprise has a 13.74 p/e ratio on it as I write. This is more than a reasonable purchase price for a company in a class by itself and a cult-like following. Though, I would prefer it “more” on sale before buying more. 

 

Knowing When to Sell

Selling can be harder than buying. Even the world-renown Warren Buffett, who says his favorite investing horizon is forever, sells investments periodically.

Even your favorite accountant has sold a few shares of his beloved MO in the past.

Let’s take an example of why selling is different than buying. Buffett’s fourth largest holding is Coca-Cola (KO). He bought KO in the 1980s (if memory serves) and has held it since. The dividend is solid and growing. 

Learn the secrets of buying under-valued stocks before they are discovered. Buy your investments on sale for quick profits.If you looked at KO today (a hated stock because they sell sweet drinks bad for teeth and accused of causing obesity) you would probably take a pass. The company is awesome with an awesome product and solid management, however. KO is dominant in their industry. But where is the growth coming from?

KO has a lot in common with MO. People are drinking less fizzy soda water and the world population is no longer growing fast enough to power profits higher. Unlike MO, KO can’t raise prices as easily. 

That said, If I owned KO I might not sell it. (I owned KO from the mid-80s to the late 90s.) The financials don’t excite me enough to buy a piece of the company. However, selling doesn’t make sense either. Selling would cause a serious tax bill if you held the stock a long time. And dividends like that are hard to come by.

When I sell it tends to be early on. If my original premise starts to erode I sometimes exit the investment. I bought Tesla and eventually sold. Of course I look smart because the stock was straight up at that time. However, my investment was more along the lines of keeping an eye on the company rather than a new serious investment position. The issue: Tesla without Elon Musk is in big trouble and they might be in big trouble anyway. I consider that a management issue in a very competitive market getting more competitive by the day.

When Facebook did a Faceplant in December, I bought. After considerable thought I came to the same conclusion about management and sold. 

Like Buffett buying KO, I bought Aflac (AFL) in the B’C.’s (actually the early 1980s) and held it ever since. I haven’t bought more in longer than I can remember. The dividends are climbing and it has been a good investment with a very accomplished management team. I looked at AFL recently (for this article) to see if I should buy more. There are certainly reasons to buy, but not enough for me to add to my position.

Certain things will have me selling fast. Hints of accounting irregularities are usually a sign to exit. If new management is failing, I leave. (I owned GE once upon a time and sold all of it because I had no faith in new management after Jack Welch left.) 

 

Waiting List

Patience is key to winning at investing. You wait for the right deal, then buy and wait forever as the business value keeps climbing. The stock price and dividends soon follow.

Finding a list of “hated” companies is easy. I want big, dominant companies in my portfolio. This reduces the chance of catastrophic failure. A good example is Boeing (BA).

BA is one of two major aircraft manufacturers in the world. (There are some smaller firms, but BA and Airbus control most of the market.) Recent crashes of Boeing 737 Max planes put BA under pressure. I bought a share so all the news stories would populate my feed. The stock started climbing so I thought I might not get a chance to buy at a “good” price. It happens. Most “watch list” businesses never become a real investment. 

BA came down again, but not enough for me to buy. Personally, I like BA more than airlines. Buffett disagrees, but I’m okay with that. 

Another watch list stock is JNJ. I owned JNJ in the past and I forget why I sold. (It was a dumb idea.) The recent asbestos in baby power/talc court ruling drove the price down. A little. Not enough to buy.

I’m watching Microsoft (MSFT) also. They really found their mojo after years where management struggled. I think Satya Nadella is a good leader at MSFT.

 

Of course, I own other businesses not discussed here. The idea is to give you the mindset necessary to win at investing.

Here is my final note: There is no crime is holding cash! Sometimes I catch heck when people realize I’m holding cash instead of investing in index funds. I can handle it. When the market is up I buy less because good investments are harder to find. When the market declines, like it did late last year, some businesses get discounted more heavily than others. Usually I find reasons to put my cash to work at those times. 

Now the market is near a new high again and new money is still looking for a home.

So I wait. Patiently. 

 

* FIRE: Financial Independence, Retire Early

 

More Wealth Building Resources

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Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

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cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

How do you tell if the stock market is too high? When do you sell? Or buy for that matter? Read this article to learn the right time to sell a stock. #wealthyaccountant #stocks #stockmarket #investing #investingtips #bonds #moneymarket Investing for beginners. Investing for wealth in your 20s or 30s. In or near retirement.The stock market is in nose bleed territory and doesn’t seem to want to stop climbing. Economic risks are everywhere. Debt levels are high, interest rates are climbing, a trade war is breaking out and the market valuations are at near record high levels.  In times like these investors get scared. The bull market is long in the tooth and “due” for a serious correction. But then again, using a gambling term might not be the best choice when investing your money.

It is rare when a client doesn’t ask me where to invest their excess funds. Virtually every client wants to pull money from the market but doesn’t know where to put the proceeds. Lump-sum payments and accumulated cash in money market accounts cause concern when the stock market would have been a much better choice.

At these level we might ask, How much higher can this go? How much longer before disaster strikes? And then the market indexes keep marching higher.

Retirement makes it even worse. If your nest egg is enough for a comfortable retirement, but lacks excess, the market climb causes concerns. Nobody ever lost money taking a profit, goes the old Wall Street adage. But is it a smart idea to sell when the market is high considering it is almost always considered high? And if selling is the right choice, where do you put the money? We will explore those important questions today, before catastrophe strikes.

Are You High

There is an advantage to age. Once you’ve lived through a few market cycles you begin to realize the best choice is to stay calm. Newscasts will tell you the sky is falling. It isn’t.

In the 1970s and 80s Joseph E. Granville was the guy to listen to on stock investing. When Granville spoke the market moved. He had a system for timing the stock market and a knack for promotion. (He had books to sell.) The Pinterest placard in this post of his 1976 book is from my personal library. (I’ve been reading investing books for a very long time.)

Robert R. Prechter Jr. is another guru from a past age (my age). Prechter published The Elliott Wave Theorist in the 1980s.

When is the best time to sell the stock market? Selling an investment is just as important as how you buy the investment. And where do you put the money once you sell? #wealthyaccountant #investing #indexfunds #retirement #selling #money #cash

The only way to time the stock market. Don’t.

Both Granville and Prechter were market timers; something we know is a bad idea when it comes to investing in the market. Warren Buffett doesn’t write books; he writes annual reports for his company. People write books about Warren Buffett. This opposed to market timers who write books on their system and sell it to the masses. See the difference. One makes money and people write about them. The others make their money selling you books on how they think you should invest. Think about that for a moment.

I bring up Granville and Prechter for a reason. These and others called for a serious market declines in the 80s. I remember watching the Nightly Business Report where a guest expressed with great confidence the Dow Jones Industrial Average would soon test the 1932 lows from the Great Depression because the Elliot Wave theory predicted it. People actually paid for that kind of advice!

When the Dow was under 1,000 it was overpriced. It was overpriced in 1932 then is bounced off the low 40s. (The DJIA closed at 41.22 on July 8, 1932; its all-time low.) You see, when the Dow was that low people had real reasons to believe the world was ending, at least economically. Even with the Industrials at 40 and change the market was high because these companies were losing money. Things were bad, really bad. And getting worse.

Then the Dow reached 10,000 and it was really high, overpriced and ready for a decline. Well, before the world actually ended the Dow notched 20,000. Of course it was painfully obvious the market had to decline. Just look at the political climate. How can it possible go higher?

Unfortunately we will have to wait for the permanent decline in the market. Yesterday (September 19, 2018) the Dow closed at 26,405.76. And you guessed it. Clients still want to know if they should sell their index funds and move to cash.

I provided plenty of links above to helpful sites on the issues I discussed. I didn’t link to Amazon for any of Granville’s or Prechter’s work. Granville actually published another book in 2010. I didn’t know that until I researched this article. It sounds like more market timing advice to me. And that is why I didn’t link to their work. I think it is terrible advice.

Perspective

Let’s bring the current stock market into perspective. At the last cycle market high the DJIA was around 13,930 at the end of October, 2007. If you had the worst of all luck and invested a massive windfall (the lottery sent you a gazillion dollar check) at the exact peak you would be up just shy of 90%! (89.55% for home-gamers.) Index funds make it easy to match the market. An all-market or S&P 500 index fund would have yielded slightly different results, but still good gains all the same.

When is the best time to buy a stock or index fund? Should you buy or sell at these levels? Inside are clear answers to investing your money in your 20s, 30s or any age. Beginners and experienced investors face the same question on when to sell and what to do with the proceeds. #wealthyaccountant #beginners #investing #tips #ideas #help #money #cash

Should you buy the stock market at these levels?

The lesson is learned. Even if today is the absolute worst day to invest, a decade down the road you still have pretty good odds it will still be a good call.

I’m not calling for the market to climb high, by the way. I might be crazy, but I ain’t dumb. I have no clue where the market is headed. Looks high to me and always does. So I bite my lip and keep invested, laughing all the way to the, ah, index fund.

The long game is always higher. Jim Collins has written extensively on the stock market and why it always goes up. Notice I didn’t say the market never goes down! The market does decline from time to time, but always climbs higher after the temporary pullbacks. The only time this will not happen is if civilization fails. If that is the case you have bigger problems than a stock market decline.

Liquid Funds

The information above doesn’t mean everyone should be fully invested! Those in or near retirement may need a few years of liquid cash in money market or bank accounts regardless the level of the stock market. Businesses also need working capital that is liquid. Money that has a five-year or longer horizon probably deserves to be in equities.

I intentionally left bonds off the list. Bond yields are low. Serious losses occur with long-dated bonds as interest rates climb. If rates stay low you still only get a meager return. I see no reason to consider bonds, except for pension funds, banks and insurance companies.

Alternatives to Index Funds

The S&P 500 and DJIA are up over 300% from the lows a decade ago. It is understandable some people have the jitters. Panic selling is the worst of all choices. If a market decline causes you to lose sleep it might be time to take a few chips off the table.

If you receive a bonus or other windfall it still makes sense to drop the lump-sum into a broad-based index fund and live with the results. The evidence is clear this is the correct choice. You might be unlucky and pick the worst day of the decade. Odds are you will not. But if you do you still have an excellent chance to enjoy nice returns in a relatively short period of time.

If your temperament doesn’t handle the market well at these levels there are options. First, pay off debt. You can’t lose retiring liabilities. The car and credit cards must be paid in full. The mortgage is always a tough call. (Stay tuned for an upcoming post on paying off a low interest rate mortgage versus keeping the mortgage and investing the funds for a higher return.) I feel paying off the mortgage makes sense for most people. “Safe” investments don’t pay as much which makes them less safe than perceived.

Once all debt is eliminated you still need to invest liquid funds. There are few good choices at this time. Capital One 360 and Discover Savings offer competitive interest rates, but they are still low comparatively. Vanguard’s money market fund is another alternative worth considering.

The Best Investment

I know how hard it is, kind readers, but a broad-based index fund is the best choice for money with an investment horizon of 5 years or longer. The market is high. It’s always high. The best time to invest has always been now.

Granville and Prechter convinced a generation they could time the market. Nobody does it consistently. The surest path to financial success is to tie yourself to the economic engine of virtually the entire economy. As the economy grows, so do you.

The best and only advice is to stay fully invested all the time without leverage (using borrowed money to buy the investment). The exception is working capital for businesses and liquid funds for household expenses of a few years, a bit more if retired or nearing retirement.

Close your eyes if it helps. Bear markets tend to end quickly.

 

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

 

Recent volatility and decline in the broad markets in the U.S has people wondering if the correction returned the market to typical valuations. There are several tools used to measure the market’s value. One of the most widely used is the price/earnings (P/E) ratio, derived by dividing a stock’s price by its trailing twelve months (TTM) earnings.

The P/E ratio on the S&P 500 stands at 24.46 as I write (February 11, 2018). The ratio has been above 20 since early 2015.

When you take long periods of market data and shake them together you end up with an average P/E somewhere in the mid-teens. There is no hard and fast rule stating what a fair or reasonable P/E should be though plenty of opinions exist.

Another way to look at the P/E ratio is to flip it upside down where you divide the earnings by the price. This is called the earnings yield.

The earnings yield is an easier way to understand if your investment is paying enough to justify the risk and lost opportunity cost of investing elsewhere. The S&P 500 earning yield is 4.09% as I write. This means if all the companies in the S&P 500 paid all their earning out as a dividend you would have a 4.09% yield.

Again, there is no hard and fast rule on what an appropriate earnings yield should be. However, if Treasuries are considered a risk-free investment and yield more than 4.09% you might want to reconsider your strategy.

History of the P/E Ratio

The P/E ratio has been all over the map. We sit near record highs in the  ratio currently, but have been above 20 for several years. This in and of itself is a bit unusual.

The other side of the spectrum had the ratio in the single digits with the earnings yield double digits. (If the P/E is 10 then the earning yield is also 10%. If the P/E is 5 then the earning yield is 20%. Example: A $100 stock has a $10 per share profit. If they paid all the profit as a dividend it would equate to a 10% yield. If the $100 stock earned $20/share the P/E (100/20) would be 5 and if the $20 were all paid out it would equate to a 20% yield.)

The actual dividend is almost always less than the profits of the underlying company as a higher dividend would require borrowed money or liquidation of assets to pay. The earnings yield is the highest amount a company could consistently pay out. Realistically, most companies can’t pay more than 80% of profits in dividends so resources are available to invest for future growth.

The P/E ratio has climbed above 20 many times in the past. Concerns over high valuations based solely on the P/E is short-sighted and a poor investing barometer.

Up until the early 1990s when the P/E climbed above 20 either earning grew bringing the ratio back below 20 or stocks declined in price or some combination of both. Since the early 1990s the ratio has been above 20 more often than not. During the dotcom craze the ratio exceeded 40 and during the Great Recession (2008-9) the ratio briefly pierced 70 as earnings declined (especially in the energy sector) faster than the market declined.

In both cases the excessive P/E ratios returned to the upper teens in a short period of time. Earnings rebounded even as stocks advanced. The faster growth rate in profits reduced the ratio. The excessive losses due to falling oil prices eventually ended and the ratio declined.

Why is this Time Different?

Why have stock prices stayed so high for so long? Except for brief periods the P/E has been above 20 for twenty-five years! This has never happened before in U.S. markets.

‘This time is different’ is the battle cry just prior to bloodlettings. History doesn’t repeat itself, but it does rhyme. Each era of stock market history has different events moving prices. If you dig down you will find the differences are only cosmetic.

What drove stock prices in the past drive them today.

The P/E chart shows the ratio climbing steadily from the early 1980s until shortly after the turn of the millennium where it made traumatic moves as it settled into the lower 20s zone.

What caused this steady ratio increase? First, the increasing ratio means the stock market has been climbing faster than earnings for a long time. People are paying more and more every year for the same dollar of earnings. At first blush this seems insane. But there is a valid reason for the activity.

Inflation was rampant (double-digits) in the late 1970s. Interest rates were increased repeatedly by the Fed until borrowing costs reached well into the double-digits.

After years of high interest rates to fight inflation, the price of goods and services stopped the rapid climb. The back of inflation was broken. Price increases moderated. Each economic hiccup reduced price pressures further until the 2008 recession when deflation (declining prices) made an appearance.

With each step lower, interest rates dropped in tandem with inflation pressures. It’s been so long since we felt the sting of inflation most people investing today don’t remember what it was like. A certain accountant in the room does, though.

Inflation and Stock Prices

Many factors drive stock prices. Earning top the list. But what is the value of those earnings?

Why did investors pay less than 8 times earnings in 1980 and now pay close to 25 times? Investors today pay three times what they did in 1980 for a dollar of earning!

In 1980 inflation was high; today inflation is low, almost nonexistent, and has been for a decade.

Inflation drives interest rates. The higher inflation the higher interest rates will climb.

If prices are steady (no inflation or zero inflation) and a company grows earning 10% the future value of those earnings are worth their full value.

If the same company were operating in a 5% inflation environment the discounted value of those future earnings are reduced by half. (This is an over-simplification to keep our story moving. Each successive year earnings are reduced by the risk-free rate of return. It has a compounding effect.) That means investors will pay less for those earnings. This is why investors pay three times what 1980 investors did for the same dollar of profits.

Future Growth Problems

When inflation climbs, interest rates follow and hence the risk-free rate of return.

As interest rates climb on the risk-free alternative (Treasuries for U.S. business and investors) it gets harder to justify many projects considered for future growth.

Value is created when the return on invested capital exceed the cost of capital. The cost of capital on excess cash held by businesses is the risk-free rate. When Treasuries pay almost nothing virtually every project projected to show any return is viable. Increase the risk-free rate to 5% or higher and many projects no longer make sense.

Of course, a margin of safety will be added by the company. In a zero rate environment a company will not accept a project with a projected rate of return of 1% just because it exceeds the risk-free rate. They will need a margin of safety to account for errors in calculated returns and to compensate investors for the risk taken.

As rates rise and fewer projects are approved, the number of goods and services eventually declines along with the number of jobs until equilibrium is found.

What Could Cause Inflation and Lower Stock Returns?

For 35 years investors have watched stocks climb faster than earnings. Deflationary pressures were more common in the 19th Century as prices swung wildly with the economy’s ups and downs. Over long periods prices were stable with the exception of the wild internal fluctuations.

Refer back to the P/E ratio chart. You will notice three times in the last 150 years the ratio dropped below 10 for an extended period: after WWI, after WWII and during the late 1970s. The starting point of the chart showing a low ratio came right after the U.S. Civil War.

At first glance you might think war was the cause of low P/Es, but you’d be wrong. Then you might wonder why the most pronounced period of low P/Es was the only one not following a war.

Well, the 1970s low P/E ratios followed a long war in Vietnam. War seems once again the cause of a low market ratio.

War does funny things to an economy. Both World Wars had price controls as the U.S. dealt with the economic stresses of fighting the war. Pent up demand and a higher savings rate allowed people to chase goods and services they were denied for a period of time. Business ramped up production and prices stabilized. With prices under control investors calculated the future value of earning at a higher rate causing the P/E ratio to climb.

The 1970s had additional issues pushing prices higher. Spending to fight the Vietnam War primed the pump for price increases. The first oil embargo in 1973 sent energy prices rapidly higher. President Nixon took the U.S off the gold standard further unleashing prices as the Federal Reserve had no real limit other than self control on how much money they could pump into the system.

Stubborn inflation was pushed even higher with a second OPEC oil embargo in the late 70s.

Now inflation became entrenched. Killing the beast wasn’t going to be easy. People expected wages and prices to climb. It felt normal so the tendency was to push prices higher.

This may seem strange to people living in a world of remarkable stable prices. But that could all change and rather fast.

Fixing Inflation

Stagflation was a new animal for economists in the 1970s. A stagnant economy still generated large price increases. It made no sense.

The newly elected President Reagan had an idea. He built a tax cut around combating stagflation problems with supply-side economic theory.

Supply-side economics has received a bad rap at times, but it was the perfect medicine for low economic growth and high inflation.

What the 1981 tax cuts did was lower rates for business and individuals. This could cause inflation to flare higher. Buuuuuut . . .

For businesses some expenses are depreciated. Back then small businesses had to depreciate assets expecting to last more than a year and costing more than $100. This kept businesses from increasing production as costs came 100% out-of-pocket (or from borrowed money) while it took years to depreciate the entire asset.

What Reagan did was genius! Before the two big tax changes of the 1980’s small businesses could elect to expense assets (IRC Section 179) up to $10,000 with certain limitations instead of depreciating. The tax law was changed to increase this to $20,000.

Small business owners could now write-off more of their investments immediately. Businesses responded. Capital investments increased requiring more employees. The extra supply brought down pricing pressures.

Over the next decades Section 179 asset expensing was constantly increased until it was well into the six figures. Bonus depreciation is similar to Section 179, allowing for additional current deductions for asset purchases. Section 179 and bonus depreciation are so high now any further increases have no real effect at sparking additional economic growth.

Primed for Inflation

The medicine needed to kill inflation worked. Unfortunately, the same medicine was used again and again driving down inflation until deflation was the issue.

Supply-side economics has run its course until the next round of inflation appears. Supply-side tax bills don’t have the desired effect to the chagrin of politicians. Might I suggest to the elected officials in Washington to think of something new once in a while.

Back in 2008 the Fed’s balance sheet was under $1 trillion. It now stands at $4.5 trillion! This is one of the biggest, if the not the biggest, percentage increase in the nation’s money supply in such a short period. Even major wars didn’t create so much additional money.

Once again, this time was different in the details. All the excess money creation was sopped up by central banks around the world and the Fed. (Yes, the Fed holds much of its own money! The offsetting entry in the ledgers is held by the balance sheets of money-center banks to make them look solvent when they had lots of bad loans.)

Lots of new money didn’t cause inflation because it never hit the economy; it’s like it didn’t exist. Money in bank vaults might be a neat gimmick to make banks look sound during an economic crisis, but it does nothing to spur economic growth.

All the money in bank vaults didn’t disappear. It was waiting for a spark to be release it. That spark came late last year with the Tax Cuts and Jobs Act. Gas was thrown on the flames with an additional $400+ billion in new spending in a bill meant to keep the government open.

To Infinity and Beyond

The money is printed and the match lit. It is of vital interest to investors what happens next.

When the P/E ratio climbs as it has over the last 35 years the stock market advances at a rate faster than earning growth. The opposite happens when the ratio declines!

I have no crystal ball. Predicting where the stock market goes next is a fool’s errand.

With the facts listed above there is ample concern for an underperforming stock market for an extended period. Those most at risk are those in retirement, just entering retirement or retiring in the near future.

History is clear. Inflation causes higher interest rates and lower market multiples. Higher earnings can keep the market ratcheting higher, albeit at a slower rate as investors pay less and less for each dollar of earnings as inflation increases.

Excess money thrust into an economy has a high probability of affecting prices. The current economic experiment is gargantuan. The pile of new money waiting for freedom has a green light. As money flows through the economy at normal velocity, the effects of the new money are magnified.

It could be self-feeding; it could be an old accountant reading the tea leaves wrong.

Ah, who am I kidding? My cup of hot tea is just fine! Massive new spending by the government means the balance sheets at banks look better so they can now lend out all that money they’ve been dying to earn a profit on.

I don’t know the future, but I bet it’s going to be one helluva ride.

After nine years of steady growth in the economy and stock market both indicators have taken a sharp turn north. Economic stimulus in the form of tax cuts in an already good economy holds the possibility of destabilizing the whole economic structure.

There is ample concern over the staying power of the advancing stock market. Valuations are at or near record highs in all measures. All news seems to be good news. Predictions for future gains have reached nosebleed territory.

Investors need to know why the market is climbing so fast to protect their ass-ets. Those close to or in retirement need to take special precautions.

To accomplish the goal of explaining why the market is climbing I need to get technical. Numbers and charts have to be part of this discussion to understand why the economy and markets are behaving the way they are.

In the Beginning

A long time ago in a country close by there once was a housing bubble. The savings rate dropped to record lows while debt levels were growing more difficult to service. In 2007 the first cracks appeared under our feet and accelerated quickly.

Housing prices collapsed and the economy ground to a halt. There was real fear in the air. Many investors today have no idea what market fear means. Fortunes will be lost when the inexperienced get their first taste.

Congress passed several bills to protect failing banks. If not for these efforts we could have looked at an economic catastrophe similar to the early 1930s.

Fed’s Balance Sheet

Saving insurance companies, banks and car companies wasn’t enough to turn the economy around.

The Federal Reserve and central banks around the world dropped interest rates to zero or close to it without the intended results. The economy didn’t want to respond.

Some central banks experimented with negative interest rates. In the United States it came close. With exception for a few T-bills issued interest rates stayed a whisker above zero.

Draconian problems require draconian policies. The Federal Reserve started buying massive quantities of Treasuries (government debt). Normally the Fed buys and sells very short-dated T-bills in their effort to keep prices stable, employment full and adequate liquidity to keep the economy functioning smoothly.

Due to the high levels of purchases the Fed was making the purchases started to extend to longer-dated securities and mortgage backed securities.

The Fed’s balance sheet held $869 billion in assets on August 8, 2007. The balance now stands around $4.5 trillion. Yes, with a “T”.

Surprising Results

The Fed creates money as part of the debt process. When Congress spends more money than comes in from taxes the Fed can come in and buy some of those bonds and make a notation in their ledgers. This and the literal printing and coining of currency are how money is created. (I’ve greatly oversimplified the process of money creation. There are plenty of YouTube videos on the subject.)

Adding trillions to the Fed’s balance sheet (see Fed’s balance sheet chart) should have more than jump started the economy. Instead, all we got was an eventual crawl out of the Great Recession with modest, yet steady, economic growth.

Predictions were everywhere inflation would run rampant due to all this so-called money printing around the world. There was ample reason for the inflation fears. History is filled with instances where the money supply is increased significantly only to destroy the economy involved with uncontrollable increasing prices.

Why was this time different? There are no examples I can think of where this level of money creation didn’t cause an inflation shock.

Where Did All the Money Go?

With nearly $4 trillion added to the Fed’s balance sheet the economy should have boomed. In a way it did, but in a stealthy way.

Asset prices have been climbing. Housing in many parts of the country are at record highs. The stock market has added trillions to the net worth of investors.

Alternative investments sopped up some of the excess cash. Bitcoin is a good example.

But it wasn’t enough to account for all the “money creation”.

To understand what “should” have happened we need to look at some charts and explain some terminology.

There are different kinds of money in a way. The Fed tracks these types of money as M0, M1, M2 . . .

M0 is the currency and coins you hold in your wallet. M1 includes cash and checking accounts. M2 includes all of M1 plus bank CDs, money market accounts, mutual funds and bank savings accounts. Each higher level of “M” includes all of the previous categories of M plus increasingly less liquid assets. For our discussion we can stop at M2.

We also need to understand something called the velocity of money. Basically, the velocity of money is how many times money changes hands within a certain timeframe. Example: If all M0 changes hands eight times in the last year we say the velocity on this money was eight for M0.

There is also a multiplier effect when the Fed “creates” money. Banks are required to keep only a fraction of their deposits on hand while lending out the rest. This is called fractional banking and many people hate it with a passion declaring the downfall of Western civilization if it isn’t stopped.

Now that we have a few terms under our belt we can ask our original questions intelligently. Where did all the money go?

The short answer is all the extra money created by the Fed and central banks around the world stayed in bank vaults and at the central banks!

The necessity for increasing the money supply was to bail out faltering financial institutions! Banks had so many bad loans on their books they had to shore up their balance sheets so the Fed used various vehicles to get money onto their balance sheets so they appeared solvent.

Central banks around the planet also loaded up on sovereign debt, both domestic and foreign. Today, trillions of U.S debt is held by the central banks of foreign countries.

Who Moved My Money

The real reason the economic liftoff from the Great Recession was so slow was because the economic stimulus wasn’t as stimulating as it should have been.

With more money available than ever it sat quietly in bank vaults. Economic growth wasn’t fast enough to justify increased lending so banks kept their powder dry so the money never hit the broad economy. The slow trickle of funds into the “real” economy provided modest, yet steady, growth.

But even modest growth for long periods of time starts to add up. Unemployment dropped from double digits to four and change. Greed and distant memories of fear from the Great recession emboldened lawmakers.

Unsatisfied with modest growth they got greedy and wanted it all NOW! Tax rates were cut massively and the market was off to the races.

But there is an unspoken problem in the room. Remember all that money? To get it into the economy the Fed had to lower interest rates to zero for a very long time. If that money were to ever be unleashed into the marketplace bedlam could ensue!

And now banks for the first time in a long time see plenty of reasons to open the vaults and start pouring out the money. Fractional banking will do the rest.

Take a look at the charts for M1 and M2 money supply. M1 (currency and coins in your pocket) has climbed steeply from $1.4 trillion in late 2009 to over $3.6 trillion today. Cash and coins (literal money printing) more than doubled in eight years! The fractional banking system can convert this physical money into about five times as much additional digital money! M1 seems to be the main driver of the steady economic growth over the past decade.

Now look at the M2 money supply chart. The money supply rarely declines in the U.S. so don’t be alarmed by the upward sloping curve. M2 also grew rapidly since the Great Depression with just under a doubling in supply.

The money supply charts in and of themselves mean nothing. (Okay, they mean a lot. Just play with me a bit longer.)

Money supply is only one facet of the equation. How fast that money percolates through the economy also makes a difference.

Look at the M1 velocity of money chart. The number of times currency changed hands in a year declined heavily since the Great Recession. Some readers will find comfort we are back to numbers similar to the 1970s. Don’t be.

Part of the reason the M1 velocity of money changed over time is due to how we spend. We spend with our debit and credit cards so cash starts to move less leading the Fed to print less currency as a percentage of the total money supply.

As less actual currency exists it tends to move faster as we saw in the economic boom of the 1990s. M1 velocity declined since the Great Recession due to additional supply, potential hording and reluctance to spend over fear of returning economic hard times.

More current data suggest M1 velocity is starting to increase. (Sorry, no chart.)

Finally, look at the M2 velocity of money chart. When you look at CDs, mutual funds and other bank deposits the velocity of money (M2) hit lows since records were kept.

Now think of this. If all the money tucked away safe and sound is unleashed on the economy what do you think will happen? Regardless what you think the unleashing has begun!

The only way for the Fed to sop the excess money out of the system is to keep raising interest rates. It could take equally high rates to equalize the supply and demand of money as it took for low rates to kick-start the economy.

With unemployment near 4% it will be hard to fill positions created by the rapidly expanding economy. This will require wages to increase (a good thing) while forcing prices to climb in tandem (not as good as wage increases).

Higher inflation requires higher interest rates. The good old days of zero percent rates is about to disappear.

What Does This Mean for the Stock Market?

Equities are on a sugar high right now. Low interest rates and inflation coupled with growing profits is the perfect recipe for substantially higher stock prices. But we have a problem.

The stock market had a few hiccups this week as interest rates on the long end of the curve are rising sharply in anticipation of what I explained above. The Fed will have a hard time controlling the long dated Treasuries. Investors will sell until rates increase to a level commensurate with the inflation risk of their income stream.

The stock market is in for a rude awakening as well. The Goldilocks economy has been over-stimulated. And as with any drug overdose the other side is filled with pain.

Interest rates and inflation are still low. That can change fast. As the massive quantities of money finds its way into the general economy from bank vaults and as fractional banking multiples the effects, the economy is sure to grow in at least nominal terms. Inflation is sure to follow unless you think this time is different.

A mere 3% or so growth rate the President promises isn’t enough to deal with all the excess money. I played with the numbers (back of the envelope) calculating what would happen if money started to move like it did in the early 2000s and the banks started lending all the extra money they’ve been holding in reserve. I come up with a U.S. economy at least double the size it is now (~$20 trillion) to as much as $64 trillion.

These are staggering numbers requiring massive growth in the economy coupled with significant inflation. The Fed may have no choice soon to raise rates faster or risk losing control on prices.

The next few years are going to be interesting. The grand experiment undertaken during and after the Great Recession has another side, a side we are about to enter.

 

Why Does the Stock Market Tend to Struggle in High Interest/Inflation Environments?

Before we finish I want to outline why the market tends to have an initial upward thrust before falling sharply in environments similar to the one we are currently in.

There are two reason markets struggle with high inflation and interest rates. The first deals with value. Remember the definition of value creation:

ROIC – COC = V

where the return on invested capital exceeding the cost of capital equals value creation.

As the cost of capital increases fewer deals get done because they are less profitable than parking the money in a risk-free investment, generally Treasuries. Fewer deals mean less economic growth eventually until the economy cools and we wait until another generation of uninitiated makes their debut.

The second reason stocks suffer in high interest/high inflation environments is the quality of earnings. When inflation is low interest rates tend to be the same.

If a company is generating 10% profit growth steadily with zero inflation and increases their growth rate to 15% with say 7% inflation, the earnings are worth less.

Either way equities suffer. With the amount of money we know exists out there, what it takes to suck it out of the economy and with the likelihood the velocity of money returns to traditional levels, inflation issues are probable.

Any readers remember the 1970s and stagflation? I do. I was a wee tyke, but I remember.

 

There is a lot of money out there looking for a home, kind readers. When a portion settles into your account the only question will be: How much will it be worth?