Shad Rowe, managing partner of Greenbrier Partners Capital Management, dispatched a terse commentary in his annual letter, dated Dec. 31.
Apprising the question presumably on his partners’ minds — how does Greenbrier intend to deal with the recent “gut-wrenching stock market decline?” — Rowe answered succinctly: “Sit tight.”
Answering the call to a complete sentence, Rowe elaborated: “We continue to believe that owning promising U.S. equities remains the best investment option . . . over the long term.”
Among the issues Rowe did not address: How are stocks likely to perform in 2019; what will be the likely effect on the market of Oval Office tweets? And: Will Apple (long in his portfolio) ever sell another iPhone in China?
Investing, he noted, is a game of alternatives. As with other investments, the results are measured by what goes in and, eventually, how much is extracted.
In the long term, only two things matter. Neither has anything to do with special counsel Robert Mueller, or with how much the market fell in December.
Market soothsayers have an unfortunate habit this time of year of forecasting what will happen to equity prices over the next 12 months. Before you pay any heed, ask yourself how many of their forecasts you remember from the beginning of the previous year?
Then ask another question: Why would it matter, since those forecasts have now expired and have been replaced by new prognostications which — 12 months hence — you guessed it, will be replaced by brand new “forecasts.”
I put the word forecast in scare quotes because most of them, professing to divine the future, merely extrapolate the recent past. Terri Spath, chief investment officer of Sierra Investment Management, told the Wall Street Journal that “the market is vulnerable right now.” It certainly is. Elaborating, she says that, due to a number of “technical indicators” having broken down, it is “hard to call for any sort of bottom.”
For those who believe that investing is the art of calling bottoms, I present to you Ms. Spath. For those who want to know more about technical indicators, consult an astrologist.
It is entirely forgivable to think that the future will resemble the past (often, it does). If it rained today, one may reach for the umbrella tomorrow. But reaching for an umbrella is not the same as being a meteorologist.
Contrary to the wisdom now on offer, if the market were to fall 20 percent from its high, it would not signal the beginning of a “bear market,” nor would it signal the beginning of anything. Yesterday’s market move is old news.
The truth is, it is always hard to call a bottom, or a top — or a middle. Strike that. It is impossible. The market’s short-term wiggles, lurches and nose-dives are, like Super Bowl wins for teams not from New England, outside the sphere of the divinable.
The dirty secret of investing is that the future is always unclear. Way, way back in the spring of 1966, the market fell steeply — why I don’t remember, but it was unrelated to iPhones. In May of that year, Warren Buffett got calls from some investors warning that the market might go lower. This raised the question, Buffett noted, of whether such people had known the previous February (before the dip) that stocks would be lower in May — and if they had, why hadn’t they called then?
In truth, stock market prices are mostly useless, and the fetish for annualized price movements are perfectly useless. Stock prices are useful only twice — when you buy, and when you sell. If the expected holding period is less than many years, you are not investing.
Investing in a stock is like owning a business, the returns from which may appreciate (apologies to Elizabeth Warren) over time. If a stock advances 20 percent one year and falls 5 percent the next, it does not mean the underlying business had a bad year, only, as is likely, two decent years, during which the market experienced various moods.
What matters with a business — as with a stock — are the earnings it generates, and the interest rate at which those profits are discounted.
You can think of the market as a giant discounting machine. It forecasts the earnings of publicly owned companies. And it discounts those earnings to a present value.
Those estimates are subject to error, as investors in Apple were reminded. The discount rate is subject to opinion but, for the investment to make sense, it must be competitive with the rate on other investments.
This is easier to conceptualize in the case of a bond. If the bond is issued by a reliable issuer — once that might have been the United States Treasury or General Electric — and a risk-free bond is paying 5 percent, you would not invest in a riskier bond unless it paid more than 5 percent.
If the risk-free rate rose, you would naturally demand a higher return for that risky investment, which means you would pay less for it.
The simplest way to visualize this is by inverting the familiar price/earnings ratio. This is the earnings yield — it tells you how much in earnings is behind every $100 of stock price. It’s analogous to the interest rate on a bond.
Of course, it isn’t completely the same. With a bond, you collect the entire coupon. In the case of a stock, some of the earnings are often retained. Apple pays out some of its earnings in dividends, but only some. If you think that Apple will reinvest its earnings wisely — or at least, as effectively as you can — that shouldn’t matter.
There is another difference. With a bond, you know the interest rate precisely. With a stock, you can only guess the earnings, or “estimate,” as they say on Wall Street. Buffett famously analogized that a stock resembles a bond in which it’s up to the investor to print the number on the coupon.
The earnings yield in the chart plots the most recent 12-month earnings on the S&P 500 divided by the price. A quick glance will show two points. That little upward squiggle at the far right reflects that, as the market has swooned, the earnings yield — what you are getting per dollar of investment — has appreciated.
But all of the recent action, one will see, occurs at the low end of the chart. We’re in expensive territory. The earnings yield went from 4 percent mid-autumn to 5.33 percent now, but it’s a far cry from the 13.5 percent yield (wow!) of 1980.
But wait a second. In 1980, interest rates were in double digits. For most of the 21st century, interest rates — long-term rates, not the ones set by the Federal Reserve — have been remarkably low. The 10-year rate today is 2.56 percent.
The question for investors is: Is the earnings yield on stocks (or a particular stock) attractive, given the alternatives?
It doesn’t matter how the market got to where it is, or that it fell 14 percent in Q4. All that matters is: Today the market is offering 5.33 percent.
If your judgment on the relative merits of that yield are correct, it won’t matter if you can forecast the effects of the next tariff or tweet, or even the duration of the recession in China. Years from now, they won’t seem important. That tweet? It won’t seem important after a few minutes.
The view here is, for truly long-term assets, 5.33 percent return on equities comfortably beats the yield on gold (zero), government bonds (2.56 percent) and bitcoin (zero again). Short-term money should be in cash. Put enough in cash so you won’t have to think about raising cash for a good while. Then, as per Mr. Rowe, sit tight.