Here’s Why You Need To Think About The Current Market Risks

September 21, 2017

Here’s Why You Need To Think About The Current Market Risks

  • Evolution hasn’t created us to look at risks in investing, which is something that can be very costly.
  • I’ll discuss in a simple, but straightforward way what the current market risks are to be aware of.
  • If you’re careful, you can earn up to $500k in 20 years on a $100k portfolio.

Introduction

Investing is a very delicate thing and few understand that we aren’t wired for success in it. Part of our brain, the amygdala, through millions of years of evolution, has taught us to fight when we might be wrong, to prove our dominance and our convictions in order to prevail and spread our genetics. Our childhood, education, and our school system is based on the same bias. We aren’t rewarded for learning from our mistakes, we aren’t that happy when we find out there is something we don’t know as much as we are when we get an A on an exam.



The problem with investing is that you want the opposite of what you’ve been trained to want all your life. First, and this is the most difficult part, you have to accept that you can be wrong and secondly, you have to look for whatever you don’t know and where you could be wrong. Looking at and learning about what you don’t know is the only way to minimize risks when investing. Low risk usually leads to higher returns and thus to a better financial life.

We’ll definitely circle back to how the amygdala influences our investments as we continue writing our Behavioral finance concepts article series, but in today’s article, we’ll focus on what the majority of investors don’t know or don’t want to see about the S&P 500 and what the key risks at the moment are. If you’re long the S&P 500 or related stocks, you probably won’t like this article but try to subdue your amygdala and learn about the facts that can help protect your portfolio. You might not sell immediately, but in the next few months it may be an option as things develop, so keep your eyes open.

A Few Factors That Indicate A Recession Is Near

A recession being close doesn’t mean one will happen tomorrow, it’s just that risk is high and as investing is a game of risk and reward, you should adjust your portfolio accordingly in relation to your financial goals and time horizon.

The first thing to take a look at is the unemployment rate which is extremely low and unlikely to go much lower and stay lower. Comparing the current environment with the environment just before the previous recessions doesn’t leave much to imagination.


Figure 1: U.S. unemployment rate. Source: FRED.

The impossibility of finding the right employee at the right price hinders growth. When everyone is employed, fierce competition between businesses is bound to lead to lower margins and lower earnings at some point in the cycle. This is inevitable and has to be considered when investing.

From a statistical perspective, the probability of a recession is much higher when the unemployment level is below 5% than when it is above 5%. It might sound counterintuitive, but it’s fact. In the last 30 years, the economy was just a few years from a recession whenever the unemployment rate was below 5%.



The second thing to look at are valuations. The current price to earnings ratio has only been higher just prior to the dot-com bubble bursting.


Figure 2: S&P 500 price to earnings ratio. Source: Multpl.

High valuations are connected to the low unemployment rate. The more people work, the higher the aggregate personal income, and, consequently, the investing demand for stocks is. In combination with index investing still being the favorite investment vehicle not just for individual investors but also for pension funds and other institutional players, the result is obvious, a constantly rising stock market that has no connection to fundamentals.


Figure 3: S&P 500 earnings have been flat for a while. Source: Multpl.

The Risks Are Rising While The Returns Are Declining

A price to earnings (P/E) ratio of 30 means that the highest return you can expect from stocks is 3.3% and the higher the (P/E) ratio, the lower the return will be.

Everything else apart from earnings that surrounds stocks is short term noise which is only important if you’re a trader. However, if you’re like the majority of market participants, i.e. someone investing for the long term, the only thing to watch are earnings.

If your earnings yield is declining while the probabilities of a recession are increasing as more time passes since the last recession, the higher the probability is of a new one due to the natural cyclicality of every economy. Therefore, I urge you to look at your portfolio critically and assess whether you want to risk a big part of it.



The Investment Horizon Doesn’t Matter

Many are attracted by the notion that the S&P 500 is the best long-term investment as it will probably be higher in the next few decades. This is correct, but such an approach could be extremely detrimental to your financial wellbeing and, ultimately, your quality of life.

Even if you’re a long-term investor with a 20 year or longer time horizon, the fact that the S&P 500 will be higher than it is now is of little relevance. Let me explain. The current S&P 500 earnings yield is 3.3% with no earnings growth. This means that your long-term returns will be around 3.3%. A portfolio of $100,000 at a 3.3% yearly return will be at $191,428 after 20 years. However, if you manage to achieve returns of 10%, the same portfolio would be $672,000, just a half a million difference over a $100,000 portfolio in 20 years.

I simply don’t understand why people don’t see this and continue to blindly invest in the S&P 500. If you want to learn more about how to achieve 10% or higher returns with lower risks, read my article on achieving 10% yearly returns.