- Positive sentiment alone has added 950 points to the S&P 500 in the last 5 years.
- The S&P 500 has returned 12% in the last 5 years, but only 4.5% in the last 10 years and just 2.7% in the last 17 years. Don’t let current positive sentiment lead you to such terrible long term returns.
- The opportunity cost might be significant, but the long term picture of not following the herd looks much better.
I know that if I buy a stock with a price to earnings (P/E) ratio of 10 and stable future business prospects, my very long-term return should be around 10%, plus inflation and eventual growth. If I buy a stock at a P/E ratio of 5, my returns will be around 20%, while if I buy a stock with a P/E ratio of 20, my returns will be around 5%. It’s as simple as that, in the long term.
In the short term, fortunately and unfortunately, it’s all about sentiment. Positive sentiment about the stock market increases demand for stocks, pushing stock prices higher no matter the P/E ratio. Negative demand or panic pushes prices lower.
Negative sentiment gives the opportunity for bargain purchases that can increase long term returns, while extreme positive sentiment allows for cashing out on investments at much higher than expected returns.
Figure 1: Positive sentiment increased the S&P 500’s P/E ratio from 15 to the current 25. Source: Multpl.
Positive sentiment has pushed stocks higher as the majority of people have been putting their money into the S&P 500. I don’t think they realize the difference between an investment in the index in 2012 and today. In 2012, the P/E ratio was 15 which indicates long term returns of 6.6%. The current P/E ratio is 25 and will lead to returns of 4% per year. At the same valuation, as in 2012, the current value of the S&P 500 index would be 1,425 points. This means that positive sentiment alone added 40% to the current S&P 500 value, or all the growth the index has enjoyed in the last 5 years. Interest rates haven’t moved much, neither have earnings, and the economy was growing then and is growing still.
The strongly positive attitude toward stocks is important because if you have been trying to outperform the market by looking at earnings, doing in depth analysis of stocks in order to minimize the risk and maximize returns, your task has been an arduous one in the last 5 years. The S&P 500 is up 75%, or almost 12% on a yearly basis.
Figure 2: The S&P 500 in the last 5 years. Source: Yahoo Finance.
Now, by buying stocks with P/E ratios around 8, a return of 12% should be reached in the long term. But a P/E ratio of 8 was almost half of the valuation of the S&P 500 in 2012, and thus difficult to find. Usually small-caps have low valuations, or emerging market companies not included in an index. The problem is that if you invest in companies that aren’t included in the most common indexes, there is no guarantee that the market will recognize their value in the short term, especially since in this bull market, most invest on sentiment. Therefore, a rational investor must be willing to underperform irrational stock markets for a while.
The value of a low P/E ratio investment will be recognized once sentiment turns. As soon as stocks start to fall, investors will look for assets that have stable earnings and nice dividends in order to find protection from negative market sentiment. The best buffers are usually good fundamentals and low debt.
If you’re a value investor and your returns in the last 5 years are just 10% per year, don’t be discouraged. As soon as sentiment turns, your time will come. It’s important to measure investment performance over a complete cycle; two cycles are even better.
Figure 3: S&P 500 returns from a peak to peak and bottom to bottom measurement are really bad. Source: Yahoo Finance, author’s calculations.
Yes, the S&P 500 has returned 12% per year in the last 5 years, but don’t be fooled by this. In the period from 2000 to 2007, the yearly return was 0%. In the period from 2000 to 2017, the yearly return was 2.7% per year (treasuries have done better). In the period from 2007 to 2017, the return has been 4.5% per year. Therefore, you shouldn’t be fooled by the latest returns as they are mostly driven by positive sentiment and not a rational analysis of fundamentals. This is similar to the dotcom bubble of the 1990s, where as you can see, long term returns were minimal for those who were invested in the general market.
Conclusion & What To Do
What to do depends on the investing mentality you have. Getting out of the S&P 500 now would mean sticking to a strategy that is opposite than what the great majority of investors have chosen. If the S&P 500 continues to roar for another year or two, you might be forced to listen to how your neighbor made another 25% while you just made 5% from the dividends of your defensive investments.
This is an opportunity cost that anyone choosing to renounce herd mentality has to be willing to accept. However, when the scenario that happened in 2001 and 2008 when the S&P 500 fell almost 50% happens again, you will be able to calmly enjoy and wait for S&P 500 blue chips to become cheap and the load up on them while everybody else is selling.
All in all, I believe the benefit of having a defensive portfolio that consists of stocks with good fundamentals at a fair price that can be mostly found in emerging markets, some gold stocks, and stocks that have short term positive catalysts and will be cashed soon will largely outweigh the opportunity cost of not being long the S&P 500 for another year or two like everyone else is.