I’ve lost count of the times that seasoned market commentators have cautioned against investing in US equities in recent years. Yet investors who ignored suggestions that US stocks were “overvalued” and simply stayed invested have been amply rewarded.
This isn’t just a recent phenomenon: experts have recommended reducing exposure to the world’s largest economy for decades. Time and again they’ve been proved wrong.
“There has been no incubator for unleashing human potential like America,” Warren Buffett wrote in his letter to Berkshire Hathaway shareholders in February 2021. “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.”
Our guest on the latest episode of The Investing Show is my co-author Ben Carlson, whose blog, A Wealth of Common Sense, is one of the most highly regarded resources for anyone interested in investing in US equities.
In this episode we addresses some key questions:
Why has the US stocks market proved so resilient despite a steady stream of negative news on the economy since the Covid pandemic?
Should investors be worried about investing in the S&P 500 when it’s so heavily dominated by a small number of large technology stocks?
What should we make of ongoing fears that the US economy will slip into recession?
And what, if anything, should investors be doing in view of the Presidential election in November?
Enjoy the interview, and remember to subscribe, if you haven’t already, so you don’t miss future episodes.
TRANSCRIPT
RP: One of the most interesting features of the global financial markets in recent years has been the resilience of US equities.
They famously bounced back from the crash at the start of the Covid pandemic, and, since then, they’ve shrugged off negative news on the economy, including higher inflation and interest rates.
So what’s going on? Well, I’ve been speaking to Ben Carlson from Ritholtz Wealth Management. A popular blogger and author, Ben is one of America’s most prominent market commentators.
I started by asking him why, in his view, US stocks have held up so well?
BC: It’s kind of crazy considering we had this big bear market in 2022, and you were underwater for about two years there before we hit all time highs again. And since the start of this decade in 2020, U. S. equities are up 12 percent per year. And in 2023 alone, they were up 26 percent for the S&P 500. So probably much better than people would assume, given the sentiment and how nasty the economy has been for a couple years now.
I think part of the reason is the, the, especially the biggest companies, um, are just kind of more immune to the macro setup. So interest rates rose. A lot in 2022, in 2023, and a lot of the biggest companies and the biggest corporations were sort of insulated from those higher borrowing costs because they borrowed money when rates were low, right?
When you need to take debt out is not like right when you need it. It’s, it’s when it’s cheap. And that’s what a lot of big companies did. So they weren’t nearly as impacted by higher rates as other borrowers would have been, or as you would have assumed. And so I think that’s one of the reasons. Things were a lot better. And there was also the fact that a lot of people thought we were going into a recession. And so the expectations for the stock market were very low. People thought, okay, if we go into recession, that means earnings are going to fall. And if earnings fall, that means the stock market is probably going to fall.
And since that didn’t happen, expectations were so low, it just, things just had to get a little better for the stock market to do well. I think that’s part of the reason that it went up so much in 2023.
RP: OK, there hasn’t yet been a US recession since the pandemic, but it certainly hasn’t been plain sailing for the economy. For Ben Carlson, the lesson for investors is, the economy and the stock market are two different things.
BC: The pandemic was this, this crazy period, and then following that you had inflation, and people were, were not used to that, because it had been 40 years since we’d seen inflation that high. So I think people were really confused about the macro setup, and I think a lot of people were paying more attention to the economy.
And frankly, I think the economy has been more volatile or more interesting than the stock market, even though we had a bear market. And so I think a lot of people conflated, well, the economy feels bad because prices are higher and it’s so volatile and it’s whipsawing all around, right? We had the pandemic where you had almost deflation and high unemployment, and unemployment came back down and prices went up.
I think that was very confusing for people, and I think it’s a good lesson in the fact that the stock market really is not the economy, right? And sometimes they’re in parallel with one another, but other times it, it really is, is completely different things.
Especially when you’re talking about something like the S& P 500, that’s so dominated by big tech companies. You know, the tech companies make up 30 or 40 percent of the S& P 500, and that’s not the way the U. S. economy is set up, right? The U. S. economy is not 40 percent made up of technology, so it’s not all, they’re not always going to work in parallel with one another, and the stock market is not the economy, especially in the short run.
RP: Many commentators have suggested that US stock valuations are now so high that they’re due for a fall. They often refer to an indicator called the Cape Ratio. What is that?
BC: The CAPE ratio is something Robert Shiller came up with, and it essentially looks at the last 10 years worth of earnings to try to smooth out so, you know, any given year you can see earnings rise or fall.
It tries to smooth things out and inflation adjusts them. To try to give you a better gauge of what the valuation of the stock market looks like over time. So it’s a price to earnings ratio, but those earnings are the last 10 years worth of earnings adjusted for inflation. So the idea is if you’re just for inflation, you kind of smooth out the earnings.
You should be able to get a better gauge of where we stand historically, and Professor Shiller brought this data back to 1871, which I’m sure was quite a heavy lift, and, and so a lot of people have looked at this as, as like the gauge for this is, is the stock market cheap or is it expensive, and right now, if you looked at the historical average, which is, I don’t know, 17 or 18 now, I think, uh, it’s, It’s running at about 30, so people would say it’s, it’s pretty high.
It’s interesting because the last time we got this high was in 2017, and people said this is the third highest it’s ever been behind the Great Depression, and then the dotcom bubble, and it didn’t really matter because returns since then have been, have been pretty wonderful. So, I think the idea here is that any valuation metric requires some context.
Peter Bernstein in his book, Against the Gods, wrote about mean reversion and how it’s one of the most powerful concepts that there is, but he said that the problem with mean reversion is what happens when the mean changes, right? And the average is different. And so if you’re looking at historical averages and expecting that there’s going to be mean reversion, it seems easy, right?
Well, this number is higher than the average, so eventually it’ll fall back to it. Or this number is lower than the average, so eventually it’ll fall back to it or rise up to it. And the problem with that thinking is what happens if the actual average changes, right? And, and for the U. S. stock market, valuations have been slowly but surely creeping higher for 30, 40, 50 years now, and, and I think that’s what makes it difficult to look at something like MetaVersion and assume, well, something looks expensive relative to history, so it must fall without first stopping to think what has changed in the market and could that average be different now than it was in the past.
RP: As Ben says the S&P 500 is dominated by large tech firms — the so-called Magnificent Seven. Should investors in the index be concerned about being heavily so exposed to a small number of businesses?
BC: I have two, two feelings about this. And that’s something people have been worried about for a while because the concentration of those companies has been increasing. The S&P 500 now represents something like 30 percent of the total, and it was 20 percent maybe 10 years ago. So those, the bigger firms have been getting bigger, Apple and Amazon and Microsoft and Facebook and Nvidia and these companies. And a lot of people worry because, you know, if these companies fall, that’s going to take the whole market down with them.
If you look at the history of the U. S. stock market, uh, the big winners like that, the biggest companies tend to have outsized impact on. The index itself, and that’s actually one of the benefits of indexing is, it’s a small handful of stocks that make up the majority of the long term gains. So Henrik Bessembinder did this study a few years ago where he looked at where have all the gains come from over the past hundred years or so.
And the majority of the gains came from like 4 percent of the companies, where it was a tiny amount. And then he looked at, and most of the companies in the stock market over the very long run have underperformed sitting in T bills or cash, right, or a savings account. And, and your first, at first blush, you’d say, well, that’s fine. I’ll just avoid the losers and try to pick the winners, which is obviously would be great if, if, if anyone could do that with consistency. The problem is picking those winners ahead of time is very difficult. And the great thing about index funds is that those winners tend to rise up and they more than offset.
And so you have these big gainers that, that have this sort of momentum like strategy and, and they, they swallow up the rest of the market. And that’s actually a feature, not a bug of indexing that, uh, you’re diversified enough where the, the big winners are more than going to make up for the losers. That’s that’s actually one of the wonderful parts about it. And I think that’s the biggest takeaway from that type of research is you don’t want to have a concentrated portfolio and try to pick those winners because if you miss out on them. Odds are you’re going to pick a loser, right? You have a much higher success, a much higher probability of picking a loser than picking the winner for picking stocks.
But with indexing, you ensure yourself that you’re going to be invested in those winners in some form.
RP: So what about the possibility of a recession in the world’s biggest economy? It is, of course, bound to happen at some stage. The problem is, nobody knows when.
BC: My whole ethos of investing is most of the time the stock market goes up, but sometimes it goes down. And that’s kind of the same thing with the economy. If you look at the economy, I think the long term averages I’ve looked at, it’s something like 80 plus percent of the time, I think it’s like 88 percent of the time, the economy is expanding, meaning like 12 percent of the time, it’s contracting and it’s in a recession.
And so I don’t think you can be oblivious or blind to the fact that there’s going to be downturns. But I think this period has shown that trying to guess when those downturns will happen is very difficult. So what we try to do is, is help people understand that you have to build these downturns into your financial and investment plan.
Of course, again, you can’t hope that it’ll never happen. They’re going to happen at some point. A recession in the U. S. for the past hundred years has happened once every, you know, five or six years. So it’s, it’s going to happen. The, the point is that you make your portfolio durable enough to handle those periods and have a plan of attack on how to handle it as opposed to trying to guess when it’s going to happen all the time and jump in and jump out.
And the thing is, even if you knew the exact timing of the recession, I’ve looked at this data in the past, it might not help you with your investment portfolio because a lot of times the stock market will, will fall before the recession starts and bottom before it’s over. Right. And so if you, even if you knew when the recession, you had the headlines in advance, recession is going to start on June 30th, 2024, nd it’s going to end in December, 2024. If you’ve had that information, it might not help you as an investor because trying to time the market based on it might not help you either because the stock market is forward looking and doesn’t always, you know, fit within these boundaries of when a recession begins and when it ends.
RP: Finally, it surely hasn’t escaped your notice that there’s a Presidential election in November. The financial media is already full of speculation on what a win for Trump or Biden would mean for the markets.
Here’s Ben’s view.
BC: The way that I view it is politicians get way more credit when things go well, more than they should, and they get too much blame when things go poorly for the economy or the markets than they should.
If politicians really had these levers they could pull to, I’m going to reduce gas prices, or I’m going to increase economic growth, or I’m going to increase rates, or decrease rates, or increase inflation, or decrease inflation. They would pull them all the time, right? They would keep hitting those buttons if it were that easy.
The U. S. economy, I think, is 28 trillion now, approaching 30 trillion. If you think one person or one group of people can totally impact, you know, how that huge battleship is positioned and turn it around on a dime, I think you’re a little delusional. Obviously, policies can have an impact and sentiment can have an impact on how people feel on the edges. But I think overall, most of the time, politicians rarely come through with the stuff that they promise in their campaigns anyway. Uh, a lot of times it’s, it’s counterintuitive that, you know, this, this, this president or this party is going to be good for energy or bad for the, and a lot of times it’s, it’s, it’s the opposite.
And so I think as much as you can you should keep politics out of your portfolio. It makes a lot of sense because they don’t have nearly as much control as some people would like to believe
RP: So, Abraham, it’s strange isn’t it? We’ve had so much negative news on the US economy over the last few years, and yet US equities have defied expectations again and again. What are your thoughts on that?
AO: I entirely agree with Ben. It’s so hard right, it’s it’s incredibly hard just to explain what has happened looking through the rearview mirror as you might say but it’s even harder to try to predict the future whether by looking at the economy or by looking at the stock market most investors will be best served to take a longer term view Of their investment and what evidence and data over the last, uh, you know, century tells us is that investing for the longer term in the stock market in a, in a diversified portfolio works.
RP: It was interesting to hear Ben Carlson sounding really quite relaxed about the domination of the S&P 500 by technology stocks and particularly the Magnificent Seven. Yet this is seen by many as a problem, isn’t it?
AO: Often, many people see it as a problem. You know, often these are people who are trying to promote, uh, active management in one way or the other.
Now, dare I say, this is not really a problem for a global investor. If you are holding a globally diversified portfolio, you know, index fund. So let’s take, you know, MSCI, um, you know, world index, for instance, the biggest company in that index will probably be about 5 percent of the portfolio. Now it’s even lower if you are tilting your portfolio towards value stock or, or, or small cap within an index structure. Um, you know, the one I’ve looked at recently, you have maybe the biggest company. Occupy, occupying around 2. 5 percent of your portfolio and the top 10 companies, um, are less than 10 percent of your portfolio.
So my point is that for a globally diversified index investor, this is not a problem. Now, compare that to, you know, an actively managed portfolio where, you know, let’s say they want to hold a portfolio of between You know, 30 to 40 stocks, um, there is even a greater deal of concentration there. So my point is that, um, you know, these people who are, uh, sounding alarm bells about domination of, um, you know, large companies in the S&P 500 or in the global stock market, for the most part, uh, you know, shouldn’t be taken seriously.
RP: We discussed the Shiller Cape Ratio in the interview. It’s currently around 30, which is on the high side and could be considered as a reason to reduce exposure to US equities. But again, Ben didn’t seem too concerned about that either, did he?
AO: No, look, I wouldn’t bet against the U S, or the U S stock markets. Today it’s around 60 percent of the global stock market. And a big part of that is because, um, you know, much of the innovation, uh, you know, the, the great companies of the world, uh, that we use in our daily lives today.
A U. S. based company, or they are listed in the U. S. stock market. And so no, this is not, uh, you know, this is not something that I am concerned about as a globally diversified index investor. Because yes, there is a chance that at some point there’s going to be some sort of reversion to the mean as, as Ben was talking about.
But to me, that’s something that you are just for and account for in your financial plan, rather than, um, you know, using it as a way to either time the market or worse, uh, reducing your allocation in, in a particular country relative to, uh, the shape of the global stock market.
RP: Finally, Abraham, any comment from you on the US election from an investing standpoint?
AO: I agree entirely with Ben to keep politics out of your portfolios. As I like to say, the stock market doesn’t give a monkeys about your stupid politics.
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