My thoughts on markets and money: Risks and returns

 (NOTE: This was originally published to clients April 2024) 

History lesson

Like first love, one rarely forgets one’s first stock purchase.  In 1999, at the height of the dot.com bubble, I bought my first stock Helen of Troy (HELE) − 150 shares at $12/share.  The company owned Revlon, my go-to makeup brand throughout late-teens and twenties.  But, like many people, I couldn’t resist the powerful narrative that dominated this period: the nascent internet would radically change how we live, work and play.  (Sound familiar?)  Any company and/or IPO that had a tech-sounding name and/or a dot.com behind it seemed destined for success.  To get in on the action…but also hedge my bets, I decided to buy WorldCom (WCOM – 50 shares at $50/share), a telecom that provided long-distance phone service

to the public. Touted as a key owner of the “internet highway,” the company seemed grounded in reality versus hope…or hype. 
 
In March 2000, the tech bubble burst, and I saw both my stocks go down with the market.  By late-2003, my WCOM stocks had sunk to $0 when the company declared bankruptcy due to “accounting irregularities.”  (Management had cooked the books.)  Meanwhile, by early 2004, my HELE stocks had doubled to $24/share.  Fearful that my HELE stocks would also eventually go to $0, I decided to cut my losses by selling all of it.  MY NET RETURN: -$2,500 (WCOM net loss) + $1,800 (HELE net gain) = -$700 or -16% (total net loss).  Financially, this loss stung a little bit.  Emotionally and psychologically, it stung a lot.  But, looking back, I now realize that $700 was a small price to pay for two of the biggest investing lessons of my life: 1) don’t invest in individual stocks, unless it’s an amount I’m willing to lose 2) the louder and more exuberant the crowd is about a stock, the market, the new invention X, the riskier the investment and/or investing environment is becoming.  Exuberance often reflects a growing disconnect between price and value (aka earnings).     

Recent history – quick recap (2022…2023…Q1 – 2024)

Beginning March 2022, to fight high-single digit inflation, the Fed began raising interest rates aggressively from 0% to 4.4% by year end.  The bull market that had begun in March 2009 on back of ultra-low interest rate began to burst.  The party seemed over and the (painful) reckoning begun. The lucrative, but expensive, tech sector that had led the (bull) market up also led the (bear) market down. 

In March 2023, financial distress seemed to spread with the sudden, dramatic collapse of SVB (Silicon Valley Bank), which was then followed by a slew of other regional banks. Interestingly, coinciding with the downturn was the launch of ChatGPT (late-2022).  It represented the advent of AI, which would radically change the way we live, work and play.  (Sound familiar?)  Despite (now) higher interest rates 5.25%-5.5%, the tech sector once again led the market up as some of its biggest companies (e.g., Microsoft, Google, Amazon, Nvidia) were viewed as frontrunners in the AI race.  By end-of-2023, the market had more than reversed 2022 decline as the Dow Index hit a new high of 37,689.  The S&P 500 benchmark annual return was 24.23%.  It was fun (again) to look at year-end statements as balance likely increased…by a lot.   
 
Coming into 2024, the overall economic environment seems promising: continued strong stock market performance (S&P 500 Q1 return – 10.6%); lower inflation (3.5%); strong corporate earnings; historically low unemployment (3.9%).  All signs seem to suggest and support the growing consensus: soft landing and likely interest rate cuts later in the year.  Painful recession averted.  Party continues.  

Potential risks 
But, beneath this growing optimism are some key risks that the public are likely overlooking, but serious investors should be aware of and take into account as we move forward.  First, if history is any guide, there’s usually a lag (about 10 quarters) between raising interest rates and feeling the (economic) effects of higher rates.  Currently, we are at the beginning of the ninth quarter as the Fed began raising rates in March 2022.  So, it’s difficult to say if we’ve averted or have simply delayed a more painful recession.    
 
Second, according to the Shiller PE (price per earnings), which is viewed as a more accurate gauge for how expensive or cheap stocks are as it factors in market cycles and inflation, the S&P 500 is trading at a PE of 33 (ending Q1, 2024 – below).  This is a market high superseded only by 2021 and dot.com bubble.  

 Source: https://www.multpl.com/shiller-pe

 
Third, domestically, we also face political and fiscal uncertainties.  In terms of politics, we have another Presidential election coming up this November, which adds a big element of uncertainty to…well…everything.  Fiscally, the massive public debt of the US government (aka us) is slated to grow dramatically as government bonds mature and are refinanced from historically low interest rate (1.6% – 2022) to higher rates (~3.2% – 2024)…and likely even higher rates, especially if the Fed has to hold it at ~5% to fight inflation.  (Source: “The Impact of National Debt on Our Investment,” US Bank, April 2024.)  

 
Fourth, internationally, geopolitics seem like a forest fire that keeps spreading by popping up in different parts of the world: Russia and Ukraine; US and China; Israel and Palestine.  Additionally, each major economies carry its own country-specific risks: US – upcoming Presidential election and growing public debt; Japan and Europe face dual demographic problems – aging population and low birth rates; China is experiencing the bursting of its real estate bubble and lower export, which have been the core engines behind it (and the world’s) astounding growth for the past 4 decades.

Fifth, there’s climate change.  Enough said.  

 
Finally, in the midst of these uncertainties, the higher yield on cash (4-5%) seems like an attractive place to park one’s money until the storms abate.  Unfortunately, factoring in inflation (3.5%), cash nets 0.5%-1.5% per year.  A heavy tilt to cash will likely limit one’s purchasing power in the mid- and especially long-term.  Unfortunately, non-risky can also be risky.

(Sorry to be a Debbie Downer.)

Potential returns

Now, for some potential investing bright spots.  First, while the US stock market is expensive (regular PE = 21, ending Q1, 2024) relative to historical average (PE = 16 or 17), there are pockets that seem to offer better risk/return ratio, foremost being value sector (PE = 16) and small cap (PE = 17).  Since the US market make up about 60% of the global equity market, it’s still important to stay invested in it.  However, it may be profitable to rebalance from expensive large-cap (especially tech – PE = 31) to less expensive value sector and small cap.  Also, as cardinal rule, regardless of where the market is, it’s best to stay diversified in terms of market sector (growth and value); market cap (large, mid, small); etc.  

Second, unlike US stock market, international stock market is relatively cheap (PE = 14).  Over the past 10 years, it has trailed the US market by a lot, based on 10-year annualized average return, ending Q1 – 2024: 5% vs 11% (US).  Not only does international stocks seem to offer more potential upside, but its dividend payment of 3.5% vs 1.5% (US) also rewards investors as they wait. Moreover, within international stock market, emerging market looks particularly cheap (PE = 13) due to increasing geopolitical tension between the US and China as both countries actively seek to decouple from each other’s economies. But, as often the case in investing, the greater uncertainty, the greater the risk, the greater the potential return.  Since the news and market are pessimistic about emerging markets and have priced in the possibility of open (military) conflict between the US and China, for hardcore contrarians, this could be a buy signal.   
 
Third, higher interest rates has made bonds look more attractive than any other time in recent decades.  One way to capitalize on bonds is by building a bond ladder with high-quality short- and intermediate bond mutual funds. Should the Fed continue to hold interest rate steady (~5%), short- and intermediate bond funds will continue to yield around 4-5% with little risk.  However, should the US economy go into a recession and the Fed needs to cut interest rates to stimulate growth, short-term bonds will likely retain much of its value while intermediate bonds will likely increase in value as investors seek safety.  Bonds and interest rates are inversely correlated.  If one does up, the other down and vice versa.  A bond ladder allows investors to enjoy decent return (4-5%) in the short-term and potentially additional upside in the mid-term, especially if economy temporarily tanks.

Final thoughts…

When it comes to investing, risk is an inherent part of return.  Higher return requires taking on greater risk.  Moreover, it’s difficult, if not impossible, to forecast economic “weather” from day-to-day.  However, based on historical data, we can develop a working sense of economic weather patterns (aka cycles or seasons), foremost being bull markets are followed by bear markets and so on. 

 
Currently, we’re enjoying the longest bull markets in US history: 2009-2024 YTD.  And, the general consensus is that we’re in for a soft-landing, if not, at the beginning of another bull market (AI-led).  Evidence: strong stock market performance; high corporate earnings; low unemployment.  Interestingly, successful investor, bubble expert, billionaire and octogenarian, Jeremy Grantham (GMO), recently observed that bull markets are born out of an economic environment of weak stock market performance; low corporate earnings; high unemployment…so, essentially pessimism vs optimism…the opposite of our current environment. 
 
Still, regardless of where we are in the economic cycle, the cardinal rules of successful investing hold true: stay liquid; stay diversified; stay invested; stay calm.