The biggest challenge an investor faces is managing his or her own emotions. That is particularly true right now, when share prices are bouncing up and down based on a rapidly shifting mix of fear and hope.
Odds are that volatility will remain with us for months to come as the world deals with the consequences of the pandemic. Here are three tips that can help you navigate this turbulent period in relative peace.
Turn off the television
For starters, it helps to practice a bit of deliberate blindness. Don’t check your portfolio every day (or even every week). Don’t follow every talking head on television. Don’t obsess over what other people are, or aren’t, doing.
Remember: Everyone has a view to tout and a strategy to recommend, especially in the middle of a financial crisis. But nobody knows for sure what will happen next.
The past week offered a striking demonstration of how much even experts can differ. Morgan Stanley’s equity strategist Michael Wilson proclaimed the current moment to be one of the best buying opportunities in years. In contrast, JPMorgan’s head of global equity strategy, Mislav Matejka, warned the economy was in a “vicious spiral” that could drag share prices far lower than they are now.
Say it out loud: Nobody knows. You should remind yourself of that regularly during any crisis.
Set your own goalposts
Are stocks expensive or cheap? In a downturn, it can be surprisingly difficult to arrive at an answer. Smart investors look at a variety of signals, but don’t get swept up by any one of them.
Right now, for instance, stocks appear to be a screaming deal if you compare their still generous dividend yields with the paltry yields on bonds.
The problem with this simple comparison is that there is no guarantee that dividends will remain where they are. European banks have already slashed their payouts. Many other companies, especially in the energy sector, are under pressure to follow suit. If dividends shrivel, the apparent superiority of stocks may vanish.
Rather than just looking at dividends, it makes sense to also compare a stock’s price with its underlying earnings per share – the price-to-earnings ratio, or P/E ratio. But this has its limitations, too.
In a deep economic downturn, profits tumble and stocks can look expensive in relation to their recent earnings even if they are actually cheap in comparison to their long-run prospects.
Still, comparing share prices with earnings does anchor you in reality. It can save you from concluding that a stock is cheap simply because it has fallen in price.
Consider the S&P 500 index of large U.S. stocks. It is down nearly 20 per cent from where it stood just a couple of months ago.
However, as Credit Suisse noted this week, the S&P is not necessarily a bargain at these reduced prices. The index’s valuation hasn’t budged – it is still selling for roughly 19 times its projected earnings for the next year. All that has changed is that earnings projections have fallen sharply.
One way to put all of this into perspective is to use the cyclically adjusted price to earnings (CAPE) ratio.
CAPE compares a market’s current price with its past decade of earnings. In effect, it shows you how current stock prices stack up against a market’s ability to generate profits over the course of an entire business cycle.
History suggests a stock market is attractively priced when its CAPE ratio falls below 15. At the moment, many emerging markets and European markets qualify as potential bargains. (You can find CAPE ratios on Star Capital’s site at starcapital.de) Canadian stocks still look slightly expensive; U.S. stocks a bit more so.
The bottom line is that despite what pundits may tell you, stocks on the whole don’t seem exceptionally cheap or expensive right now. So relax.
Embrace the pain
A friend of mine, a champion distance runner, once told me he spent the last couple of kilometers of every race focused on a single thought: If I’m hurting this bad, everyone else is hurting worse.
Same thing holds true for investors. Yes, you’re suffering at the moment. So are most other people. Assuming you began the downturn with a sensible portfolio, your relative wealth probably hasn’t changed all that much.
At times like this, it’s worth remembering why stocks generate better returns than other types of assets. Their prices are volatile and investors must be compensated for bearing that volatility. The pain you’re feeling right now is the price you pay for better returns down the road.
And those better returns will come. Verdad Capital, a U.S. hedge fund, likes to demonstrate the fickle nature of markets by pointing to the strong inverse relationship between present prosperity and future stock market returns. Bad news now is good news for investors who buy and hold for a few years.
Verdad measures the current state of the economy with what it calls the prosperity index – growth in gross domestic product (GDP) minus the unemployment rate. The lower the prosperity index, the better future stock market returns tend to be.
When the prosperity index falls below minus 4.2 per cent (as it surely will this quarter), the economy is in miserable shape. However, in these situations, the stock market has historically generated an annual return of 18 per cent over the next year. There are no guarantees, of course, but investors should feel at least mildly optimistic whenever things get as bad as they are right now.
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