HH The Deck Is Stacked: Putting Risk And Reward Into Perspective

"The individual investor should act consistently as an investor and not as a speculator." - Ben Graham.

We are frequently told that valuation analysis is irrelevant because fundamentals do not signal turning points in markets. Scoffers of valuation analysis are correct, as there is no fundamental statistic or for that matter, technical or sentiment indicator that can provide certainty as to when a market trend will change direction.

Despite being humbled by recent market gains and the difficulties associated with timing the market to call a precise top, we remain resolute about the merits of a conservative investment posture at this time. At some point, current equity market valuations will succumb to financial gravity and the upward trend of the last eight years will reverse. When that day arrives, it will not be because a valuation ratio hit a certain level or because the market formed a well-known technical pattern. It will simply be the day that selling pressure overcomes demand.

In prior articles, we compared the current economic landscape to the early 1980's. Let’s revisit that contrast to further quantify the risk and reward associated with the U.S. stock market during both time periods. 

As Graham so eloquently stated, speculating and investing are two vastly different endeavors, and we prefer the practice of investing.

Risk-Return Tradeoff

Investors contemplating a new investment or evaluating an existing holding are typically faced with two basic but essential questions:

  • How much of my wealth am I willing to risk?
  • What returns do I expect in exchange for that risk?

When Ronald Reagan took office in 1981, investors needed to evaluate whether his fresh economic policies could spur sustainable economic growth. In the decade preceding his election, the economy was hampered by significant inflation, double-digit interest rates, and a steadily rising unemployment rate. The Dow Jones Industrial Average (DJIA), essentially flat over the prior decade, was resting at levels similar to those seen 17 years earlier in 1964. Valuations over this period were equally stagnant, with the Cyclically Adjusted Price to Earnings (CAPE) ratio, as an example, ranging between 7 and 9.  Despite the bargain basement equity prices, few investors believed that market trends would reverse.  Equity valuations had been low and falling for so many years to that point, the trend became a permanent state in many investors’ minds by way of linear extrapolation.

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