stock market

Dear Investors,

A lot of my clients are worried about a potential stock market crash. The higher the market goes, the more they worry and the more questions they ask on the subject.

I understand why they worry. Human beings see patterns in everything. Several fascinating studies have been done on the subject.

In one study, researchers had a machine flash either a red light or a green light. Human subjects were asked to guess which light would turn on and got a reward if they were correct. The lights were random, with green appearing four out of five times and red appearing one out of five times. The test was performed on both humans and animals. Rats and pigeons did very well. After some random guessing, the animals continually picked green. Humans, however, habitually tried to find a pattern in the randomness and kept guessing red at various times. Even when researchers told the subjects the low probability of red appearing and that the lights were random, the humans persisted in guessing red.

Maybe the humans in that study were just dumb.

Another group of researchers conducted an experiment that pitted rats against Yale students. Food was put at either the left or the right end of a T shaped maze. The placement of the food was random, with food appearing on the left 60% of the time. The rats eventually figured out food appeared on the left more and always went left for a 60% success rate. When the Yale students were asked to guess where the food was more likely to appear, they only had a 52% success rate. They couldn’t get over the urge to try to see patterns and make guesses.

So what “patterns” have appeared in the stock market over the last decade and a half? The market goes up due to a bubble and then crashes back down. It has happened twice. This, to most people, is a pattern. We become conditioned to expect a rapidly rising market and then an inevitable crash. The takeaway is that to successfully invest, you need to time the market. Ride the wave up and then bail before it’s too late.

That’s why many clients are asking, in essence,  “Is now the time to bail?”

I don’t blame my clients (or anyone) for asking this question. It’s an important question.

A Two-Part Answer: Do You Own the Stock Market or Something Else?

I have a two-part answer for this question. First, I say, “You don’t own the stock market, so in the long run the only thing that matters is the performance of the small group of businesses you actually own.”

Many of my clients have had funds invested with previous financial advisors, usually a broker at a big wire house. Their previous portfolios usually contained a raft of mutual funds—a dozen different equity mutual funds was not uncommon. These portfolios typically performed almost exactly like the stock market, mostly because when taken together the funds probably owned most of the stocks in the stock market.

There are about 3,000 to 3,500 domestic stocks that are reasonably big enough that you might consider investing in them, with only about 1,000 being well followed by other investors and large enough for big institutional investors to buy.

Want to see the number of stock holdings in several of the world’s largest mutual funds? The Fidelity Contrafund has 325 holdings, the American Funds Growth Fund of America has 282 holdings, the Dodge and Cox Stock Fund has 145 holdings, and the American Funds Capital World Growth and Income Fund has 271 stock holdings.

There is invariably some overlap between the holdings, but advisors usually fill a portfolio with all different types of funds. There is a growth fund, a value fund, maybe a dividend fund, and usually at least one variation of my personal favorite, a “Strategic Opportunities” fund (the implication being the other funds that the mutual fund company offers have the non-strategic stocks?)

It wouldn’t surprise me if my client’s previous portfolios had 500 or even 1,000 different underlying stocks in it.

When this is the case, it makes a lot of sense to worry about the market. You basically own the entire stock market, so wherever it goes for the long term, you are going too.

Okay, you say. That’s all fine and good but when the stock market goes down even my clients’ portfolios may go down too. Maybe not as far. For instance, our dividend stock portfolio has been 75% less volatile than the market since its inception. Even so, if you own stocks you can’t escape the stock market completely, so it’s probably important to actually answer the implied question: Is the stock market overvalued and a bubble?

A Two-Part Answer: Is The Stock Market Overvalued?

Is it overvalued? No, not really.

Let’s start with the argument that the stock market is a bubble and see what evidence there is in support of that.

Tobin’s Q
In the 1960s, Nobel laureate James Tobin came up with a measure of valuing the stock market. It looked at the ratio of the value of the stock market to the replacement cost of assets (similar to book value) of the companies. The median value is .7 and the current value is 1.02.

As you can see in the graph above, we are well past the danger zone (the red line) and in fact we have generally been past the danger zone since the mid-1990s.

The fact that we have been living in what, according to Tobin’s Q, is a bubble for twenty years should be a clue that something might not be quite right with this valuation methodology.

Tobin’s Q worked great for the 1950s through the 1970s when it was developed. During that time, most publicly traded companies were asset-heavy manufacturing, materials, railroad, or utilities companies.

Today, the market is made up largely of asset-light services, technology, software, and financial firms.

For those who are unfamiliar with what I’m talking about, allow me to explain “asset-heavy” and “asset-light.”

Suppose you run a widget manufacturing company. You need to buy a large building to use as a factory, you need to buy lots of machines to make the widgets, and you need to buy forklifts and other tools to move the widgets around. You need to keep a stock of raw materials like steel and rubber (I guess we are making steel and rubber widgets…) on hand. So your widget company has a lot of assets that are reflected in the financial statements on the balance sheet at something usually reasonably approximating what they are worth (subject to various accounting rules).

Now, suppose you run a software company. What assets do you need? A couple of computers for your employees, some desks, and some chairs, and some office space? Or maybe not even that. Employees can work from home. The main assets the company has will be the intellectual property rights to the software, which will not be recorded on the balance sheet at anywhere close to the actual value.

I did some research on the composition of the stock market in 1957 and today in 2013. I looked at what types of companies made up the S&P 500 (INDEXSP:.INX) stock index. I grouped each company into one of

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