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Market Valuation Models - Are They Useful for Identifying Opportunity & Managing Risk?

Valuation models such as the Price/Earnings (P/E) Ratio or adjusted versions of the latter such as the Shiller price-to-earnings ratio (which is a P/E ratio based on average inflation-adjusted earnings from the previous 10 years) aim to project and predict the relative earnings power of a company over a period of 10 years. The higher the PE ratio is, the greater the expectation a company will deliver strong growth and profits. The expectations of strong growth and profits and rewarded by the markets with a higher valuation. Conversely, the lower the P/E Ratio, the lower the expectation of the company's growth rate. This is likewise reflected in the overall valuation of a company.  Price/Earnings rate multiples will inevitably decline once a company reaches a certain size which is offset to a degree by the greater earnings realized.

Can the P/E ratio help you mitigate risk and optimize returns? It can be a useful factor or variable that should be taken into account along with a number of other variables. For example, it is a useful measure for comparing a company to it's competitors and the aggregate P/E ratio of companies in a particular sector vs another sector of the economy or the market as a whole. Expectations are of course based on human analysis and an unknown outlook of the future. The higher the expectations and resulting valuations, the more risk as a lot needs to go right and keep going "right" in order to justify higher P/E ratios and valuations.

High P/E Ratios can help you identify up and coming companies that the market is identifying as having the strongest potential. Such companies are often referred to as "Momentum" stocks and can deliver significant gains. Companies with strong sales growth provide a foundational underlying metric that offers investors a rational reason for paying a high P/E Ratio for a company. However, this is not always the case. Companies can command high P/E ratios on the promise of high sales and earnings expectations while not yet having any meaningful revenues or earnings. Such companies command even higher risk and warrant expert analysis.

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Market Psychology & Cycles That Repeat

As investors for the long term, market cycles are an inveitable part of the capitalist boom (expansionary monetary environment) and bust (contraction of credit) cycles that ebb and flow with the economy. Bull and Bear markets are a constant. History proves out for the last hundred years that the overall market trajectory is up, so if you are investing for the long term you dont have to worry providing you are not relying on the market for a significant part of your monthly income. For long term investors who dont need to draw down on their portfolios for income purposes, the psychology to adopt is: "ignore market downturns" and "continue to live your life." The markets will come back. The last hundred years proves they always do!

For strategic traders who want to take advantage of transitions from Bear to Bull Markets or Bull to Bear markets, market psychology can prove a valuable tool (among others) to gauge when to get out or get in.

So what do market tops or bottoms have in common?

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Why Has The Fed Shifted to A New Policy Framework?

The Fed monetary policy is changing, focused now on the "broad based and inclusive goal of full employment". The long held belief that low unemployment was a signal for potential inflation turned out to be a "false" belief. Prior to COVID-19 when the USA apprached its lowest level of unemployment in 50 years economists were surprised to see that there was little to no spike in inflation. The measure(s) of inflation however are complex and an entire paper can be written on the obfuscation of the truth hidden in over 15 different measures of the money supply and how increases in rent, food, health and education expenses are factored into the measure of inflation. We will also not dwell on the fact that trillions of dollars in newly minted currency has entered the economy via the stimulus bills and Fed underpinning of the economy.

For the purposes of this post, we will take the Fed at its word that inflation has been held to less than 2%. That goal however is now going to be sacrificed for the sake of stimulating the economy, job creation and the goal of full unemployment. Forecasts, at this point in time, do not see unemployment falling to less than 5% until the end of 2023. The damage to business and the conomy caused by the coronavirus is going to take time to rectify. The big winners resulting from COVID-19 are the tech businesses that have seen trillions of dollars added to their market cap in less than 6-9 months. It is worth pointing out that ten years ago tech may have represented approximately 16% of the S&P 500 whereas today it comprises almost 37%. That is an enormous shift. At some point "tech" stocks will inevitably correct and with it the S&P 500 to a greater degree given the heavier tech weighting it now bears.

In practice this new Fed policy shift means that they will not consider raising interest rates unless inflation rises above 2% and even then, may continue to keep interests rates low for the purposes of encouraging business investment and a stronger labor market. While this will inevitably mean higher food prices, new asset bubbles forming and who knows what else, the goal of full employment is worth the cost, at least that it is the new theory or belief. This new belief also assumes that if individuals and businesses believe that inflation is inevitable and will result in a dilution of their future dollar spending power, they will be incentivized to borrow, spend and invest their money sooner, leading to a virtuous cycle of stimulating the economy, job creation and rising markets.

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COVID-19 and The Implications of Rising National and Corporate Debt

The arrival of COVID-19 has caused the greatest disruption in the global economy since World War 2. It has exposed significant weaknesses in the modern day global economy and in the healthcare systems to respond to such a pandemic.

This article is going to focus on the impact that COVID-19 is having on the national debt, both globally and nationally and on corporations as well as the potential implications of the latter, especially as we do not know how long COVID-19 will be with us or when an effective vaccine will be proven out, distributed and administered.

At this stage in the pandemic we can point to actualities. The International Monetary Fund estimates that public debt as a percentage of GDP will rise above 130% in 2020 and 2021. It will exceed levels only seen during and after World War 2. Global debt is close to 331% of GDP or a staggering $258 Trillion and in more mature markets it is estimated to be as high as 393% of GDP. These numbers are hard to digest. Britain's national debt for example is forecasted to be at 418% of GDP in 2070. Only 4 years ago economists were forecasting it would be 87%.

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How Much Do You Need To Retire On?

There is no "one size fits all" when it comes to answering the question: "how much money will you need to comfortably retire on"? It is entirely dependent on your retirement goals, desired lifestyle and how flexible you are. 

The most common wisdom that you will find on the internet will tell you that the number is 70% of your pre-retirement income. That number will of course vary depending on your expenses which in turn will depend on where you are living. The good news is that - if you are flexible - there are different retirement options for almost every budget if you are willing to move where the costs can accomodate your income. For example an article in MoneyWise covers 20 different countries where you can retire on a lot less than you may think is possible.

Countries such as Portugal, Uruguay, France, Costa Rica, Portugal, Thailand are covered in the article where yes, appartment rentals can be found ranging from $350 to $750/month. If you have a retirement income of $2500-$3000/month for example, you may find that one of these countries could serve up a workable and enjoyable retirement. 

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Hawley Advisors
1600 South Main Street, Suite 190
Walnut Creek, CA 94596
Phone: 925-906-9800
Fax: 925-906-9884
info@hawleyadvisors.com

 

 

Hawley Advisors is an investment advisor, registered with the State of California. Any investment ideas or strategies on this website are for the purposes of education and general information only and should not be construed as specific investment advice. For more information about our firm please check the SEC Public Disclosure website: https://www.adviserinfo.sec.gov/

 

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