The Road Back

Jonathan Clements

WHEN I WAS A TEENAGER and bathroom walls were the equivalent of today’s Twitter, you’d often read that “100,000 lemmings can’t be wrong.”

It turns out that the bathroom scribblers were misinformed and that lemmings aren’t, in fact, given to mass suicide. Still, the scribblers’ confidence in the wisdom of crowds was spot on. If 100,000 lemmings did indeed commit mass suicide, there would likely be a good reason.

Which brings us to today’s stock market.

Millions of investors are sending a message: The global economy will soon recover, and corporate earnings won’t be far behind. That doesn’t mean we won’t get many more coronavirus-related deaths. But investors are betting that those deaths won’t stop the recovery, which is why they’ve bid up the stocks in the S&P 500 by 36.1% since the March 23 low.

These investors may collectively be wrong, but I’m not inclined to argue with them. Their combined grasp of the economy is undoubtedly far better informed than anything I could muster sitting here at my dining room table. The upshot: Amid this remarkable rally, here are five things I wouldn’t do:

1. Don’t doubt the recovery. The market’s rise may reflect the collective wisdom of millions of investors, but there have been naysayers every step of the way, and that’ll continue. The media loves a good debate, so bearish strategists and money managers will get a fair amount of airtime.

And every so often, they will seem prescient. We’ll have bad days and weeks in the stock market when news about the economy or COVID-19 disappoints. Indeed, the speed of the economic recovery remains a huge unknown—and developments that suggest it might be slower than expected will dent share prices. But the setbacks will likely prove temporary. The issue isn’t whether the economy and hence the stock market will recover, but when.

2. Don’t sell too soon. After the stock market’s shellacking over the four-plus weeks through March 23, many investors are no doubt relieved to have recouped much of their losses—but also fearful that the rally could go into rapid reverse. Tempted to sell? Blame it on the old “get even, then get out” mentality.

To be sure, a little selling could be justified. If your portfolio targets are 60% stocks and 40% bonds, and you rebalanced back to those percentages earlier this year when share prices were depressed, you likely now have significantly more than 60% in stocks—and you’ll want to rebalance at some point. I can’t tell you when’s the best time to do so. It’s a tradeoff: Postpone rebalancing and your portfolio will perform better if today’s rally continues, but you’ll also suffer more if share prices falter.

Of more concern to me are those who, both scared and scarred by this year’s slump, decide to radically reduce their stock holdings now that they feel they’re back to even. We got a taste of stock market risk earlier this year: If folks sell now, they’ll have suffered through that risk—without ever getting their long-run reward.

3. Don’t bet only on the S&P 500. On this one, I feel like a broken record. For the past decade, owning the large-company stocks in the S&P 500 has been pretty much a one-way ticket to wealth. Even this year’s bear market was surprisingly painless: Yes, the S&P 500 fell 33.9% from peak to trough, but it now sits just 10.1% below its Feb. 19 all-time high. Other areas of the global stock market have been punished far more.

Will large-cap U.S. stocks continue to dominate—or will smaller U.S. companies, emerging markets or perhaps developed foreign markets shine over the next decade? U.S. small company stocks—especially small-cap value—have posted impressive returns during the recent rally, and some think this might herald a long-term resurgence. Will it? I have no clue, and nor does anybody else. Faced with our lack of clairvoyance, the smart move is to diversify, making sure we have a healthy sum in both foreign markets and smaller U.S. stocks.

Not inclined to diversify globally? If your only stock holdings are the S&P 500 companies, ask yourself, “What would be the consequences if I’m wrong?” Over the past 90 years, U.S. stocks have outpaced foreign shares in four decades, while international markets had the edge in the other five.

If you look at each of the nine decades, the performance gap between U.S. and foreign stocks ranged from 1.4 to 13.9 percentage points a year. In other words, you could invest solely in U.S. stocks and risk massive underperformance over the next decade—or you could own a globally diversified portfolio and have greater confidence that your returns will be respectable, no matter which parts of the global market sparkle.

4. Don’t look at valuations. In 2019, the S&P 500 companies generated reported earnings of $139.47. This earnings figure is adjusted so it’s comparable to the level of the S&P 500 index, which closed yesterday at 3044.31.

For 2020, the folks at S&P Global are expecting reported earnings of $93.88, a 32.7% decline from 2019’s level. If the stock market simply treads water for the rest of this year, its price-earnings ratio would leap to 32.4, well above the 50-year average of 19.4. That shouldn’t frighten you (but I’m sure some bearish commentators will try). If all goes well, corporate earnings will recover in 2021—and surpass 2019’s level.

5. Don’t get too comfortable. While I think stocks remain the best bet for long-term investors—and my hunch is that diversifying beyond the S&P 500 will pay dividends—I’m still surprised at the strength of the current rally and that the S&P 500 is down just 5.8% for the year to date. Think about that 32.7% hit to company profits. That’s a big chunk of corporate earnings that shareholders won’t benefit from—and which arguably justifies today’s lower share prices.

To be sure, we shouldn’t look at stocks in isolation. In 2020, interest rates have fallen to rock bottom levels, making bonds and cash investments an unappealing alternative. Indeed, I think a globally diversified stock portfolio will handily outperform bonds and cash in the decade ahead. But make no mistake: As bad corporate news trickles out the in the months ahead, there will be days when that forecast looks utterly foolish.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Look ForwardTake Heart and No Alternative.

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