Suppose you are the proud owner of a US core stock portfolio. If I asked you what that portfolio was worth, what would you do? If you’re like most people, you’d check the price of each stock, multiply that times the number of shares you own, then add it all up. “$1 million,” you’d proudly announce.
Probably, that’s wrong. To illustrate why, let’s look at the only two stock ownership scenarios that matter.
Maybe you’re a trader. You buy and sell stocks every day. Your portfolio is marked to market every afternoon. Your P&L is calculated daily, weekly, monthly, quarterly. You look at the pricing of stocks today and you look at your charts and market momentum and you don’t like what you see. In other words, despite what Mr. Market is saying, there’s no way you, personally, would pay $1 million for the portfolio. Given your negative outlook what you’d actually pay would be closer to $800,000.
Another trader might have a much more positive view of the markets and hence of your portfolio. He’d be delighted to snap it up for $1 million, but he’d also be willing to pay more if you’d hang tough for awhile.
In other words, as far as short-term traders are concerned, your portfolio might be worth $1 million, but probably it’s worth more or less than that, depending on how many traders are positive and how many are negative on the short-term outlook for the market.
Now let’s switch to the other end of the stock ownership spectrum: long-term investors. If you’re a long-term investor you couldn’t care less what the market is saying your portfolio is worth today, since you have no intention of selling that portfolio for many years. If you’re an institution or a wealthy family, your time horizon is measured in generations. You should be thinking, as I’ve said many times before, dynastically, not tactically. Even if you’re a retail investor (who isn’t retired), your investment time horizon is likely measured in decades.
For a long-term investor the only relevance of Mr. Market is to help you decide whether to add to – or, possibly, subtract from – your portfolio. If Mr. Market is discounting the price of stocks significantly, you might decide to add to your portfolio. If Mr. Market is wildly over-pricing stocks, you might decide to take some profits off the table and lighten up (though the tax hit might make you think twice). Other than that, you couldn’t care less.
So if neither short-term traders nor long-term investors are interested in the fact that your portfolio happens to be priced today at $1 million, what sense does it make to say your portfolio is “worth” $1 million? The short answer is, “None.”
This is an important point, because investors tend to get seriously confused when they price their portfolios, especially when pricing falls at the extremes. In the late 1990s, the stock portfolio we’ve been talking about would have looked like it was “worth” close to $2 million, because that’s what the pricing charts said. Sensational! Except it wasn’t. A few months later it was “worth” closer to $500,000.
Similarly, in early 2009 that portfolio looked like it was “worth” close to $500,000, because that’s what the pricing charts said. Horrible! Except it wasn’t. A few months later it was worth over $1 million (and still climbing).
So let’s go back to the first question: What’s your portfolio worth? The correct answer is, “My portfolio is “worth” about 15X 12-month trailing earnings.(1) Forget what the actual price is, because if your portfolio is priced at a lot more than 15X – say, at $2 million – then pretty soon you’re going to lose a lot of it. Maybe you want to sell, but at the very least you will recognize that your portfolio isn’t really “worth” anything like $2 million.
And if your portfolio is priced at a lot less than 15X – say, $500,000 – then pretty soon it’s going to go up a lot. Maybe you’ll want to add to the portfolio, but at the very least you won’t despair, thinking your portfolio is really “worth” anything like $500,000.
If you’re a believer in efficient markets, you will want to calculate its value according to “Fama” PEs, and if you don’t believe markets are efficient you will want to calculate its value according to “Shiller” PEs.(2)
The next time you price your portfolio – or get your performance report – you will get a better handle on where you stand if you compare how it prices out to what it’s really worth.
(1) Because 15X is about the average, or normal, value of core US stocks. Just because the stock market is euphoric or in despair is no reason for you to get excited. “Price is what you pay. Value is what you get,” says the Sage of Omaha.
(2) A “Fama” PE is exactly as stated earlier: the current price of the stock divided by its 12-month trailing earnings. A “Shiller” PE “normalizes” the calculation by using the real (that is, inflation-adjusted) price level of the S&P 500 as the numerator and a moving average of the last ten years’ earnings as the denominator. This version is more formally known as the Cyclically Adjusted PE Ratio, or CAPE. Eugene Fama and Robert Shiller both won the Nobel Prize in 2013, but they can’t both be right.
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
