Don’t Confuse Brains With A Bull Market

Photo Credit: Bouncey2k (https://commons.wikimedia.org/wiki/User:Bouncey2k)

According to the Shiller 10 Year PE, the S&P index is expensive, valued at 30.23 as of this writing (Thursday 8/03/2017).   Two US Federal Reserve Presidents have also gone on record stating that the US market is getting, “frothy.”

What does that mean?

If you read Nate Silver’s awesome book, The Signal And The Noise, he illustrates the relationship between the Shiller 10 year PE and average stock market returns.  Here’s a great summary of the chapter.  The basic premise is that while the Shiller 10 year PE is a pretty lousy predictor of short term returns, it is a very strong predictor of long term returns.  The higher the Shiller 10 year PE, the lower the expected return.  The lower the Shiller 10 year PE, the higher the expected return.  The long-term average Shiller 10 year PE  is about 16.  The take away: the market feels expensive.

I can tell you from our personal experience, it has been an outstanding ~decade.  I started tracking our net worth in early 2009, and it’s safe to say that we’ve done well.  Obviously, saving as much as we can helps.  Our net worth has doubled since mid 2015.  That’s right, in 2 years!  In those two years, a couple of pretty big things have happened for us:

  1. The S&P went from 2028 on Jan 1, 2015 to 2472 on July 21, 2017.  An aggregate gain of about 21%.  (2472-2028)/2028 = 444/2028 = 21%.
  2. We substantially increased our retirement savings rate via our 401(k)s, Roth IRAs, etc.
  3. We bought a rental property that has appreciated (in funny money dollars) and generates real positive cash flow
  4. We had a kid (probably not a net worth boost, definitely not a cash flow boost…but totally worth it nonetheless!)

Here’s the plot of our net worth over time:

Being a nerd, I keep a trend line fitted atop our net worth vs time chart.  Among other things, I can use the line equation to estimate when we’ll achieve financial milestones.  Here’s the problem though: the linear trendline doesn’t fit so well anymore.  Our R^2 (a measure of how much variation is explained by the trendline) is at 0.96 for the linear fit.  A better measure when comparing non-linear models is actually s (standard error).  For the linear model, ours is $34,690.

Here’s the same chart with an exponential trend line.

Look at the standard error… it’s less than a third of the original model.  To me that says that the exponential curve better fits our actual data.  And, that fits what folks say about saving and investing.  It takes a long time to feel the effects of building a portfolio.  But, time is one of the greatest tools we have.  And, once you get going on that exponential curve, it’s hard to get off!

Now, to connect everything.  Like most “normal” investors, we benefited from steady savings through the past decade riding the wave of rising values.  Our portfolio gains have almost nothing to do with intelligence and everything to do with time, consistent savings, and maintaining low costs.  It’s not very sexy, but it works!  We have no illusions that we are different from any other investor.

So, maybe it’s time to take some age old advice.  Maybe it’s time to rebalance our allocations, locking in some of the stock gains while shifting our hard working dollars into bonds or even cash to preserve our capital for when the inevitable downturn does come.  The trade off is the opportunity cost of keeping those dollars in the market so they could reach even higher valuations.  I think it makes sense for each person to consider their own risk tolerance, time horizon before needing to tap their investments, and asset allocation to make the best decision for themselves.  But with market valuations approaching, “frothiness” I also think the time is right to do that consideration soon.

Are you taking any action to re balance your portfolio?  Are you letting things ride?

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