The Wisdom to Show Restraint

Jan 27, 2021
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“Do not wear yourself out to get rich; have the wisdom to show restraint. Cast but a glance at riches, and they are gone, for they will surely sprout wings and fly off to the sky like an eagle.” Proverbs 23:4-5

Market sentiment is more euphoric than ever. So notes the Citigroup Panic/Euphoria indicator, which in early 2021 showed a level of elevated investor sentiment surpassing the early-2000 prior all-time high.

Indeed, signs of market excess are everywhere. One of Warren Buffett’s favorite market-valuation signals is the ratio of the total U.S. stock market value (market cap) to U.S. Gross Domestic Product (GDP). A year ago, exactly one week before the COVID-19 bear market began, SMI alerted readers that this indicator had just surpassed its March 2000 peak level of 142.9%. Today, following a year of lockdowns and a massive global recession that we’re still battling back from, the ratio has soared to 192%! In other words, the stock market has never before been so richly valued relative to the actual economy.

We could go on listing any number of additional signs of market exuberance. Those would include SMI’s Sector Rotation strategy, which followed its +39.4% Nov/Dec 2020 gain by soaring another +18%...in the first 12 trading days of 2021.

Trying to attribute market behavior to any single factor is usually a fool’s errand. But the uncomfortable truth is today’s speculative excess is based on the belief that the world’s central bankers and governments are justifying these valuations via low interest rates and massive stimulus injections. Investors have learned the lesson well over the past dozen years: when governments take these actions, a large portion of the stimulus winds up driving the prices of financial assets (such as stocks and bonds) higher. These actions have never been taken at the scale currently underway around the globe.

As a result, markets face two possible forward paths:

  1. Eventually, the bubble pops anyway and we get a deflationary/bear-market result similar to most prior episodes of significant financial market excess.

  2. The value of money is debased significantly enough that the 40-year inflation cycle reverses. In this scenario, inflating nominal (non-inflation adjusted) asset prices mask the fact that the purchasing power of those assets is being eroded. This could potentially allow escape without asset prices declining significantly (in nominal terms).

Policymakers are targeting outcome number two. Confident they can contain the inflationary beast once awakened, they realize the peril of letting the markets (and likely the broader economy) go down the deflationary path of pain.

Investors are buying into the idea of the inflationary path as well — quite literally, as they flood into “reflation” plays such as commodities, energy stocks, and so forth.

In 1993, John Templeton famously warned that “This time is different” are among the “most costly words in the annals of investing.” What most investors don’t know is Templeton conceded that 20% of the time the phrase is true.

This time really is different. There is no historical precedent with which to compare today’s unprecedented policies, making it impossible to say for sure which of the two paths markets will follow.

How should we respond in the face of this uncertainty? The Proverb atop this editorial offers an important key. Regular investors can easily fall into the trap of blowing past restraint en route to imagined future riches. Here are a few tips to help check that impulse.

  • Focus on risk first, returns second.
    Your investment choices regarding strategies and the kinds of assets you want to own in your portfolio should be informed by the knowledge that another sharp downturn could happen at any time. As you continue to invest, do so soberly. Recognize that high-risk, high-reward strategies (such as Sector Rotation) can be useful in moderation, but dangerous when restraint is abandoned.

  • Don’t take more risk than is necessary to meet your goals.
    If you’ve been blessed to be in position to meet your retirement goals with a less-aggressive investment plan than you once anticipated, rejoice — then dial back your risk! The object isn’t to build the biggest nest egg possible. It’s to be a good steward and be able to provide for your future needs.

  • Set an ultimate “finish line” — and scale back risk when it is reached.
    This can protect you from sacrificing things you truly treasure (financial freedom and security) in pursuit of what you will no longer need (more dollars in an investment account).

Written by

Mark Biller

Mark Biller

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark also serves as Senior Portfolio Manager to SMI Advisory Service’s Private Client managed-account program and the SMI Funds.

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