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Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.
Canadians cheered when sprinter Andre De Grasse won a bronze medal in the world championships on Sunday in Beijing. But his medal didn't thrill everyone. Fans of American Mike Rodgers likely wanted him to collar the young Canadian. Instead, the U.S. runner finished fifth.
In sports, there are always winners and losers. Fans create heroes and villains. Not everybody cheers for the same team or player. Our sentiments about the stock market shouldn't be different. Some people should celebrate when stocks fall. Others should rejoice when stocks rise.
Over the past 12 months, the S&P/TSX composite index has dropped more than 13 per cent. Most Canadians should be happy – if they're cheering for the right team. About 14 million Canadians are between the ages of 25 and 55. Most of us are working. We're in the collection phase of the investment game. While collecting stock market assets, we should hope to see stocks fall or stagnate. Not doing so is like hoping that Russia crushes Canada in Olympic hockey or that Americans clean our clocks in track and field. Most people, according to Warren Buffett, cheer for the wrong team.
In Berkshire Hathaway's 1997 letter to shareholders, he tries to set people straight. He asked if hamburger eaters should hope to see the costs of beef rise. He also asked whether those buying a car from time to time should be happy if cars get more expensive. In both cases, the answer should be no, unless you're a cattle or car producer. Then he adds a final question.
"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall."
Cheering for stocks to rise, he says, is like a hamburger eater celebrating the rising costs of burgers. My big beef is with one-sided headlines. When stocks fall, headlines scream: Investors Lose As Stocks Drop!
Yes, it catches attention. But that doesn't make it right for most Canadians. Headlines should sometimes read: Investors Win As Stocks Plummet!
Now, I'm not forgetting that about 10 million Canadians are older than 55. Most investors that age should cheer for rising markets. After all, these investors will soon be selling pieces of their portfolios. When they retire, they'll need the money to cover costs of living. The age-old mantra brings the demographic difference home: Buy low. Sell high.
Yes, I would feel for the boomers if stocks kept falling. But most have already enjoyed a great run. Consider a working lifetime, from 1978 until 2014. The S&P/TSX composite index averaged 9.1 per cent a year. If $100 were invested at the end of 1978, it would have grown to $2,409 by the end of 2014. In other words, Canadian stocks gained 2,509 per cent over 37 years. Since January, 2015, they have dropped just more than 9 per cent.
Yale University professor Robert Shiller developed a P/E ratio that measures a stock's price, relative to a company's cyclical business earnings. It's called a cyclically adjusted price-to-earnings ratio (CAPE). It compares stock prices with 10 years of real earnings. It's a much tougher measuring stick than a typical P/E ratio, which can be affected dramatically by an unusual level of earnings in a single year. He found that when stocks trade well above their historical CAPE levels, they usually disappoint for the decade ahead. When they trade well below the historical average, stocks go on to outperform.
On June 30, Joachim Klement, the chief investment officer at Wellershoff & Partners Ltd., calculated the CAPE level for Canada's S&P/TSX composite index. Its historical average was 19.8. At the end of June he found that it traded at 18.9. It was a better deal than normal – but barely.
Since June, however, the S&P/TSX composite index has dropped 10.5 per cent. Its CAPE level sits at about 15.2. Now it's on sale.
The markets, of course, could fall further. That's good news, or bad news, depending on your side.