Frothy Valuations and Fancy-Pants ETFs

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Alexis is making her exodus. Exodus. You're leaving.

Exodus. Yes.

Exit is a cross between exit and Exodus. You're—

I like it.

You're leaving us this podcast. Was it something I said? I'm difficult to work with, right? Tell the people.

Well, you know, Jack, it's not you. It really is me.

So here's what we're going to do. We'll answer some listener questions this episode. We're working on an episode with some reporting I recently did on the road, and we will be joined, as I understand it, by— I guess I won't say yet, but a familiar voice from the past of this podcast. For at least a few weeks or so. Let's get to some questioning and some answering. And yes, I'm leaving the G's off the end of both those words and putting apostrophes just to keep it folksy. Who do we have?

Texas really changed you, Jack. First up, we have Brad from Michigan.

Hi, Jack. Hi, Alexis. Brad from Michigan here. First-time voice memoer, long-time listener. Jack has mentioned in a lot of episodes that the market seems frothy over the last few years and price-to-earnings ratios aren't quite matching what the history of the S&P 500 or other US indexes have shown. My question is, in 2021, a lot of money was created. This money all needed somewhere to go. Is it possible there's a new normal, a new baseline for price-to-earnings Thank you, Brad.

It's an excellent question. If we say that the S&P 500 trades at, let's call it 25 times earnings, a little more than that if we're looking at trailing earnings, a little less if we're looking at forward earnings. And if we say that historically the average price earnings ratio is closer to 15 or 16, that's a long history to come up with a number like that. That's looking back a century or so. We could also look at more recent time frames and take averages from those. I'm looking at data from FactSet late last year. It gives the 5-year average PE for the S&P 500 as 20, and the 10-year average is close to 19, and the 15-year average is 17, and the 20-year average is down to 16. So which is the right one to use? Is longer always better, or is there something that might have happened recently to change what we call normal for the stock market? And Brad, you have a solid theory. There's basically a glut of savings chasing relatively scarce financial assets. This was even starker back when interest rates were near zero. If there's all that money that needs to pile into investments, then maybe the S&P 500 is just permanently more expensive. I've heard another theory that has to do with the Federal Reserve. It's basically that central banks have gotten more sophisticated over the years at managing financial crises and more willing to intervene and do so early. And if central banks are better at managing wild swings in the economy, then maybe the stock market isn't quite as risky as it used to be. And that would make it worth more. Maybe the normal valuation for the stock market here in the U.S. and other developed markets, maybe it's just structurally higher than it used to be. There's a phrase that's used ironically in finance, "This time it's different." The famed investor Sir John Templeton called that the four most dangerous words in investing. You might recall that was a title of the book during the global financial crisis. This Time Is Different: Eight Centuries of Financial Folly. The book basically looked at 800+ years of financial crises, and it discussed how people sometimes ignore the warning signs of excess because they become convinced that there's something new that has eliminated or reduced risk. So that phrase makes me cautious about the idea that the stock market is supposed to be this expensive, but on the other hand, maybe it is different. Finance, I often say, is not physics. Sometimes investors are prone to physics envy. They try to mathematically reduce things to knowable laws and certainty. But the price-earnings ratio of the stock market is not gravity. We don't really know how it behaves. First of all, the data set isn't as robust as you might think. Yes, stocks are 4 centuries old, dating back to the Dutch East India Company. And the exchange that was created to trade those shares in Amsterdam. But modern econometrics, the study of stock market data, that didn't really get going until after the Great Depression. That's less than a century old. How many different cycles, swings, booms, and busts have we had in that time? Not enough to know anything for certain. That's kind of part of the deal with investing in the stock market. Historically, you've made a much better return there than in, let's say, safe short-term bonds. But in safe short-term bonds, you get to know what the rules are. And in stocks, you don't. You put money in shares of businesses. You believe that the people who run those businesses will find ways to make them more valuable over time. And you participate in that growth. And we do see a pattern where people tend to do better over the long term when they're buying into the stock market when valuations are relatively low, and worse when they buy when valuations are relatively high. But there is no be-all-end-all source of enlightenment on what the price tag of the stock market should be. Not only do you get a different answer depending on the timeframe you look at for your averages, but the way earnings have been calculated has changed over time. Whenever you look at these long-run data series, if you look at a, a century's average for the price-earnings ratio of the market, you're typically looking at trailing all-in earnings. Trailing because you haven't always had this Wall Street infrastructure of analysts that you can use to create an earnings consensus forecast. So you haven't always been able to look at forward earnings estimates. And all-in meaning we used to just count everything that happened. Now it's become common to look at operating earnings. You say this is the stuff related to the actual running of the business. This big charge over here, that's just a one-time thing. We better not count that. But in the past, it was more common to count everything. Let me give you one more possibility, Brad. If the question is, couldn't 25 times earnings be the new normal for the stock market and 15 times earnings be an outdated measure? I guess. But you could also pick some number in between. Maybe 18 or 19 times is the new normal for the stock market and 25 times is still pretty expensive. That's a long winding path to me saying, I don't know. The best you can do, I think, is first of all, stay invested because sometimes an expensive stock market becomes more expensive. Second, do what you can to rebalance in a way that brings your average portfolio valuation lower. Maybe you shift some of your S&P 500 money in developed markets overseas. Maybe you put a smidgen in small caps. Keep your proper allocation in bonds in case S&P 500 returns do disappoint from here for an extended period. Make sure you have enough liquid money and emergency savings to get you through a long rough patch without having to sell your shares. And you know, I'm a fan of portfolio income for the same reason. Consider adding some dividend income. Brad, I hope that non-answer answers your question. Alexis, you want to squeeze in one more quick question? Question before we take a break?

Yeah, let's try it. Uh, we have one from Gordon who asks— he didn't have audio, but I'll read it for you. He wants to know, how does a fund that tracks an index or indices make money as compared to a fund that owns stocks in a category? For example, VTI versus MAGY or XLE.

Thank you for your question, Gordon. This is a little like asking What's better, a vanilla ice cream cone or the 1985 movie Spies Like Us or a pet donkey? They're not really things that naturally lend themselves to comparison. It kind of depends on what you're into. Personally, I'd watch Spies Like Us while sharing an ice cream cone with a donkey. I'm a diversifier, but I'll give you a very quick assessment of these 3 tickers. VTI, that's a great idea. I like that for you a lot, assuming that you're someone who should have broad, cheap exposure to stocks. Most people are, although the percentages might be different from person to person. That's the Vanguard Total Stock Market Index Fund, and the expenses there are 0.03% a year. Even a cheapskate like me can feel good about that. Let me take XLE next. That's the State Street Energy Select Sector SPDR ETF, and the expenses there are pretty low too, 0.08%. But that's kind of a different thing. That's not broad stock market exposure. That's a specific bet on the energy sector. That fund is loaded up on stocks like ExxonMobil and Chevron and ConocoPhillips and SLB and Williams. Do you have a reason to believe that the energy sector is going to outperform the rest of the stock market? Do you have an investment core that has broad stock market exposure, but you're trying to add a little extra in energy, or are you making some kind of focused, concentrated short-term bet? XLE is most appropriate for investors with one of those things going on. It's not a way to invest in the broad growth of the stock market over time. It's a way to get exposure to a particular theory or hunch. The third ticker you mentioned, MAGY. That's even more of a niche. That's called the Roundhill Magnificent Seven Covered Call ETF. I'm not terribly familiar with it, but I do speak finance and I think I can get my head around what's going on here. Roundhill says the fund offers exposure to the Magnificent Seven subject to a cap while providing the potential for current income. It sounds to me like you're taking those big tech stocks that have been driving the stock market higher for so many years. Amazon and Microsoft and Nvidia and so on, and then you're writing covered calls. Why do you buy those stocks? Because you want a lot of price upside if AI continues to boom. Why do you write covered calls? Because you want to generate investment income and you're willing to sacrifice some of your upside to do it. Why would you want to buy something for price upside while simultaneously giving away some of your potential upside? I don't know, maybe you just enjoy paying a hefty 0.99% a year in fees. I think you see where I'm going with this, Gordon. That fund isn't for me. I doubt it's for you. I don't really think it's for anyone. In general, I think that there are way too many of these niche fancy pants ETFs. And it seems like the fancy pantsier they are, the higher the fees. To answer your question, Gordon, there's a night and day difference in how these 3 funds that you mentioned make money. And more important, which type of investor they're useful for, or whether they're useful. If you want to learn more about all the different choices out there, keep asking questions. But I think in the meantime, your money is best off in something with the broadest exposure possible to stocks at a low price. Of the 3 you mentioned, that's definitely VTI. Break time, Alexis. I know I said quick. That was not my quickest, right? We'll be back right after whatever happens now.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back. Listener question special. 2 questions down, 2 to go, Alexis, or does it depend on how long I yammer on on number 3?

2 to go. Well, it depends on how quickly you get through this next one.

That's yammering. That's code for yammering. Okay, let's do it. Uh, who, who do we have next?

Next up, we have a question from Julian.

Hi, Jack. On the show, you've often talked about the standard strategy of pouring your money into the S&P 500, waiting for a few decades, and enjoying a peaceful retirement. Nowadays, many brokers offer you to leverage your portfolio by taking out a loan of 50 or 70% of your portfolio. What's keeping me from leveraging that good old S&P 500 strategy? Intuitively, I'd think, well, that'll just boost my returns over the long run. But that seems too good to be true, on second thought. Where's the catch? Can you tell me?

Thank you for the excellent question, Julian. What is wrong with using leverage to amplify your stock market returns? I would say two things potentially. First of all, just as borrowing can increase your returns to the upside, it can also increase them to the downside. Over time, the stock market tends to go up, but you better be careful about what happens in the near term when you start adding leverage. If you add leverage and the stock market tanks, You've just bought yourself a worse downturn than everyone else. And one of the whole keys to building wealth in the stock market is being able to ride out the rough patches. You want to be careful about doing anything to make the rough patches rougher. They can be pretty darn rough on their own, even without the help of leverage. The second thing is what happens if you add leverage and the stock market goes up and it works and you make money. This kind of depends on you and your personality. But it can be tempting to think that if a little bit is good, then more must be better. You might end up adding a little more risk here and there as time goes on. When we look at the epic stock market downturns that we've had historically, they were generally made worse by forced margin calls. People who had borrowed money and they were forced to sell investments to pay back their loans. That added to the selling pressure. That suggests to me that there's a never-ending supply of people who get in too deep on borrowing to try to juice their returns. So, Julian, I'm not going to tell you that borrowing as part of your investing is a bad idea for everyone or a bad idea for you or a bad idea always. I'm just going to tell you to be very careful and think about resilience during the worst of times. Did I mention that margin costs interest so that now you create a hurdle rate for yourself that you have to get over with your investment returns, which makes things a little more complicated, more difficult than they otherwise have to be? Maybe that part goes without saying. Alexis, one last one in 30 and 60 seconds. Who do we have next up?

We have a question from Matt.

Hey Jack, question for you. So over the past few months, I've heard several episodes from you discussing dividends and the importance of them to the long-term investor. And oftentimes you've cited that 40% of the S&P earnings over that time frame have come from dividends themselves. But in saying that, aren't we assuming that those companies paying those dividends would not have reinvested that money to create extra returns? Or said another way, if those companies had not paid their dividends, wouldn't they have used that excess cash to create additional returns? That are not reflected in the historical share price movements we've seen over time. Thanks for all you do.

Thank you, Matt. Yes, you're right. If those companies had not paid that money out in dividends, the money would've earned a return somewhere, just sitting in a cash balance earning interest, or it could have been deployed as capital investments, invested in growth, spent on advertising, what have you. I like to think there's a self-sorting mechanism that goes on here. The companies that have the best opportunities to invest money for returns, they're spending all they need to. When there's money left over, hopefully they're considering paying out dividends. If there's no money left over, that's fine for those companies to invest in their growth while the getting's good. Companies with fewer opportunities out there to invest for growth, they should be paying out a lot for shareholders. I think right now there's a large cohort of companies that could be paying more than they do. They're not paying more just because investors aren't demanding it, and investors aren't demanding it just because price gains have been good for a long time for the stock market. I think investors will want more income if prices turn south, and I think then you'll suddenly see more of these companies discover that they can afford to pay out more cash to shareholders. I want to thank Brad and Matt and Julian and Gordon, and thank all of you for listening. And I want to say goodbye and good luck to Alexis, who is moving all the way to probably a different floor in the building where we both work now. Going to be tearful, but okay. If you have a question that you'd like played and answered on the podcast, send it in. It could be in a future episode. Just use the voice memo app and send it to jack.hough@barons.com. Alexis Moore was your producer this one last time. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, write us a review. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.