The Mathematical Case for Active Investing

Just to clarify: the market is on a serious rally. Records are being set for intraday highs, as the DOW continues its climb towards 20,000. Some credit Trump with the move, citing his plan to decrease business regulation and lower corporate tax rates as bullish for US stocks.

But what about the long-term? What’s going to happen after this honeymoon period?

Right now, equities are extremely expensive, and have only gotten more so after the Trump victory. People are buying stock at higher prices on the aggregate, especially relative to earnings. This equates to lower returns in the future, as the value of the stock normalizes, putting a dent into expected income.

But why is this happening? Why can’t the market keep on going up and up?

Historically, the SP 500 has had an average annual return of 9.6%. Many people think that this type of environment will continue. However, as mentioned earlier, stocks in today’s environment are extremely overvalued. People who received the return of 9.6% in the past were buying stocks at much lower relative prices than investors are today.

The returns that investors receive are determined by dividend yield. As the valuations on equities continue to increase, dividend yields decrease. This is due to the math behind the Price-Earnings Ratio (P/E). For the SP 500, the PE ratio currently sits at 24, much higher than the past century average of 16. As the P in P/E continues to increase due to rich valuations, you get fewer dividends per each dollar invested in the stock. Right now, the dividend yield for the SP 500 sits around 2%, far off its historical average of 4.9%.

Real growth in earnings per share also determines the return an investor receives. Earnings are currently dipping, as evidenced by the 15% decline in the S&P profits over the past 2 years. However, throughout history, earnings growth has been positive. US profits tend to expand as the economy expands, which it has done at an average 3% rate the past century (albeit, much lower in the past few years). But earnings per share, what matters to investors (the capital gains, ultimately) has only expanded at 1.5%.

The lag between the EPS growth and Earnings growth is due to a “watering-down” phenomenon. Companies issue new shares constantly, rewarding executives or making acquisitions of other businesses, which is arguably good for growth. However, these shares are hardly ever bought back (and when they are, it’s often to inflate the stock price). The extra shares issued dilute the profits that each individual investor receives.

Also, the market itself can become watered down due to the entrance of IPOs, which often take a large share of the overall profit pie. For (a very simple) example, Jim’s Car Wash and John’s Car Wash can each receive about 50% of all customers, approximately, equating to 50% of all profits. But when Kyla’s Car Wash opens up down the road, all of the sudden, Jim and John are only receiving 1/3 of total profits- about 20% less revenue than what they used to get.

Beyond all that, returns in the stock market for passive investors are rather dismal. With inflation predicted at 2% by the Fed, passive investors can expect to generate a 3.5% (2% dividend yield + 1.5% earnings per share – 2% inflation) return on equities, if everything goes perfectly.

But things are hardly likely to go perfectly. The high P/Es are just that- too high. A P/E of 24 is unlikely to rise any further, and when it goes on its eventual decline, stocks are going to take a hit.

But for simplicity’s sake, let’s say everything goes well. The P/E sits at 24. Everything remains the same. The average investor has a 60:40 mix of stocks and bonds, respectively. The current yield on Treasuries is 2.2%. That brings the total return of the portfolio, in a perfect world, to 4.2%, net inflation.

4.2%? That’s okay, you say.

But compared with the historical average of 7.6%, that looks very dismal indeed.

My solution? Nix the 60:40 portfolio. Get rid of the passive mindset. Instead, become active, and decide your own returns. Make the market work for you, instead of sitting back and allowing things to happen. Take advantage of every sort of environment, and sell a few calls, buy a few puts. Soon, your returns will EXCEED that of even the most stellar index fund. That’s the power of YOU.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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