Strong Dollar

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• Investors can expect a nominal return from stocks of 4.3% per year going forward.
  
• The story looks far different for speculators. The strong dollar and higher debt costs should weigh on the economy and stocks.
  
• Specific sectors and international diversification offer a better risk reward situation.
  

The Dow Jones is flirting with 20,000 points, and it’s possible that by the time you’re reading this, it has already crossed the mark. In addition to the Dow reaching all-time highs, the dollar index has also reached new highs for the decade.


In today’s article, we’ll analyze how the saying “be fearful when others are greedy and be greedy when others are fearful” should be applied to these market conditions.


While it’s pretty easy to know whether to be greedy or fearful, it’s essential to apply this insight to your personal investing goals.Investment returns will be perfectly correlated to underlying earnings and economic growth in the long term. This has and will always be the case with shorter or longer term imbalances due to economic cycles or market sentiment.



To get even more precise data, it’s good to use the cyclically adjusted price earnings (CAPE) ratio and yield. The CAPE ratio uses 10-year average earnings to calculate ratios in order to eliminate cyclical impacts on earnings. As the current S&P 500 CAPE ratio is 28.08, it translates into a 3.56% yield from stocks. When we add earnings growth of 2% per year and 2% inflation to the equation, we get a nominal yield from stocks of 4.3% per year for the next 10 years. By taking inflation into account, the real yield would be 3.97% per year.


The returns above have the highest probability of being realized and investors should count on it. Getting $150 in 10 years for a $100 investment isn’t a bad return.

However, this certainly isn’t going to be linear. Perhaps we’ll see all the returns materialize in the next two years, or we could see a bear market in 2017 that creates a lost decade for stocks. Such scenarios are anybody’s guess but, as in investor, you should know that and not care much about the ups and downs because you’re happy with market returns, and as we have shown above, they will be around 50% in the next decade.


Now, if you aren’t happy with a 4.3% yearly return, then you aren’t a general market investor but leaning more toward investing with a specific goal or toward speculating.

Some of the top investors/speculators of our time say that the time to be greedy is when others are fearful and vice versa. PE ratios above 25 and expectations of earnings growing 10% in 2017 aren’t the result of fear, but of pure greed in the markets. According to history, we should be underweight stocks at the moment.

There are several factors that will hit stocks in the next few years that will give you better than current entry opportunities. This requires you to invest accordingly and also to risk some of the upside if the risks we are about to talk about don’t materialize.

The first factor that’s going to hit the economy and markets is the strong dollar. A stronger dollar lowers international revenues and earnings for U.S. corporations while also lowering the export competitiveness of the economy. As the dollar was relatively weak in the last decade, the net export deficit slowly declined. However, with the dollar 40% stronger in relation to its 2011 lows, the deficit can only expand.


Net export deficits can be countered by increased domestic demand, but this will probably just increase debt burdens. In relation to the debt burden, what few look at ahead is debt financing costs. U.S. public debt has been soaring at a much faster rate than the economy. At some point in the future, there will have to be a deleveraging.


In the last few years, the public debt has surpassed GDP. As we know, interest rates are rising and expected to rise more in the future. This will weigh on public as well as on private finances lowering demand and economic growth.

The main problem for us speculators/investors is that we don’t know when the above described risks will hit the economy and markets. However, from a risk reward perspective, the above indicates a high probability that we could see a recession in the next two years and a bear market. Therefore, it’s extremely important to position yourself in a way that protects you from the inevitable, albeit not yet happening, negative influences on the S&P 500 and U.S. stocks.


All of the above indicates a potential steep market decline in the next few years. This doesn’t necessarily mean it will happen, it just increases the risk of investing. As the best investors are those who get the best returns by taking the lowest risks, the general market strategy advised by many through index funds might not be the best at this point in time.

You can diversify internationally to lower your risks, and into specific sectors. Keep reading Investiv Daily as we dig deeper into the risks and rewards of specific sectors in the coming weeks. Perhaps it’s just the time to be smart, not greedy or fearful.

source: investiv