October 21, 2017

On Friday, the S&P 500 was up another 0.5% to yet another record high. Toronto was up 0.2%.

The S&P 500 is now up 15.0% this year to date. That is impressive especially considering it entered 2017 already at a record high and trading at 23.7 times trailing actual GAAP earnings and 21.0 times trailing operating earnings.

During 2017 S&P earnings have increased sharply which does provide support to higher stock prices. Despite being 15% higher this year, the S&P 500 right now is trading at 22.4 times estimated 2017 GAAP earnings and 20.4 times estimated 2017 operating earnings.

So, the good news is that the S&P 500 is slightly cheaper in relation to earnings than it was at the start of 2017. But the S&P 500 is nonetheless expensive.

There is a risk that the S&P 500 could fall if investors decide that a reasonable multiple is say 18 times trailing GAAP earnings. And GAAP or operating earnings could fall.

Back on March 9, 2009 the S&P 500 bottomed out at 666 as earnings were quite low due to the financial crisis. The P/E at the bottom was 11 times trailing GAAP earnings to March 31, 2009 and 10 times operating earnings. Pessimism abounded. THAT was a fantastic time to buy. The S&P 500 is up a staggering 287% from the absolute low. If I use the 798  level of March 31, 2009 (rather than picking the absolute low of 666) the S&P 500 was trading at about 13 times trailing GAAP earnings and the S&P 500 index is up 223% since then. Of course, the real doomers back in early 2009 were waiting for the S&P 500 to fall even further to eight times earnings or whatever. They are still waiting.

So, markets remain optimistic at this time and are relatively richly valued. But the P/E ratio is not at record highs. It is certainly possible that U.S. stocks can keep rising.

But surely, some caution is warranted. I have said often that it is ALWAYS the case that markets can move lower at any time. A 20% decline almost anytime should not even be considered much of a shocking event. But I also think it is impossible to accurately guess when that could happen.

Everyone’s risk tolerance and (more importantly) financial risk capacity is different. One approach is to never allow the equity allocation to get too high. Those with a balanced portfolio may be well advised to simply carry on. That tends to work well over time.

In my own situation, with a very heavy exposure to equities, I am inclined to try to build up more cash. That is always difficult to do in portfolio of individual stocks since it can mean selling some shares that I would rather not be selling. I think it would be easier to sell down an ETF than a particular stock since there tends to far less emotional attachment to ETFs. As previously indicated, I did sell some shares last week. I may do more of that this week.

Meanwhile as to how individual stocks on our list fared on Friday:

Canadian Western Bank was up 1.4%, Costco was up 1.5% and the U.S. banks did well.

The Canadian dollar was down almost a full U.S. cent.

I note that Concordia International, a Canadian pharmaceutical company is entering a process to restructure some debt. The company states that this is not a bankruptcy or insolvency. Perhaps not, but it surely represents an attempt to renege on some debt (albeit in a negotiated fashion). I am really not familiar with the company at all. Concordia’s shares fell 39% on Friday to 72 cents. But more importantly the shares are down from about $3.00 earlier this year and from all-times highs of over $100 in 2015. This is basically a total wipe out, an approximate 100% loss for those who bought near the high in 2015.

I try to avoid buying shares with any obvious risk of going to zero. That’s the main reason I always look at the balance sheet. A company with large debts compared to equity is a potential candidate for bankruptcy. If it has strong profits and cash flows it may still be safe. But a highly leveraged balance sheet is a red flag. I saw such a red flag at Valeant at its peak and steered clear. Last week I sold my Bombardier preferred shares. That company may limp along for a long time yet and may even always be rescued by government. And maybe it will even become profitable and restore its equity to a positive level someday. But I am happy to get clear of such an over-leveraged and generally unprofitable company. Someone else now owns my shares and has both the risks and rewards of that.

In contrast, a company with zero or very low debt can survive a period of losses. It is very difficult to go broke if you don’t have any debt.

Warren Buffett’s rule number one is “Don’t lose money.” That does not mean don’t invest in shares that might go down. Instead, he means don’t invest in shares with much of a chance of going down and permanently staying down. He also advises to be ready with ample cash for times when shares get very cheap.


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