The Stock Market Is Getting More Expensive

Includes: DIA, QQQ, SPY
by: Vishal Khandelwal

Market analysis One of the most underrated but among the most valuable skills required to succeed in stock market investing is resilience i.e., the ability to properly adapt to stress and adversity - either in the market, or in the businesses one is owning.

How easily can you bounce back from a market crash? What would be your reaction to a sharp decline in your stocks' prices? How many 'surprises' can you withstand in quick succession? How safe are your overall finances in light of extreme stress on the equity component of your portfolio?

These are extremely important questions you must ask yourself every time you are looking at your portfolio, or looking to spend cash to buy more stocks.

Surprisingly, despite its importance, resilience is least talked about by stock market investors and experts alike, and rarely considered an important mental model in investment decision making.

Most of the time, we build our lives, our jobs or businesses around today, assuming that tomorrow will be a lot like now. Resilience, which is the ability to shift and respond to change, comes way down the list of the things we often consider.

And yet, a crazy world is certain to get crazier. Jobs aren't steady anymore. The financial market has gotten more volatile. The Earth is warming, ever faster. And the rate and commercial impact of natural disasters around the world is on growing exponentially.

Hence the need for resilience, for the ability to survive and thrive in the face of change.

Stock Market is Getting More Expensive
Certainly I am not talking about stock valuations here. Because, if that were to be the case, the BSE-Sensex's valuation - if you go by P/E - is now cheaper at 18x trailing 12-months earnings as compared to 23x just six months ago.

Noted financial writer George J.W. Goodman - who used the pen name of Adam Smith - wrote this in his wonderful book, The Money Game -

If you don't know who you are, this is an expensive place to find out.

By "this", Smith meant the stock market.

The people who bought commodity, infrastructure, or real estate stocks in 2006 and 2007 because they thought they had a high tolerance for risk - and then lost 95% over the next one year (some such stocks are down 95% even after eight years) - know just how expensive the stock market can be.

While speculating on such stocks, they seemingly failed to answer the questions around their levels of resilience. And thus many ended up betting their houses and other people's money on stocks that were destined to go down the drain.

Something similar has happened to the guys who were utterly charmed by "moats" and forgot the subtle difference between paying up and overpaying over the last two years. A lot of such moated darlings are down between 30% and 50% over the past six months. Those who would have borrowed money to invest in such stocks are sitting on even bigger losses and much bigger dents to their egos.

You see, knowing more about who you are as an investor can make you a fortune - or save you one. Knowing how resilient you and your portfolio are to severe market downturns also solves that purpose.

Can You Handle Mr. Market Well?
If you have been glued to financial media or online portfolio trackers, fixated on the sight of falling stock prices over the past few days and weeks, then this should tell you something about yourself that has enormous long-term importance - you probably have too much in stocks even as you don't have the resilience to see your portfolio value declining (and that's why you are checking stock prices so frequently).

If you feel distressed by a decline of a few hundred points on the BSE-Sensex, then you are kidding yourself if you think you can withstand a drop of a few thousand points when it comes.

Benjamin Graham, the father of value investing, divided investors into two types in his book The Intelligent Investor - defensive and enterprising.

The defensive investor, Graham wrote, wants to avoid "serious mistakes or losses" and seeks "freedom from effort, annoyance and the need for making frequent decisions."

On the other hand, the enterprising investor, as per Graham, is willing "to devote time and care to the selection of securities that are both sound and more attractive than the average."

So, if you are an enterprising investor, then you should observe the stock market carefully in the hope that a substantial fall will present bargains. But if you are a defensive investor, you should observe yourself carefully.

  • If you are not nearing retirement and have many years to invest and thus ability to see through a few big downturns;
  • If you are not investing on borrowed money;
  • If you are investing your own money, not other people's money;
  • If you do not owe a lot of money by way of loans, and have sufficient disposable income that prevents you from selling your stocks to meet your needs; and
  • If you have seen through past market crises without much psychological upheavals…

…you have adequate resilience to manage any major stress that the stock market may present you now.

However, if you do not meet any or most of the above criteria, then beware. Reconsider your decision to be in stocks directly. Else, maybe, trim back on your stocks to create the much needed financial cushion so that any big decline does not become an even more expensive way for you to find out who you are.

Remember what Keynes said -

Markets can remain irrational longer than you can remain solvent.