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Portfolio Update

|About: Vanguard Total World Stock ETF (VT)

I aim to outperform the stock market while taking on even less risk. There's only one reason why I even care: experts told me that I can't do it. I've never been very good at doing what I am told, and I suppose that at 49 years old, I'm too old to start now. 

The first step of my plan is to take on no more risk than I'd take with the Vanguard Total World Stock Index ETF (VT). I want my portfolio diversification to be similar to the overall global stock market, with a large number of US and non-US stocks. VT owns a far larger number of positions than I do, but most of those extra holdings account for virtually none of the risk or return for the fund.  If my portfolio can deliver the statistically relevant risk/return equivalent of the top 100 holdings of VT, I feel that I have accomplished what I set out to do. 

Second, I want the overall PE ratio for my portfolio to be less than the S&P500, so I know I'm not taking on the extra risk of owning expensive stock. How can I measure that? 

Fortunately, GoogleFinance offers a quick solution. It will automatically fetch earnings per share data for almost every position I hold. But it isn't failsafe. For REITs, for example, I feel that FFO (rather than earnings per share) is a better reflection of the wealth the company creates each year for its shareholders. I can pull the FFO annual estimates right off SeekingAlpha. Next, I need to update the EPS data for each of the funds I own - that information I can pull off the fund sponsor's homepage. Finally, I have to do a reality check. GoogleFinance includes only quarterly data, which can be extremely volatile. If I see an unreasonable one-off item, I round it out for average annual earnings estimates (which I pull off SeekingAlpha and input manually).

I then multiply these EPS figures by my total number of shares and I can see the entire corporate earnings for my portfolio. I divide the overall price for my portfolio by the total EPS, which is weighted according to the number of shares I hold in each position. There's my portfolio's PE ratio. Currently, it stands at 16.9. Vanguard reports the current PE ratio for (VT) at 17.1. I'm fairly confident now that in terms of valuation, my portfolio is a shade less risky than VT. 

Last of all, I want to make sure that my portfolio isn't too risky on an absolute basis. What I mean by that is I could sell everything I own right now and reinvest the proceeds into US Treasuries, and earn 2.05% a year without batting an eye and with virtually zero risk. Owning stocks only makes sense if you can win substantially more in risky corporate earnings than you could earn with just the risk-free rate of return.

How much more earnings would make it worth your while to own stocks instead of bonds? 

To answer that question, I'll take a page out of history. Using data from Professor Robert Shiller's homepage, I see that ever since 2000, the average earnings yield on the S&P500 has been 1.59 times higher than the prevailing risk free rate of return. Today, based on Robert Shiller's data, the earnings yield on the S&P500 comes in at 4.58%, which is 2.23 times the risk free rate. By that measure, stocks today are far cheaper than average.

It is fair to point out that the data today could be skewed, since interest rates are far below the average interest rates we've seen since 2000 (interest rates have averaged in at 3.46% since that year). Based on that figure, stocks today are only 1.32 times the average interest rate on a US Treasury since 2000, which would suggest stocks are slightly more expensive than they've been over the past 19 years  (or at least, stocks would be expensive if interest rates were to rise to 3.46%). If you want my opinion, the prospects of rising interest rates seems unlikely at the moment, but I don't know anything more about that than you or anyone else knows.   

What I do know is that the earnings yield on my portfolio clocks in at 5.9%, which is nearly 2.88 times the risk-free rate. I figure that if you can get paid nearly 3 times more owning stocks than you can get paid owning bonds, that is a very wide margin of error. Earnings could plunge like mad, while still remaining relatively cheap compared to bonds. 

So, generally speaking, I'm pretty sure my portfolio is no more risky than a portfolio such as the Vanguard Total World Market Index, and isn't too risky relative to the bond markets. The only question is whether my portfolio performance is at least as good, if not better. So far, so good, but I'm guessing it will be another 10 years before I know for sure. 

Here is the latest breakdown of for the portfolio EPS and constituent holdings. 

Every once in a while, I also like to take a step back, and ask myself "what is the big trade?"  I may style myself as an investor, and not a trader, but I also know that in reality, anyone with so much as one penny at stake in the capital markets is placing a trade. Whether they want to admit it to themselves or not. 

So, my big picture thesis is this. The world is starving for yield. Interest rates across the globe are falling - and likely to go lower still. Why? Technology continues to lower production and distribution costs, and the only way to keep prices from falling into a deflationary spiral is to either (1) cut interest rates, (2) engage in trade wars, or (3) raise costs by hiking VAT and/ or sales taxes or collecting one-off fines from large companies.  To my view, option (1) is the easiest and thus, more likely than the other two options over the long-term. In fact, what we see whenever we look at the newspaper is a combination of all three options, but suffice it to say that in my view, as long as technology advances, this tendency towards lower interest rates seems likely to persevere for the long-term. 

As you see, interest rates are actually negative in some parts of the world, meaning lenders are now paying borrowers for the privilege of using their money. One of the last places to make a positive yield on your investments is with dividend stocks. I expect that simple fact would compel investors (including central banks, pension and endowment funds, and governments) to start pigging out on shares of high quality dividend growth stocks like KO, MMM, JNJ. After all, if you are lending out money at a negative interest rate (already, multiple central banks around the world do just that), you've got to have some positive income somewhere to make up the balance. What's the easiest (and thus, in my view, more likely) solution? Answer: own positive yielding assets such as shares of dividend growth stocks. 

Let me state it clearly. I think that one day, the US Treasury (as well as the treasuries of countries in Europe and Asia and Africa) will own shares of dividend stocks like MMM, KO, and other stocks with high credit ratings and steady payout histories. They will own shares like this because they need to, for all the reasons stated above. The alternative approaches for funding the  yawning budgetary and banking system shortfalls are far, far less palatable, and thus, in my view, less likely over time.  

No surprises here, in terms of what I own in my portfolio. Producers of steady and growing income. At the moment, the overall portfolio trades at a discount. I am betting one day, many shares of stock in the portfolio may actually trade at a premium - which is where the big Alpha will come from. There's the upside proposition.

And what if my big picture thesis is all wrong? Then the downside proposition is "I'll keep collecting a growing stream of dividend income and reinvesting whatever I don't spend." The power of compounding, the most reliable form of wealth creation in history, is what I plan to use for capping my downside risk.

That's why I feel that I can beat index funds like (VT), (VBINX) and (VTI) on a risk-adjusted basis. I don't think I can pick stocks any better than anyone else out there - and I don't think that fact matters, either. The moment when most other investors start to believe that I can do what I set out to do, my portfolio will yield results no different than those for a portfolio such as VT. Fortunately, at the moment, the experts don't believe that investors like me can even exist in theory. Thank heavens! 

Disclosure: I am/we are long abbv.

Additional disclosure: I am long every share listed in the attached charts, and have no other financial positions besides those. I am not an investment advisor and nothing in this blog is investment advice.