Zen And The Art Of Risk Management

The graph below compares five-year rolling S&P earnings growth rates and their trend (dotted blue line) with implied earnings growth rates (orange). More often than not in the last 30 years stock prices have higher implied earnings than the market has delivered.

Zen, Zen and the Art of Risk Management

Current Valuations

Currently, the S&P 500 implies earnings growth of 9.25% over the next 40 years. The actual historical trend earnings growth is 5.85% and trending lower. The last time real earnings growth exceeded the current implied level (9.25%) was in the early 1980s.

Our use of a 40-year duration is subjective. Much of what we have read on the topic prefer shorter periods. The longer the period, the lower the implied growth. As such, we believe our assumption is conservative.

Understanding investors’ lofty expectations is the first step to understanding risk. The second step is to equate it to value and put it into context with prior periods.

The black line in the following graph quantifies how much the S&P 500 would change if implied earnings revert to trend earnings.

Zen, Zen and the Art of Risk Management

The S&P has to fall 73% for implied earnings to equal trend earnings growth. We admit the calculation may be exaggerated. As such, we think it wise to compare the current level versus those in the past. A return to the average change required (green dotted line) still involves a decline of nearly 50%. A 40% decline matches the average of the last 20 years. A drawdown of 40% is not farfetched considering the previous three major drawdowns, 2000, 2008, and 2020 had sell-offs in that neighborhood.


Stop, Sit and Breathe

You may frightfully read the paragraphs above and think about selling immediately. Stop, sit, breathe, and relax. Now is the time for investor Zen.

The market is grossly expensive, but as we stated valuations have poor predictive ability to help gauge what will happen in the next few weeks or months. Despite extreme valuations, we can ride the market higher with other greedy investors. However, unlike most investors, we are aware that the risk of significant losses is not minimal.

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