High risk

Would you buy an asset with a 3% expected return with a 50% chance of loss?

       That is exactly what Goldman Sachs is recommending. In their 2017 forecast they are advising clients to be OVERWEIGHT U.S. equities. They are forecasting a 3% return for a moderate risk portfolio. To arrive at this conclusion they state “valuations don’t mater”.

I have compiled 3 points to break it all down. Let’s look at these in a little more detail.

       1. Why are they recommending overweighting U.S. equities? They always do. They have to. Investment firm outlooks are part of their marketing toolbox. The majority of an investment firms earnings and bonuses come from corporate finance work. But, they need someone to buy the products – that’s you. How do I know this? I owned an investment firm. We would continue to find reasons to recommend buying even when the asset was overpriced. We needed to support our clients that paid us enormous amounts of money to do so. How could the corporate clients ever engage us if we did not publicly support them? Recommending selling is a suicide mission for investment firms.

         In early 2000, months prior to a 78% drop in the Nasdaq market there were virtually NO 'sell' recommendations by the major investment firms. June 2007 (prior to the financial crisis) with the S&P500 index at 1526, Goldman Sachs, Bank of America, J.P. Morgan, A.G. Edwards, and Merrill Lynch all had targets of between 1525 and 1675. Within 24 months the index was at 676, a decline of 55%. Yes markets do lose 50 plus percent when valuations are too high.

       Recommending the best performing historical asset (U.S. equities) also keeps clients calm, happy, and gives a safe feeling. These outlooks feed on human behavior – herd mentality. The investment firms have no risk in continuing to be positive, nor are they suggesting any downside potential. Recommending more reasonably valued assets in places like India, Japan, or emerging markets, although may make sense, is too risky, let alone will negatively affect their ability to receive income from their largest clients.

        2. “Valuations don’t matter”, Goldman states, that because of Trump’s vision of lowering taxes while reducing regulations, earnings will catch up to stock prices. This in fact could be true if a) Trump is able to execute all that he would like to, b) it is done quickly without congress or senate issues, c) if these changes enhance global trade, and d) there are absolutely no negatives to these plans. Goldman is betting on the fact that unemployment will decrease (from a very low level), rates will not move higher (which the FED says they will), that debt will not increase (which Trump says he will), wages will increase (without affecting corporate earnings), and global demand will increase (even if he implements tougher trade deals). Could there be ANY risk in this? Remember, investment firms and their advisors are always positive (even before a 78% or 55% loss).

“Valuations don’t matter”? Really. Really?

       In fact, there is nothing else that does matter when investing in assets long term other than its value. Ask Warren Buffett, “price is what you pay, value is what you get”. The cost (price) of the market or a stock is based on its current and future earnings.

The chart below is showing the long-term price to earnings. As of March 3rd we are equal to 1929. The prices that you are paying today for those company’s earnings are the second highest in history, followed only by the 1999 prior to the tech bubble and above 2008/09 crisis. Does valuation matter? It better, because that is why we invest, to benefit from higher earnings by purchasing assets at a reasonable price.


         3. Goldman is suggesting you stay invested in a risk asset like stocks for a forecasted 3% return. You can get a guaranteed 2% return through a GIC and have no risk. Could stocks go down 50%? Yes. If valuations were to trade at their average multiple over the past 120 years the market would be 53% lower (not to mention global tension, interest rate increases, possible decline in real estate prices, European issues, higher debt costs, or any Black Swan event).

        Since Goldman is forecasting a 3% return on a high-risk asset, and you could return 2% with no risk, you are staying in the market for a 1% premium return with a chance of a 50% loss. You should always look for positive risk/reward situations, not negative. If you have a chance to lose 50% you should be looking at a possible 100% return (positive 2:1). But today you are looking at a negative risk/reward scenario: 1% increase in return for a risk of losing 50%. That doesn’t make sense.

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