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Thursday, September 28, 2023

📈 Do Lofty Market Valuations Matter Anymore?

September 28, 2023 View online | Sign up
Finny
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Good day. As the saying goes, "time in the market beats timing the market", but this doesn't stop us from speculating about details like valuations and other metrics. No matter your stance on the matter, one thing is for certain — metrics are up. After a green 9 months, can you guess what the S&P 500's current P/E ratio is? a. 18.2 b. 24.6 c. 32.6.

Here are the topics for today:

  • Do Lofty Market Valuations Matter Anymore?
  • The Art of Selling at a Loss
  • Why You Should Always Contribute to a Roth Account

MARKET OUTLOOK

Do Lofty Market Valuations Matter Anymore?

There's no perfect way to evaluate the market. Each indicator has its flaws and biases, and each stock, industry, and sector comes with its own asterisk to consider when weighing its valuation.  

Nonetheless, when a multitude of metrics seem to corroborate that the market might not be cheap, it might be worth giving that idea some thought. 

The real question is — do high valuations matter anymore?

  • Basic metrics: Dating back to the 1800s, the S&P 500's average P/E ratio is 14.94. If we look at forward earnings, the long-term average is higher at 24.31. If we compare that with where we are now — the P/E ratio is around 25, and forward P/E is around 20.
  • Ratios like this matter to an extent because they tell us how the market is priced relative to how its stocks are growing. Historical averages can give us an idea of how far the aggregate market has strayed from the norm it's established — i.e., a price to earnings of 50? That would be wild.
  • So, comparing history to present times, we can see that the basic P/E is higher than normal, and the forward P/E has fallen amidst slowing earnings growth recently. But if we compare the P/E ratio to the S&P's 10-year P/E ratio of 31.0, the market starts to look a lot cheaper relative to the past decade.
  • Secondary measurements like the CAPE ratio, Buffett Indicator, and more, we'll see that they're both a bit overextended historically. The question then becomes this — are these higher numbers the new normal, or has the market been overextending itself for years now?

Do these numbers matter?

  • In short — no one knows for sure, but the most likely scenario is almost always that the market keeps itself in check in a natural way, just as it always has. Even if the market is "overvalued", the odds of a catastrophic collapse that decimates generations' worth of investors are extremely unlikely.
  • Barring a black swan-type market collapse, investors shouldn't pay that much attention to metrics like these over the long run. The market goes through up and down cycles like anything else in the economy, and time in the market almost always beats timing the market or hyper-focusing on this.
  • Take the worst investor ever for example, who invested $184,000 in several increments before some of the biggest market crashes ever from 1970 through 2007. Every time this investor put in some cash, their investments plummeted in value. By the time they retired in 2013, they still ended up with $1.1M.
Valuing Stocks
Investing Basics
5 mins

INVESTING & TAXES

The Art of Selling at a Loss

Selling at a loss is something that many of us have gotten very accustomed to lately. With the markets in nonsensical disarray, now is a great time to learn how to use this to your advantage. 

Selling at a loss is an emotionally painful thing, especially to an investor's ego when they thought they'd done their due diligence. Despite the agony it may cause, it's an inevitable aspect of investing that we make work in our favor.

Yes, this is about taxes

When you sell a stock, receive a dividend that isn't reinvested, or sell other assets like property, you usually incur a capital gains tax on the profit. As we've been over and detailed before, capital gains are a tax specifically created for taxing and tracking the sales of equities and assets that lie outside of ordinary income, and something all investors must contend with. 

The good news is that, well, the tax code wants you to minimize your tax bill so you're incentivized to invest, and that's where tax-loss harvesting (TLH) comes in. It helps you turn a negative into a positive.

How to TLH

When your tax bill is calculated every year, the amount owed is based on your total income from investments, minus your cost basis for those investments. What you paid for the investment is subtracted from what you profited, and because of that, investments that you sold at a loss end up decreasing your tax bill. 

By using tax-loss harvesting, you can decrease the amount of your taxable capital gains if you strategically sell positions that are presently sitting at a loss. The amount of money you have in your investment account doesn't change, it's just that you've converted some open positions into cash instead to pay less in taxes this year.

For example: If you made $10,000 on all sales in your brokerage account this year, but in November you got caught holding the bag on $GME again to the tune of $2,000, you can sell that bag and reduce your capital gains income to $8,000. The difference it makes on your tax bill will depend on your income bracket, and if you held the stock for over a year (long-term gains) or not.

It's way more legal than it sounds

Tax-loss harvesting is perfectly legal. The IRS can't exactly say "hey guys, you're not allowed to sell positions that are at a loss in December to decrease your tax bill for 2023." That would be ridiculous.

They do try to curtail any blatant harvesting though. The IRS has placed somewhat of a safety net underneath the loss harvesters known as the wash sale rule, which essentially prohibits investors from buying back the same or any "relatively identical" security within 30 days of selling a position at a loss.

That "identical" part is where the ambiguity lies, and is sometimes open to interpretation. For most people though, this isn't an issue, and can easily be avoided by simply staying away from the stocks you sold for the next month before buying your positions back up again.

Take this related lesson on this topic and earn Dibs 🟡 while you're at it:
What's the Wash Sale Rule?
Investing Basics
6 mins

INVESTING

Why You Should Always Contribute to a Roth Account

Many employers are now offering the Roth accounts alongside the traditional pre-tax retirement accounts, giving employees another way to save for retirement. 

Deciding which option is best can seem, on the surface, a lot of work to figure out. But it doesn't have to be. In fact, it can be wise to keep a Roth account open and accrue gains even if you already have a traditional retirement plan. 

Reasons to contribute to a Roth alongside

  • Uncertainty: The tax benefits of traditional retirement accounts are best maximized when the account owner is in a lower tax bracket at the time of withdrawal. Avoid taxes now while you earn more — pay less taxes later when you withdraw and your income is lower. Roth accounts are the opposite, but the reality is that we can't predict the future. If your income does end up being higher at the time you want to start cashing out, having a post-tax Roth account and access to tax-free cash will feel like a weight lifted off your shoulders.
  • Flexibility: Let's say you're 67 — well into retirement age and your income is still high at around $100K. If you want to tap your retirement funds for something, withdrawing $10K from your 401(k) will result in a $2,200 federal tax expense plus state taxes. But withdrawing $10K from a Roth? No cost to you.
  • Maxing out: The contribution limit for 401(k) plans in 2023 is $22,500, and $30,000 if you're eligible for catch-up contributions. But, if you also have a Roth IRA (Must be an IRA, 401(k) limits apply to all 401(k)s combined) alongside this, you can contribute another $6,500 to it as well, amplifying your annual gains and compound interest.
IRA Fast Facts
Retirement Planning
8 mins

🌊 BY THE WAY
  • 📊 Answer: 24.6. Despite a positive year so far, a turndown in recent months has curtailed the index's run a bit (Multpl)
  • 💵 The economy is bad, but my finances are good, say most consumers (Axios)
  • 👀 ICYMI. The best strategies to handle a credit card balance (Finny)
  • 💳  Amex ups the ante on their sign-up bonus (The Street)
  • 📚 Finny lesson of the day. Before you invest in something, it's best to understand how it works. When it comes to crowdfunding, Regulation A plays a pivotal role in granting us access:
What is Regulation A?
Advanced Investing
5 mins


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