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Scary Stuff

Scary Stuff

Jonathan Clements  |  October 31, 2020

IT’S HALLOWEEN, but not much frightens me—at least financially. My portfolio is broadly diversified, I have the insurance I need, and I have enough set aside for retirement. The highly improbable could happen, but I’m not going to lose sleep over that.

Still, even for those of us in decent financial shape, I see two key reasons for concern. We have no control over either—which is why they might seem scary—but we can take steps to limit the potential fallout.

Rising rates. I’m not forecasting a sharp increase in interest rates. But if that came to pass, not only would bonds take it on the chin, but also we could see grim short-term stock market returns.

U.S. stocks have spent much of the past three decades at what was once considered nosebleed valuations. The long decline in interest rates is a key reason. As the yields on bonds and cash investments have fallen since the early 1980s, investors have become increasingly willing to buy stocks, and that’s driven up price-earnings multiples.

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On top of that, U.S. stocks have been nudged higher by two other factors. Corporate tax rates have fallen sharply in recent decades, while company profit margins have been at historically high levels. But these tailwinds could become headwinds: Interest rates might climb, corporate tax rates could rise and profit margins may narrow further.

Still, I think there are two reasons to believe stocks will continue to sport above-average price-earnings multiples. First, as the world has grown more prosperous, investors have more money to invest and an increased appetite for risk, and that’s led them to buy stocks.

Second, today’s big technology companies—as well as other businesses focused on building intellectual capital—almost inevitably look overpriced based on standard market yardsticks, and that’s affecting average valuations for the broad market indexes. What’s the issue? Current accounting standards punish the earnings of companies that spend heavily on research and development, while the intangible assets that often result typically don’t appear on corporate balance sheets.

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