'History always repeats itself but never in the exact same way': Rechtshaffen on AI/dot-com bubbles

Key Concepts

Schiller PE Index (CAPE Ratio): A valuation measure for stocks that uses inflation-adjusted earnings over a 10-year period. A higher number indicates a more expensive market.
Dot Bubble: The period of rapid growth and subsequent collapse of technology stocks in the late 1990s and early 2000s.
Diversification: Spreading investments across different asset classes to reduce risk.
Hedging: Taking steps to reduce the risk of potential losses in an investment.
Premium Yield Funds: Investment funds that aim to generate income through option strategies.
Correlation: The statistical relationship between two variables, in this case, how closely an investment's performance moves with the stock market.

Market Valuations and Historical Parallels

The discussion begins with a brief mention of Scotia Bank exceeding adjusted profit estimates, highlighting ongoing bank earnings reports. However, the primary focus quickly shifts to market valuations, particularly in the United States. Ted Rex Shaffen, portfolio manager, president, and CEO of Tri Delta Private Wealth, expresses concern over current market valuations.

Schiller PE Index and Historical Comparisons

Key Metric: Shaffen points to the Schiller PE index (also known as the CAPE ratio) as a crucial indicator of market valuation. This index, with data dating back to 1880, measures stock market valuations using inflation-adjusted earnings over the past 10 years.
Current Level: The Schiller PE index reached 40 in the current month.
Historical Context: The only previous time the Schiller PE index hit 40 was in 1999, coinciding with the peak of the dot-com bubble.
Argument: Shaffen acknowledges the argument that "it's different this time" due to the profitability of major companies and the influence of AI. However, he cautions that high valuations are often driven by immense future expectations, which companies may not always meet. He states, "they're expensive not because of how great they are today. They're expensive in part because the future expectations are huge. And they don't always meet them."

Investment Strategies in a High-Valuation Environment

Given the concerns about high valuations and potential market downturns, Shaffen outlines the strategies being employed by Tri Delta Private Wealth.

Lessons from the Dot-Com Bust (2000-2002)

Market Performance: From 2000 to 2002, the S&P 500 experienced double-digit declines for three consecutive years.
Impact on Investments: A hypothetical $1 million investment in stocks during this period would have dropped to $625,000.
Bonds as a Safe Haven: In contrast, bonds performed exceptionally well, with double-digit gains for three consecutive years. A $1 million investment in bonds at the start of 2000 would have been worth $1.3 million by the end of 2002, significantly outperforming stocks.
Strategic Implication: This historical data provides a rationale for considering alternative investments beyond stocks.

Diversification and Risk Mitigation Strategies

Shaffen details several investment approaches being utilized to navigate the current market conditions:

Traditional Bonds:
- Focus: Exploring both corporate bonds and more tax-efficient corporate class bonds.
- Rationale: Bonds historically offer a hedge against stock market downturns.
Option Strategies:
- Objective: To generate returns that are uncorrelated with the broader stock market.
- Expected Returns: Typically aim for 4-7% returns.
- Tax Efficiency: These strategies are noted for their tax efficiency.
- Specific Funds: Shaffen mentions Purpose Premium Yield Fund and similar offerings from Dynamic as examples. He expresses a preference for Purpose's fund due to its lower correlation to the stock market, emphasizing the goal of reducing stock market risk, not simply shifting it to another correlated asset. He states, "If I'm trying to remove risk from the stock market, I don't just I don't want to put it right back into something that's tied to the stock market."
2-Year Notes:
- Specific Product: A 2-year note structured with a company offering a 10.25% interest rate.
- Payment Frequency: Interest is paid monthly.
- Correlation: This investment is also noted for its lack of correlation with the stock market.

Portfolio Allocation Adjustments

The discussion addresses how these strategies translate into portfolio adjustments.

Gradual Shift: Shaffen emphasizes that timing the market perfectly is impossible. Therefore, the approach is not a sudden shift from high stock exposure to zero.
Reducing Stock Weighting: For clients who typically hold 50-70% in stocks, the aim is to reduce this allocation to the 50% range, rather than the higher end of the spectrum. This involves "trimming back" overweight stock positions.

Market Outlook and Uncertainty

Shaffen acknowledges the inherent uncertainty in predicting market movements.

Timing of Downturns: While historical data suggests potential for significant drops (10-25%), the exact timing remains unknown. It could happen "today or in six months."
Cautious and Hedged Approach: The current strategy is to be "a little bit cautious and a little bit hedgy."
Historical Precedent: The Schiller PE index has not reached 40 before, except in the late 1990s. While not an exact "apples to apples" comparison, Shaffen believes the current situation is sufficiently similar to warrant caution. He states, "Is it apples to oranges? And are oranges still fruits? Yes, they are. So, so I think it's close enough that that and part of our job really is to say, how do we how do we look at caution and react to it and not ignore it?"

Conclusion

The core takeaway is a cautious approach to investing in a market characterized by historically high valuations, as indicated by the Schiller PE index reaching 40, a level last seen before the dot-com bubble burst. While acknowledging the unique aspects of the current environment, the strategy involves reducing stock exposure and diversifying into assets with low correlation to the stock market, such as certain bonds and option-based income strategies. The emphasis is on risk mitigation and hedging against potential downturns, rather than attempting to perfectly time market peaks and troughs.