International Selection 10:55 - Febr 3rd 2015

«The stock market seems to be ignoring the big risks»

John Bogle, founder of the Vanguard group, spots risks of a severe setback in the stock market but encourages investors to stay the course even if the ride gets bumpy.

John Bogle has single-handedly revolutionized the asset management industry. The founder of the Vanguard group launched 1975 the first index mutual fund which marked the start of a mass movement among investors all over the world. Today, Vanguard surpasses $3 trillion in assets under management and is the largest mutual fund company. Even Warren Buffett recommends to invest in the Vanguard 500 Index Fund which tracks the S&P 500 (SP500 2271.31 0.34%) Index and is the largest fund of the group. «Index investing is the biggest change in investing in history, and it’s changing the shape of the world», says Mr. Bogle. He advises investors to keep cool despite of rising tensions in the financial markets. He cautions that the mood of the stock market could switch suddenly and that a severe setback could easily happen. Nevertheless, in the long term he thinks there’s no alternative to equities and he encourages investors to stay the course.

Mr. Bogle, we’ve seen some wild swings in asset prices over the last few weeks. What are your thoughts when you look at today’s financial markets?
I look at them a little nervously. We live in a very uncertain and fragile world with big risks. Now, we have a little bump going on here and if it gets more serious who knows really what’s going to happen. Sentiment in the stock market has been quite bullish and sometimes that bullish thinking changes for no apparent reason. Fundamentally, today things are not very different than they were at the end of December when the S&P 500 climbed to a new record high. But now, the market seems to have taken on a nervous cast and there is very little anybody can do about that.

What’s the biggest risk for stocks right now?
There are financial risks, economic risks and the risk of war rising all over the world, particularly in the middle east. And those are big risks, not little ones like corporate earnings which are easy to measure. But the markets looks at them and says: «We don’t have to worry». Is the market right? Well, only time will tell. I’ve been saying for several years that we have a stock market that seems to be ignoring those kind of risks. I think we’re seeing a turn in lower global economic growth and a turn in lower corporate earnings and I’ve been telling people for years: When you can’t afford a 25 or 30% drop in the stock market you should not be in the stock market. I have no reason to think this will be a correction that strong but it easily could be.

So what would be your advice for investors?
Well, what I’m trying to do and what I’ve been trying to do all my career is to persuade individual investors that they should ignore the fluctuations in the marketplace and continue to invest. When you get market declines – even for a protracted time - keep investing because when you use the same amount of Dollars you are getting more and more shares. So if you continue to invest you’re taking advantage of the ever descending prices a bear market brings. And don’t stop because things are getting cheaper. That’s what’s so funny: In your everyday life you don’t like it when prices go up. But in the stock market you do. When the price goes down for steak you love that. But in the stock market you hate it. So try to take the emotions out of investing.

A reason for concern is the ample volatility in the currency markets and an almost unprecedented uptick in central bank interventions. What is your take on the new bond buying program of the ECB?
They waited a long time to do it and they probably should have done it at the beginning of the European debt crisis. The European community was too heavy on austerity and too light on making money easier.

In the US, the Federal Reserve is moving in the opposite direction and plans to raise interest rates which is probably one of the main reasons behind the strong rally of the dollar.
The strong dollar means two things: It’s tougher for US companies that are exporting products and services. But it’s also tougher for international markets to do well because the rising dollar means that they have to rise even more to be equal to US stocks. But that’s not going to go on forever and the dollar will eventually stabilize. I’m struck by the level of the Dollar right now compared to the Euro. It’s almost exactly the same exchange rate at which the Euro was introduced in 1999. So all these fluctuations came back to kind of a norm and that’s what we should expect with anything that has to do with the markets – some kind of a reversion to the mean.

How will the financial markets react if the Fed gets serious and starts rising interest rates?
When interest rates rise it’s going to be difficult for bondholders and particularly for bond speculators. It’s curious that in this recent unpleasantness of the last number of days interest rates have actually continued to go down almost all over the world. But eventually they have to rise. Because with the yield on ten year treasuries below 2% and a presumed inflation rate of around 1.8% you get just about a real return of zero. I don’t think that’s sustainable. As investors, we are starving for yield over here, and probably all over the world. The actions of the centrals banks have been good for businesses and good for the economy but terrible for savers.

What’s the difference between investing and speculation?
Lord Keynes defined it pretty well: Speculation is betting on what investors will think about an investment. An investment is the long term capitalized value of a company’s earnings. It’s a question of intrinsic value and not market price. So you could even say the stock market is a giant distraction to the business of investing.

The stock market is a specialist’s place. You should go in there to buy your portfolio. But once you have made your bet, get out! Get out of the casino! Trading, by any academic measure, is costly to investors. So the more you trade the less you make. It’s just simple math.

Another astonishing development is the steep drop in oil prices. What are the consequences of the oil shock for investors?
I limit myself to stocks and bonds. I’m not into commodities and things like that because they do a lot of damage to your portfolio. So I’m just a layman in this area. But it’s amazing to me that basically none of the petroleum experts could see this incredible decline coming. Also (ALSN 93.3 0%), the market is very ambivalent. It seemed to be very bullish for stocks when the oil price dropped from around $115 per barrel to $50 because of all the huge advantages for the consumers. But now, after the price has dropped to this level, it’s all of a sudden bearish.

And what’s your point of view?
There are two sides to every trade in the stock market. Oil producing nations are going to suffer quite badly and that’s where a huge part of the world’s wealth is located. With respect to that the bust is not good.

In the US, stocks have rallied strongly since the financial crisis. Also, the S&P 500 has never dropped more than 10% since 2011. Isn’t it about time for a healthy correction?
Looking at valuations, certainly no one would say that US stocks are cheap at maybe 20 times on the basis of the reported earnings in the past twelve months. Normally, that multiple is around 14 to 15. But on the other side, stocks are not hugely overpriced in contrast to the dotcom bubble for example.

But in other countries the stock markets are clearly valued lower.
If you believe that the price earnings multiple is a measure of valuation, it’s clear that non US stocks and particularly emerging market stocks are a good bet. They have a lower multiple, I understand that. But I think it’s because they have higher risks. The United States seem to have weathered the storm of the last few years since the economic crisis far better than most other industrial nations. Actually, our recovery in gross national product was better than in any industrialized nation expect Switzerland. Fact is, the US is the most diversified economy on the face of this earth, the most resilient and the most innovative – and that’s got to be worth something.

So what kind of return can investors expect from US stocks?
To get what I call the investment return, I add together the current dividend yield and the assumed earnings rate for the next decade. That’s the equipment we have to do this analysis. Today, the dividend yield is 2%, and I think we probably will be able to get 5 or 6% in earnings growth annually over the next ten years. So in total that’s a 7% investment return, even if we use the lower number. Then there’s the question about a special return. That’s the change in the P/E multiple. Normally, if the P/E ratio is above 20 it’s likely to go down during the decade. So you can offset a point. In total that would be a 6% return on stocks over the next decade. That’s below the long term norm of 9%. But what are you supposed to do? That’s my question really.

What do you mean by that?
For instance, you could choose to not invest at all. But that’s one way to make sure you will have nothing when you retire. Inflation will eat away your cash. So it’s really about stocks and bonds: Hope for the best over the long term, hope for the productivity, hope for the imagination and hope for the competitiveness of modern capitalism to produce better and better goods and services for lower and lower prices. This is not a risk free choice. But I acknowledge that a portfolio with stocks and bonds is the lowest risk way of proceeding that I know of. So just make sure that your asset allocation suits your needs. And if it suited your needs in December it is almost certainly going to suit your needs today. So I think what’s best for almost all investors is to stay the course.

But how about taking some chips from the table and save those recent gains for a while?
If you think it’s the right thing to get out now you will also have to know when to get back in. It’s a two-step decision: Being right the first time you got one chance out of two, but being right twice you got one chance out of four. So to stay the course is basically the only rational thing to do.

Would you allow a personal question at the end of this conversation? Despite that you’ve suffered several heart attacks and even had a heart transplantation, nothing seems to be stopping you from your work. What are you expecting from life?
I expect to live life to the fullest to the day I die. I expect to be at least a voice for reform, particularly in our financial system which is where I have the most to say. I had my first heart attack in 1960. That’s 55 years ago and I survived all kind of things – you can’t imagine how many of them. So my motto is pretty simple: Roll with the punches, try to stick to your values, tell the truth and try and help society.


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