Fear Retreats…For the Moment

I am having so much fun watching this stock/bond market top out it’s sinful. As I wrote last week, there was a slight whiff of fear in the air on August 18th but now everyone has fallen back into a complacent stupor. But the dangers are no less.

The market data still signals a likely crash…valuations are absurdly high and the advance in the indices has been extremely narrow. Fewer and fewer stocks are rising. Smaller companies (the Russell 2000 or RUT) are down for the year indicating that the market is slowly becoming risk-averse. But hardly anyone sees it.

I am reminded of the George Carlin quote: “Think of how stupid the average person is, and realize half of them must be stupider than that.”

If investors were intelligent, they would choose their investments on the basis of valuation. Here is Wayno’s rule on valuation in two simple statements: Cheap assets are good. Expensive assets are bad.

Or, as I used to say when I was more patient and used more words: “There is no investment so good that it cannot be ruined by overpaying for it.”

Now, I fully expect some idiot to write back to me that he bought Amazon for $200 so he did not overpay. This would be an email from someone who is in the 50% who are dumber than the average. Every day you own that stock you are agreeing to buy it all over again.

So let’s restate my rule: “There is no investment so successful that you should not sell it.” But that’s not how people think. The reality is they like financial assets that have worked, whose prices have risen strongly in the recent past. Human beings are nothing if not rigorous extrapolators. This is not to put down price momentum, which is a perfectly respectable trading strategy if you are also perfectly prepared to sell as soon as the momentum dies. But that’s not what your average investor does, who drives by way of the rear view mirror.

I have the greatest respect for Jeremy Grantham, a British investor and co-founder and chief investment strategist of Grantham, Mayo, & van Otterloo (GMO), a Boston-based asset management firm. He is even older than I am. Grantham has been hugely successful for decades because he buys on value (cheap) and SELLS on value (expensive). In their latest research, he points out that NOT ONE U.S. LISTED STOCK meets the valuation standards of the patron saint of value investing, Benjamin Graham. Which is why GMO holds mostly Asian stocks.

GMO points out that between 1970 and 2015, the US stock market generated, on average, a real annual return of 6.3%. Of that 6.3% return, over half (3.4%) came from dividends. Capital growth was next, accounting for 2.3% of the return. Two other factors, margin expansion and earnings multiple expansion, accounted for the relatively modest remainder.

Now consider a more recent period, 2010 to 2017. What’s “different this time” is the make-up of the far higher average annual real return of 13.6%. Dividends account for just 2.8% of the return. Capital growth accounts for 3.1%. Margin expansion accounts for 3.2%. Multiple expansion has been the single biggest driver of recent market returns, accounting for an annualised 3.8%. Multiple expansion is code for “paying more for the same earnings”. It means overvaluation.

The most aggressive monetary stimulus in history has encouraged investors to bid up stock market earnings multiples. Why would you want to buy this market? If you are sitting on a profit, what on earth could possibly be wrong with cashing out? Can’t you wait for a lower price? Because, dear reader, lower prices are coming, just as the night follows the day.