Current market valuations: Why patience is key.

[Kiltacular]

I am not sure the general market is valued very high.  The number of cheap stocks is down but not non-existent.  There are a number of threads on potential undervaluations.  I don't think stocks are all that popular based upon 5 year flow of funds into mutual funds bonds are much more popular.

 

Packer

 

I am often in sync with Packer on these attitudes.  My take would say: "While the market could certainly drop 20 - 30% in a relatively short time period, I would expect the return over the next 10 to 20 years to be about 6 to 6.5% per year over that time period."

 

I realize GMO and others don't agree but their reasoning is too complex for me.

 

When the whole market is really overvalued you must have one condition that we don't now have.  Namely, you must have the large cap. stocks be very expensive -- think Nifty Fifty from the late 60's and the 1999 bubble.  The largest stocks were wildly expensive in those periods.  When that is the case, it is predictable that the CAGR from that point for the next 10 to 20 years is not going to be pretty.

 

Aside from such a situation, Buffett expects the Dow to be at 1,000,000 by 2100 -- work backwards from there to find times of large over or undervaluation. 

[Happy]

Tom1234 that is one side of the argument and I think it makes sense, but I can see some sense in Graham's allocation rules too.  It comes down to a personal decision. I think if I had a billion dollars or even 20 million I probably wouldn't worry about having cash either. 

 

Graham's rules kept him safe while allowing him to still make good returns.  He might have made more money if he was less cautious and I think investors will probably end up richer in the end always being fully invested, but that doesn't mean the allocation rules were a bad idea.

 

I agree that you can decrease your volatility and particularly the "worst case risk" by holding some cash the more expensive the market becomes. But I would note that the year 2000 must have looked far scarier in terms of the overall market than it does today and most top value investors actually racked in great performances as the market dropped (e.g. Greenblatt was up +100% in 2000). It's true that back then the discrepancy in valuation between "cheap stocks" and "expensive stocks" was probably at its extreme, but I learned from it that it's not a given fact that your portfolio has to decline with the market. These guys would have been far worse off had they not bought their good opportunities because the general market looked extremely overvalued. I guess the more overvalued the market, generally the bigger is the discrepancy in valuation to your portfolio (at least if you invest in 12 stocks or less) and thus the worse the overall market risk will serve as a proxy for the risk of your portfolio. So I will have a more careful attitude when the market is high than when it is low, but as long as I do find that 50 cent dollar I will buy it and not worry about the valuation of all these other businesses. If you lived in a town and someone you know offered you a part interest in a business that you were familiar with and where you thought the deal was very favorable to you, should you not take it because the stock market currently is at a high level?

 

Charlie Munger once said at an annual meeting that the idea basically is to grow rich enough (by fully exploiting the value of your opportunities) to be able to stomach the inevitably higher losses (that will arise at some point from being fully invested in not too many positions). Unless you get unlucky right away by the time the feared decline comes you may already have earned enough extra money to be better off even at the worst point of the decline and it is extremely likely that you will do better this way over a very long period. That thought reasoned very well with me, but I can understand if people are afraid of "being unlucky before the aggressive approach starts to pay off".

 

[PatientCheetah]

Tom1234 that is one side of the argument and I think it makes sense, but I can see some sense in Graham's allocation rules too.  It comes down to a personal decision. I think if I had a billion dollars or even 20 million I probably wouldn't worry about having cash either. 

 

Graham's rules kept him safe while allowing him to still make good returns.  He might have made more money if he was less cautious and I think investors will probably end up richer in the end always being fully invested, but that doesn't mean the allocation rules were a bad idea.

 

I agree that you can decrease your volatility and particularly the "worst case risk" by holding some cash the more expensive the market becomes. But I would note that the year 2000 must have looked far scarier in terms of the overall market than it does today and most top value investors actually racked in great performances as the market dropped (e.g. Greenblatt was up +100% in 2000). It's true that back then the discrepancy in valuation between "cheap stocks" and "expensive stocks" was probably at its extreme, but I learned from it that it's not a given fact that your portfolio has to decline with the market. These guys would have been far worse off had they not bought their good opportunities because the general market looked extremely overvalued. I guess the more overvalued the market, generally the bigger is the discrepancy in valuation to your portfolio (at least if you invest in 12 stocks or less) and thus the worse the overall market risk will serve as a proxy for the risk of your portfolio. So I will have a more careful attitude when the market is high than when it is low, but as long as I do find that 50 cent dollar I will buy it and not worry about the valuation of all these other businesses. If you lived in a town and someone you know offered you a part interest in a business that you were familiar with and where you thought the deal was very favorable to you, should you not take it because the stock market currently is at a high level?

 

Charlie Munger once said at an annual meeting that the idea basically is to grow rich enough (by fully exploiting the value of your opportunities) to be able to stomach the inevitably higher losses (that will arise at some point from being fully invested in not too many positions). Unless you get unlucky right away by the time the feared decline comes you may already have earned enough extra money to be better off even at the worst point of the decline and it is extremely likely that you will do better this way over a very long period. That thought reasoned very well with me, but I can understand if people are afraid of "being unlucky before the aggressive approach starts to pay off".

 

That is a really good point and resonate with my experience. Everyone needs to understand themselves and how their psychology work. When you are starting out and have limited capital, there is only so much pain before your inner daemon takes over. I think environment matters, individual security matters (if the business is in a upwing/market agrees with it/then no hell with the overall market, if this is not the case, be cognizant of the potential market absurdity). In the end of the day, mental models are here to enhance your chance of winning - use them, be flexible with their premises, and good luck!

[vinod1]

Most deep value investors would find that there aren't many actions to be made in the market right now. Especially on the buyers side of things. Still however, human nature pushes us to be active. And recently, this is a dilemma that I've been facing as I've discovered a few compelling businesses selling for cheap. I'm sure I'm not the only one. 

 

If, like me, your heart is telling you to buy but your brain is telling you to remain patient you may find value in re-visiting one of Benjamin Graham's lectures.  Here is a short excerpt and some food for thought:

 

You have to wait too long for recurrent opportunities. You get tired and restless -- especially if you are an analyst on a payroll, for it is pretty hard to justify drawing your salary just by waiting for recurrent low markets to come around. And so obviously you want to do something else besides that.

 

The thing that you would naturally be led into, if you are value-minded, would be the purchase of individual securities that are undervalued at all stages of the security market. That can be done successfully, and should be done -- with one proviso, which is that it is not wise to buy undervalued securities when the general market seems very high. That is a particularly difficult point to get across: For superficially it would seem that a high market is just the time to buy the undervalued securities, because their undervaluation seems most apparent then. If you could buy Mandel at 13, let us say, with a working capital so much larger when the general market is very high, it seems a better buy than when the general market is average or low. Peculiarly enough, experience shows that is not true. If the general market is very high and is going to have a serious decline, then your purchase of Mandel at 13 is not going to make you very happy or prosperous for the time being. In all probability the stock will also decline sharply in price in a break. Don’t forget that if Mandel or some similar company sells at less than your idea of value, it sells so because it is not popular; and it is not going to get more popular during periods when the market as a whole is declining considerably. Its popularity tends to decrease along with the popularity of stocks generally.

 

These are internal demons most of us investors face since it directly contradicts his main message of ignoring Mr. Market. Keynes, Buffett and Graham himself heavily emphasize the dictum:

It is preferable to buy dollar bills at seventy cents, rather than selling them at seventy cents in the hope of subsequently repurchasing the notes at fifty cents.

 

Vinod

 

As much as Graham believed in the Mr Market parable, there was a part of him that always feared losses, even paper losses if they lasted too long, as a result of his experience during the Great Depression.

 

Good point.

 

When it comes to shaping people's outlook regarding stock market's future returns, personal experience almost always trumps centuries of historical data. - James O'Shaughnessy

 

Vinod

[wachtwoord]

Self-doubt in absence of results is very human. The trick is to stay rational when experiencing this emotion.

[moustachio]

Looking back historically (over the past 140 years), it's a fairly normal valuation right now.  Could go down, could go up.  I am fully invested.

 

I have to disagree.  I think it is clear that some segments of this market is overvalued if not in full out bubble territory.  First, the Russell 2000 at 100x trailing P/E is overvalued, period.  I don't care how many "high fliers" are in the index.  Next, I agree with David Einhorn that we are witnessing the second internet bubble in 15 years.  Third, biotech sector is out of control. 

 

Here is a link on the trailing P/E for the Russell 2000.

 

http://online.wsj.com/mdc/public/page/2_3021-peyield.html

 

On the flip side, I believe many large cap stocks are at market or below market multiples.

 

The market cap of the underlying securities for the S&P 500 and Russel 2000 are 16,700 billion and 500 billion, respectively. Both of those are from wiki and the Russel number is not dated, but I think it should be accurate enough to illustrate the overall point. The overall value of the Russel 2000 is pretty insignificant compared to the S&P 500. Also, many of the high flying tech stocks and biotech are included in the S&P500 (Amazon, Netflix, etc) and the PE of the index by many people's measures(mine included) seems to be about fair, despite overvalued stocks being included. Biotech may or may not be wildly overpriced as a whole. There are probably some pretty big game changers coming soon that will add a lot of value to some of the winners of the biotech industry.

 

Personally, I worry about the psychological impact of a crash in small caps or tech stocks and how that might impact sentiment and thus the overall market more than I worry about the effect of overvalued stocks on overall market valuations right now. However, haven't they been overvalued for some years now? The market has still given us good returns.

[alertmeipp]

 

 

Personally, I worry about the psychological impact of a crash in small caps or tech stocks and how that might impact sentiment and thus the overall market more than I worry about the effect of overvalued stocks on overall market valuations right now. However, haven't they been overvalued for some years now? The market has still given us good returns.

 

Seems to be money is actually flowing from high beta stocks to dividend and boring companies.

 

Btw, holding cash seems far away from risk free to me, especially, for us live in Canada.

[PatientCheetah]

 

 

Personally, I worry about the psychological impact of a crash in small caps or tech stocks and how that might impact sentiment and thus the overall market more than I worry about the effect of overvalued stocks on overall market valuations right now. However, haven't they been overvalued for some years now? The market has still given us good returns.

 

Seems to be money is actually flowing from high beta stocks to dividend and boring companies.

 

Btw, holding cash seems far away from risk free to me, especially, for us live in Canada.

 

The inflow into E&P is puzzling for me. There are also a lot high leverage companies still trading at high valuation. Stocks like MSFT/CSCO/ORCL/GE make sense to me. Hope this reversion to quality/value last a while.

[racemize]

From a Schloss Interview:

 

OID: You mentioned earlier that you prefer to be - and generally remain - nearly 100% invested. As I recall, before the Crash, you were 90% invested.

Walter Schloss: That's correct. Over any extended period of time, stocks generally outperform bonds. Most people who have been really successful in the securities markets say the same thing - that they're not smart enough to get into the market and out of it. So they tend to remain more or less in the market at all times. I don't know anyone who got rich owning high-grade bonds.

 

OID: What percent invested have you been over the years on average?

Walter Schloss: Very close to 100%.

 

OID: What's the most out of the market that you've ever been?

Walter Schloss: 10%. And again that was before the Crash.

We try to buy good values and not worry too much about what the market is going to do. You could say, "How come you had 90% of your money in stocks if you thought the market was too high?"

Our answer was that what we owned didn't seem that overpriced. But when the market went down, our stocks went down too.

 

OID: But you were up more than the market before the crash and down less during it.

Walter Schloss: That's correct. And if we'd sold out, we might have missed being up 26% for the year. We did better by being in the market and not trying to figure it out.

It's the same thing today. I think the market may be vulnerable. I don't know what's going to happen. But I think I sleep better owning stocks than owning cash.

But everybody's different. You should own what you're comfortable with.

[Packer16]

What was the date of the Schloss interview (so what crash are we talking about)?  Thanks.

 

Packer

[peter1234]

Packer, I believe it was from an OID Interview in 1989. He is talking about the 1987 crash.  :)

 

...

Walter Schloss: The 1987 break was much more like 1962 than it was like 1929. The market was far too high. And it revalued itself - much of it in one day.

But we never know where the market is going. In October of 1987 before the market broke, we were both saying that the market was too high.

 

[matjone]

Yeah I remember that interview.  I think I also remember Schloss quitting when he thought valuations had gotten ridiculously high and he couldn't find anything.  Also, when Buffett closed his partnership bonds were yielding more than stock earnings yields.

 

My lesson from all this is that I should just keep my money in whatever has the best expected return, and not sit in cash waiting on better times.  Maybe it is a good idea to put some floor on what you are willing to accept though- maybe make a rule that if you can't find any decent companies with greater than say a 6% yield earnings yield, and bonds are yielding low single digits, maybe it is time to switch at least part to cash and wait for better times.  But I think even a rule like that is only necessary when you are working with many millions of dollars.  For  investors of small means such as myself I think there is probably always a juicy deal out there, it is just a question of whether I am hard working enough to find it.  Buffett pretty said pretty much that in '99 and I think I remember someone on this board bringing up some examples of ridiculously cheap things in the walker's manual from back then that worked out very well.  Of course, if another great depression hits, and earnings dry up and dividends get cut and banks and companies are failing left and right, and I have to live like Tom Joad for a while, then I may come around to Graham's more conservative views.

 

  It is interesting how well Schloss performed  during bear markets.  That is one reason why I wish there was more on him.  Graham and Klarman are two others who I believe did well during down markets, but I think their style is harder to copy.  Graham was very talented at finding arbitrage opportunities that weren't correlated to the market, and Klarman tends to invest in things that are too complex for me, and unavailable to me anyway.

 

 

[crastogi]

Yeah I remember that interview.  I think I also remember Schloss quitting when he thought valuations had gotten ridiculously high and he couldn't find anything.  Also, when Buffett closed his partnership bonds were yielding more than stock earnings yields.

 

My lesson from all this is that I should just keep my money in whatever has the best expected return, and not sit in cash waiting on better times.  Maybe it is a good idea to put some floor on what you are willing to accept though- maybe make a rule that if you can't find any decent companies with greater than say a 6% yield earnings yield, and bonds are yielding low single digits, maybe it is time to switch at least part to cash and wait for better times.  But I think even a rule like that is only necessary when you are working with many millions of dollars.  For  investors of small means such as myself I think there is probably always a juicy deal out there, it is just a question of whether I am hard working enough to find it.  Buffett pretty said pretty much that in '99 and I think I remember someone on this board bringing up some examples of ridiculously cheap things in the walker's manual from back then that worked out very well.  Of course, if another great depression hits, and earnings dry up and dividends get cut and banks and companies are failing left and right, and I have to live like Tom Joad for a while, then I may come around to Graham's more conservative views.

 

  It is interesting how well Schloss performed  during bear markets.  That is one reason why I wish there was more on him.  Graham and Klarman are two others who I believe did well during down markets, but I think their style is harder to copy.  Graham was very talented at finding arbitrage opportunities that weren't correlated to the market, and Klarman tends to invest in things that are too complex for me, and unavailable to me anyway.

 

Here is the OID interview.  The interview has a performance record.  It does seems he lost less than the market in down years

 

Walter-Schloss-OID-Interview89.pdf

[Kiltacular]

Yeah I remember that interview.  I think I also remember Schloss quitting when he thought valuations had gotten ridiculously high and he couldn't find anything.  Also, when Buffett closed his partnership bonds were yielding more than stock earnings yields.

 

My lesson from all this is that I should just keep my money in whatever has the best expected return, and not sit in cash waiting on better times.  Maybe it is a good idea to put some floor on what you are willing to accept though- maybe make a rule that if you can't find any decent companies with greater than say a 6% yield earnings yield, and bonds are yielding low single digits, maybe it is time to switch at least part to cash and wait for better times.  But I think even a rule like that is only necessary when you are working with many millions of dollars.  For  investors of small means such as myself I think there is probably always a juicy deal out there, it is just a question of whether I am hard working enough to find it.  Buffett pretty said pretty much that in '99 and I think I remember someone on this board bringing up some examples of ridiculously cheap things in the walker's manual from back then that worked out very well.  Of course, if another great depression hits, and earnings dry up and dividends get cut and banks and companies are failing left and right, and I have to live like Tom Joad for a while, then I may come around to Graham's more conservative views.

 

  It is interesting how well Schloss performed  during bear markets.  That is one reason why I wish there was more on him.  Graham and Klarman are two others who I believe did well during down markets, but I think their style is harder to copy.  Graham was very talented at finding arbitrage opportunities that weren't correlated to the market, and Klarman tends to invest in things that are too complex for me, and unavailable to me anyway.

 

Well said.

[bmichaud]

Public pessimism towards stocks my ass:

 

http://www.thereformedbroker.com/2014/04/29/america-is-all-in/

[james22]

If you believe that value matters but valuations do not necessarily mean revert, you should move your portfolio of risky assets around pretty aggressively as valuations shift among the various risky assets. But you should keep a fairly constant allocation to risky assets over time except in the rare instances where valuations are so extreme that risky assets are actually priced to lose out to lower-risk assets.

 

That strategy will outperform a naïve strategy over time, but if valuations do mean revert, it is substantially sub-optimal. If valuations mean revert, you can improve the risk/reward trade-offs of your portfolio substantially by adjusting how much risk you take through time, taking more risk when the return to risk is high, and less when it is low.

 

- GMO