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Excellent quote about the market and Depression from the Davis Dynasty


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"“Yet, just as the stock market had crashed when the economy was bountiful, the stock market soared when the economy was woeful. In the fiscal funk of 1932-1935, the papers were full of demoralizing tidbits…Wall Street then launched one of the most profitable rallies in its history….Courageous investors who had a tin ear for public opinion and spare cash to put into disparaged equities quadrupled their money in four years. The Dow rose from 41 to 160, and the S&P500 did even better. This unexpected bonanza was a good lesson for Davis. It reminded him that stocks don’t read the papers or swoon in response to scary headlines. When they’re priced for desperation, they can rally in the face of desperation, escaping the dumps while the companies to which they’re attached are still wallowing in the dumps.” – The Davis Dynasty- John Rothchild"

 

I think this is what Buffet meant in this years annual report when he wrote that a bad economy does not necessarily mean a bad stock market.

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i found the comparisons to that time to be interesting, but I do not know anything as to why the investing public bought stocks during that time period.  And I am very fearful of believing anything an "expert" may tell about why that time period is similar to now.

FWIW

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Guest JackRiver

scorpiancapital

 

Wonderful quote.  Those of us that are starting to run low on cash can only hope it plays out like that going forward.

 

Something that I find interesting:  I'm thinking of the old Keynesian saying about the market staying irrational longer than you can stay solvent.  Now, Keynes was referring to short selling and why an investor shouldn't short.  The way I like to think about it is that once you identify something as overvalued, irrational, its folly to try and make sense of it, and by shorting stocks you are by default suggesting that you think you can make sense of irrationality (the extreme of which is trying to time the top).  Of course, the key to Keynes's point is insolvency.  That is, an irrational price can be 20% overvalued to 40% overvalued to 100%  or 1000% overvalued etc.  It's irrational and therefore you don't know where it will end or if you will be able to stay solvent in the process.

 

Now to the reverse.  What about irrational pricing on the downside (long investor)?  First, if you are not leveraged, there is no need to worry about solvency in this context, but you are still faced with the same problem of wanting to try and make sense of irrational prices (the extreme of which is trying to time the bottom).  But as above, you can't make sense of something that is irrational.  So you are left with only one logical option, that is, buy when you feel the price offers you an adequate rate of return (I suppose you can assume that a margin of safety is factored into your valuation/pricing).  I say this is your only logical option, but others will be tempted to try and anticipate irrational behavior (pricing).  I think we are seeing some of that today, and I think it is the point Buffett was/is making when he describes his purchase of the Washington Post.  That everybody else was trying to anticipate irrational prices, that is, they felt that WPO was undervalued but also felt they could buy it lower still.  History shows it went lower but this type of thinking is flawed.  Like above, you don't know if it's 10% lower, 20% lower, or 50% lower.  These investor are trying to anticipate an irrational price.

 

My point is that I think investors are, in part, using this flawed logic today.  Sure there is ample reason to be scared in this environment, and sure, who really knows what normalized earnings should be and what prices are fair, but a lot of people are taking money out and clustering on the sidelines to try and time the bottom.  That's irrational because you can't make sense of irrational prices (downside or upside).  And if prices are irrational today (God I hope they are), that means that irrational shareholders are selling, and of course, you can't control an irrational partner (mr. market) if he wants to sell at too low a price.  Kind of crazy, like having 20% of the float shares and short sellers dictating the price to the other 80%.  We might be in a situation were the irrational partners are setting the prices on the downside much like they did on the upside.  So is our markets.

 

Yours

 

Jack River

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Good post JackRiver.  Its hard to figure this one out.  As the market moves lower like this, I really wonder if it can set itself up at some stupid level like S&P at 500 so that it is truly a no-brainer to buy - i.e. so it is truly priced for desperation.  Somehow, I would think this would not be the case and investors would be more rational so as to not give others such a no brainer.  Makes me think it settles somewhat higher - like somewhere around here.

 

I am very tempted to take half my hedges off in the morning.

 

 

 

 

 

 

 

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Guest ericopoly

So how far away is 1981 prices from here?

 

Maybe picking out a few companies with non-debt-bubble earnings would help -- companies without any fear baked into them (I won't use WFC or BAC for example):

 

KFT, JNJ, PFE are all at P/E of ~10.5x.  Where were similar companies trading in 1981?

 

I know in 1982 the market P/E was about 8x.  At what multiples did similar stocks trade?  Could you pick up a JNJ at 8x?

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And those types of high quality companies are also the ones where the E will not shrink as much as the general market.  These types of companies seems like the best place to be.  They may indeed be as cheap as in 1981.  1981 was a time of compressed E along with compressed P/Es - the latter due to very high inflation.  Because the Es of these high quality companies should tend not to compress that much due to their higher quality, they may not have got wacked with that double-wammy back in 1981. 

 

I don't have data going back that far on these specific companies, but I would guess that those are getting quite cheap right now.  Its the "value" stocks and the market overall that I am more fearful of, not these high quality ones.

 

 

 

 

 

 

 

 

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Guest ericopoly

Mungerville,

I can't shake the suspicion that if it weren't for really high interest rates, investors in 1982 would not have demanded a P/E of no more than 8x.

 

8x is an earnings yield of 12.5%.  But you could get 15% from long Treasuries.

 

Stocks at 8x offered inflation protection, and thus the yield did not exceed that of long treasuries.  Stocks at 8x offered P/E expansion, but long bonds at 15% offer capital gains opportunities too.

 

Today, you can't get shit for yield from long Treasuries. 

 

So, what really drove the P/E to 8x in 1982?  I don't know but this comparison with the interest rates of the day seems to be a necessary part of the conversation.

 

The key ingredient here was inflation.  You got a P/E that compensated you for the inflation (or the fear of it), and then you got real earnings growth hopes on top of that to give you some real return.

 

Today, why in the world do we need to go down to a P/E of 8x?  It sure as hell isn't inflation.  And it sure as hell isn't yields on safe alternatives either.

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"Today, you can't get shit for yield from long Treasuries."

 

But you do get your money back.  I know a lot of people who would take Treasuries over what was / is sitting in their brokerage accounts. 

 

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But that rally only came after a 90% fall.  Even after the quadrupling between 32-35 most investors were still deeply in the red.   

 

I think the idea behind this quote is not so much where the bottom is but that there IS a bottom and the rebound can be very strong (of course we'll only know in retrospect). Anybody who bought at the peak of anything is always going to lose. The question is if the person who bought at 25% below the peak, 50% below the peak (like now) is going to lose much MORE. A few % point more is no big deal and I don't think we're going to hit -89% this time around - no way.

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I agree that long dated Treasuries would be a poor choice.  But people who are in a fit of panic watching their wealth evaporate before their eyes are not in a state conducive to rational decision making.

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In my opinion, I think this bounceback has already happened off the 90's bubble.  The October 2007 high was the bounceback.

 

On a contrarian side, everyone is looking for this, like since it happened once, it will happen again. 

 

But of course, WTF do I know? 

 

Love the new board, great job Sanjeev. 

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I don't think we'll a 90% drop this time around, but I do have a target of Dow 4000, so another 40% from here.  1994/1995 is when many companies really started to increase leverage and prices and earnings started to go parabolic.    I think we return to those levels and then start growing again, but this time at a more reasonable pace.  Irrational exuberance is one of the few things Greenspan got right, and many people have just forgotten how insane valuations were looking in 96-97. 

 

To me the key isn't necessarily how far we'll drop, but how long it will take before we start to see growth again.  Even if this is the bottom, or we're very close, it will be years before we see earnings growing at the same rate as the 90s. 

 

In the meantime there is money to be made by investing in companies that pay out earnings as dividends, don't have debt, and have consistent sales.

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Ericopoly,

 

I agree and I think that is what most market commentators are missing. If you buy a stock you are getting a "yield" (I prefer to look at free cash flow yield or in the case of FFH the after-tax annual book value gain, rather than actual dividend yield) and you are getting "inflation protection". Obviously with an oil company you get more from this hard-to-value "inflation protection" component than you would from a manufacturer with high maintenence capex costs".

 

I think you can look at "fair value" of stocks as FCF yield, minus some risk premium, plus a bonus for inflation protection (or growth). This "yield" should be equal to the long term treasury yield (becasue you are subtracting for risk). So if Wal Mart has a FCF yield of 10%, you subtract 7% for the riskiness over treasuries and add back 2% for growth (inflation protection). This would leave you 5%, which is more than the long term bond yield.

 

I think we would all agree that treasury yields are unrealistic right now, and it would be better to use some "normalized" measure, like the average of the yield on really safe debt (KO etc. and the treasury curve) - something like 4% for ten year and 6% for 30 year. Even using these higher rates, you are already out earnings treasuries with the FCF at a lot of companies. If you think 7% is a fair equity risk premium, then you need 12-13% FCF from a safe stable stock to equal the normalized treasury yields above. There are stocks where you can get this yield and you get the inflation protection for free.

 

Basically, I think stocks are cheaper than '81 considering the outlook and where bond yields are. This is an awfully good time to get some free inflation protection in my opinion.

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Something that Grantham said was obvious yet interesting to consider.  He said P/Es should not contract in times of high inflation because stocks are an inflation hedge and provide a real return.  Obvious as it sound, I think the above should be incorporated into the thinking.

 

The other concept is the market price to replacement value of the firm.  No matter how low other yields go on governments or corporate debt (as they did in the past 5 years), replacement value has to be an anchor on stock prices.

 

Both of these concepts somewhat refute the idea of using the "Fed Model" of comparing earnings yields on stocks to the yield on 10-yr treasuries.  And this is what some seem to be arguing here to some degree.  I am not saying its totally wrong to this, just these two points need consideration as well as comparing corporate bond prices to stocks.

 

 

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Guest ericopoly

Something that Grantham said was obvious yet interesting to consider.  He said P/Es should not contract in times of high inflation because stocks are an inflation hedge and provide a real return.  Obvious as it sound, I think the above should be incorporated into the thinking.

 

I'm afraid I cannot agree with him because he is ignoring something fundamental... long term (30 yr) treasuries at 15% provided a real return, with the promise of huge capital gains when inflation subsides (fall in interest rates).

 

Inflation:

1979  11.3%

1980  13.5%

1981  10.3%

 

I think people were looking for an earnings yield from stocks that closely matched inflation.  I mean, the coincidence is uncanny -- the market P/E reflected very closely the rate of inflation.

 

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Consider what market timing really is.

 

Assume the IV of coy X is 600, the fundamental value is 400, & it trades at 200. I dont buy today because I think it'll be lower tomorrow - & tomorrows open will prove it. It is effectively a casino bet on either higher/lower.

 

In fact, this is extremely rational behaviour

- We live in a world of business cycles & they bias the daily quote direction. In a down cycle even if I'm wrong today, tomorrow & the next day; I'm still likely to be right more times than I'm wrong. Therefore I have an incentive to wait.

- 200 reflects a logic error in the market view. Not buying today is a bet that the error will still be there tomorrow & possibly more irrational still. A reasonable risk as logic errors typically take same time to recognize. Or in market parlance 'no change untill you can show me the money'

- Worst case I'm wrong, & the price starts going up drastically. An automated buy at 10% above the low will cut the opportunity 'loss' to -20 (200-220). Against the opportunity 'gain' of 200 (400-200)

 

Value investors suffer downside volatility because we typically buy too early.

- We'd buy at 260 & gloat that we have a 35% MOS to fundamental value, & a 43c $ relative to IV. Then suffer buyer remorse because a market timer subsequently picked it up at 220 on a bad day, & we have a 15% unrealized loss.

 

Most of the investment world are not value investors

 

SD

 

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Mungerville,

 

Fed model has been pretty discredited. Asness paper "Fight the fed model" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480) does a pretty good job of systematically taking out its rationale.

 

Are you sure Grantham has said that? I would be surprised if he said that.

 

The rationale is that stocks are a claim on real assets so the earnings yield on stocks gives you the real yield vs nominal yield provided by bonds. This point is disagreed by Buffett who pointed out that despite the level of inflation the ROE of firms has consistently been in the 12% range. If inflation is purely pass through, then ROE should jump when inflation increases, yet we have not seen this in the 70s.

 

Thanks

 

Vinod

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Guest ericopoly

 

An automated buy at 10% above the low will cut the opportunity 'loss' to -20 (200-220). Against the opportunity 'gain' of 200 (400-200)

 

 

How can you have an automated buy at 10% above the low if you do not know what the "low" is?

 

Let's say back in November you thought the low was 750 so you set in an automated buy at 820.  And here we are today, not higher than where you bought.

 

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Guest JackRiver

SD

 

If we didn't get price quotes minute by minute day by day what would we do then?

 

As Graham might agree, we are buying a piece of a business and not a stock price.  You seem to be suggesting we focus on stock price.

 

Yours

 

Jack River

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Guest ericopoly

No JackRiver, I'm rebutting the suggestion that anyone knows what the low price is.  You're not understanding my point.

 

And I'm not arguing for the Fed model either Mungerville  :)  

 

However, what's all this talk about pricing stocks against some intrinsic value using some risk-free alternative of 7%?  What do you do when the risk-free alternative is 15%?  Is that what the market did in 1982?

 

 

 

 

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Guest JackRiver

Eric

 

My post/reply was directed towards SharperDingaan.  He signed off "SD" so I replied with "SD."  If you are still referring to something I wrote can you please elaborate, otherwise as I understand it, our individual points are in harmony.

 

Yours

 

Jack River

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Eric: All we have is todays price & a chart of the historic price; you have to look at the chart & decide on what the trend is. Depending on your historic timeframe (minutes, weeks, months, etc.) you'll get different results. Look for the lowest point on the historic trend & set at 10% above that. Essentially using the technical approach where its best at.

 

JR: You remain focused on the business & you've allready decided to own a piece of it. The only issue is whether you can reasonably expect to get it for even less. No different to waiting to replace your wardrobe untill Jan/Feb, in anticipation of a 30-40% off sale because its a slow time in the retail year. The sale might not happen, or may even be for less than 30-40%, but most would think it worthwhile to wait.

 

 

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