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Schiller Market Prediction


bmichaud
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http://pragcap.com/robert-shiller-the-sp-will-rally-13-in-the-coming-9-years

 

This seems hard to believe that the market would return 13% cumulatively by 2020, but Klarman and Watsa probabaly would agree to some extent given how hedged they are. Tough to take on significant market exposure at these levels when prominent investors/prognosticators are predicting such low returns. Consensus currently is:

 

1. 2011 market will advance anywhere from 10 to 20%

2. Emerging markets will power equities through all economic problems

 

I am a little concerned that consensus is 100% certain these two events will take place. To be honest though, I have a hard time putting on hedges here given that the Fed is working so hard to keep the market elevated, profit margins are so high, and the market perceives cash balances to be at record levels (completely ignoring the fact that companies have issued record amounts of debt to generate this cash - similar to taking out a $500,000 mortgage and saying that you are flush with cash). We'll see what happens - I don't know what will take the market down in the next five years, but I think it is prudent to continue to build cash, put on selective individual company shorts, and hedge market indices where appropriate.

 

 

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Why not find high cash flow generating companies for low prices and let the market take care of itself?  No one knows what the future will bring.  Shiller has brought some good historical observations to the table but going out and predicting future returns is pretty speculative.  The growth rate of only 1.3% per year assumes a valuation change of 4% down per year (assuming a historical E growth rate of 5.5% per year) (or 33% lower PE over 9-years with 15 forward right now or a P/E of 10).  I think Bogel has better approach and his returns are on the order of 6 to 7% per year.  The only thing we can do is but cheap cash flow generating assets.  I would rather own these cheap assets than investing in cash waiting for the downturn - a market timing game I know I will lose.

 

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Shiller's figure does not include inflation -- he notes that in the 100 years ending 1990, earnings grew at a real rate of 1.5%. He is simply extrapolating current earnings 1.5% annually for 10 years, then putting 15x multiple on it. So with "normal" inflation returns of probably 4-5%.

 

With higher inflation, lower profit margins, lower GDP growth, etc., real earnings growth could easily be less than 1.5%. (Some negative real growth occurrences, listed below:)

 

10 years ending / Annual decline in real earnings

1933 / -5.2%

1946 / -3.8%

1960 / -0.3%

1975 / -1.3%

1986 / -2.6%

1991 / -3.4%

2009 / -1.9%

 

Certainly there are individual companies and industries now that may be great prospects regardless of the market -- but there will be headwinds from economic growth and overall valuations. So if someone can beat the index by 5%/year, it may mean 10% returns as opposed to 20-25% if had been starting in 1982.

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Pabrai funds owned lots of "cheap cash flow generating assets" and lost 70 percent over a two year period. That is unacceptable in my opinion.

 

I have gleaned the following lessons from the last three years regarding general market valuation:

 

1. Buffett personally was in all cash until his NYT op ed (around Dow 8500)

2. Watsa was fully hedged until fall of 2008, and is now back to significant hedging

3. Klarman went all in in the fall of 2008 and is now 50% cash

 

All of these prominent value guys thought/currently think this level of the market warrants caution. They obviously take the general market valuation in mind when investing as did Graham. They dont time things which is key - as evidenced by the fact that all three of these guys were early to the market in the fall of 2008. I am going to take their lead and approach taking on market exposure with caution.

 

 

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Pabrai was also invested in large amount of resource companies along with a sub-prime lender.  I don't expect a repeat performace given what he has learned. 

 

Asset allocation for these large funds is a function of large $ amount of ideas out there.  FFH also needs to be hedging for the insurance business they are in.  You are correct there are not that many large $ ideas out there but if each of these guys had smaller $ they probably could find plenty of places to invest.  Just look at the 1960's and the Buffett Partnership as an example.  Graham had stated in 1959 and again in 1964 that the market valuation level was high.  However, Buffett was able to outperform throughout this period in part becasue of the small size of the partnership at the time and the ability to invest in smaller situations that others could not.

 

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"You are correct there are not that many large $ ideas out there but if each of these guys had smaller $ they probably could find plenty of places to invest.  Just look at the 1960's and the Buffett Partnership as an example.  Graham had stated in 1959 and again in 1964 that the market valuation level was high.  However, Buffett was able to outperform throughout this period in part becasue of the small size of the partnership at the time and the ability to invest in smaller situations that others could not."

 

 

Perhaps they could. It's not fair to say that I cannot find companies selling at a legit 2, 3, or 4X earnings because I simply do not have the time to research given my full time job and studying - if I was able to devote 40+ hours a week, I might be able to find opportunities such as Buffett finding Western Insurance (I believe it was Western Insurance) selling at 2X earnings, or Michael Burry finding a company selling for less than 1X free cash flow back in the early 2000s. Or maybe if I understood the insurance business better I would find some of the ideas on this board more compelling. All that to say - I am in the market enough and look at a variety of screens looking for incredibly cheap stocks and I cannot find anything close to what I was finding back in 2008 and 2009 when there were in fact "net nets" available (SOAP and CROX for example) and high quality companies selling at a ridiculous multiple of normalized earnings (American Express ultimately bottoming at $9 versus $3 to $5 of normalized eps).

 

In order to generate the "50% guaranteed returns" that Buffett claims he would be able to generate with less than $1 million, one would have to invest a significant percentage of NAV in a limited number of Western Insurance-type opportunities. So for example, a MFI stock that I find compelling right now is Seagate - it currently has a a $7B market cap, a $2B announced BB, and LTM earnings of $1.6B. This is outrageously cheap, but given the competitive landscape of the business, it is not something I want to own long term or hold a substantial position in. I do want to own it though given that it doesn't have to do much more than fart to generate a decent return on a stand-alone basis and has the potential to be taken over - but it's only a 5 to 10% position. If it doubles, I make 5 to 10%. I need ten 5% positions such as this to generate 50% returns - I can't find those opportunities right now.

 

I ultimately want to manage more than a trivial amount of capital (aka I want to manage money professionally), so I try to invest how I would manage other people's money (for example, the aggressive portion of my parent's retirement account). Would I feel comfortable putting maybe 15% of my personal discretionary money into Seagate right now? Perhaps. Would I put 15% of my parent's money into Seagate? Heck no - maybe 5%.

 

Regarding Buffett's outperformance: for all of his rantings regarding the overall market valuation back when he ran his partnership, he found a HUGE number of net net opportunities. Given the number of net nets, I find it rather difficult to believe that the general market was that over valued - AND Buffett was a lot of times 80% exposed to the market, not exactly a defensive position. Buffett never truly invested through a bear market cycle (as Klarman or Watsa has) - he got out a little before the ultimate market top. Not unlike if a hedge fund manager started in the early 1990s and got out at the top of the tech bubble. I would love to have seen how he would have performed through that 70s bear market that Munger got destroyed in.

 

All that to say - given the general level of the market right now, I think it is highly dangerous going virtually "all in" in opportunities such as a Seagate, Apollo, or any gaming companies that have been mentioned on this board, and letting the market take care of itself. Even if I diversified and bought the top 30 small cap MFI stocks and forget about the market at this level, I would get OBLITERATED in a 2008/2009 downturn - I don't care how cheap the security is.

 

Perhaps I am wrong though - I may be waiting 20 years for another 2008/2009 opportunity. My plan though is to generate superior risk-adjusted returns through this period of market overvaluation while waiting for the "fat pitch" of a substantial market downturn where I can truly go "all in." Only time will tell.

 

Ben

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All that to say - given the general level of the market right now, I think it is highly dangerous going virtually "all in" in opportunities such as a Seagate, Apollo, or any gaming companies that have been mentioned on this board, and letting the market take care of itself. Even if I diversified and bought the top 30 small cap MFI stocks and forget about the market at this level, I would get OBLITERATED in a 2008/2009 downturn - I don't care how cheap the security is.

 

Perhaps I am wrong though - I may be waiting 20 years for another 2008/2009 opportunity. My plan though is to generate superior risk-adjusted returns through this period of market overvaluation while waiting for the "fat pitch" of a substantial market downturn where I can truly go "all in." Only time will tell.

 

I could not have said it better than you! I am also nibbling at an opportunity and another here and there and selling for nice profits but I am not going all in or waiting for long periods of time. There is just too much risk out there and it is an expensive market filled in with earnings estimates reflecting the past when the future might look really different. Investors are completely bypassing the fact that this is a high risk environment. It is amazing watching everybody dense on top of the highest pile of private debt to GDP or assets ever seen by this country and by far.

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Clearly the bargians are not falling out of the sky like they were at a bottom of the bear market in 2009 but Graham said as much (at market bottoms all stocks are cheap but at other times only secondary stocka are cheap).  I agree with you about Seagate (there is technological obsolesecne risk which has turned many a tech stock into a value trap) however there are many other smaller firms where there is considerable value.  Take media/entertainment as an example.  You have part a declining part (primarily newspapars - but even here you have some flat/growing niches like DJCO and GVC.TO and portions of telecom - pagers and ISP), slow growth parts (gaming, movie theatres, radio stations, TV stations, incumbant telco and wireless) and growing parts (cable and portions of internet). 

 

Clearly the declining portion is going to cheap because is declining, the trick here is to determine the correct decline rate.  I have tendancy to stay away because this is too hard for me.  The flat/slow growth part is where I have focused and found many shares selling for less than 5x FCF and all less than 7-8x FCF.  Some of these include SALM, SGA, SURW, MGAM, CKEC and LNET.  Screening is good initial tool but I doubt you would find some of these firms in a screen.  You have to dig into an industry, understand the competitive advantages then dig their financials.  I have found some stocks via screening but only after understading the industry and re-calcing the FCF.

 

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