By Alex. Originally published at ValueWalk.
The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.
Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one–common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.
How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms. In my view, it is only a matter of time before today’s yield pigs are led to the slaughter house. The shares of good companies and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today’s investment-grade issues will be downgraded to junk status if the economy doesn’t begin to recover soon.
What if you depend on a higher return on your money and can’t live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss. Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable.
I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the gettin is good. Caution has not been a profitable investment tactic for a long time now. I strongly believe it is about to make a comeback.
The above is from a Forbes article written by legendary value investor and hedge fund manager Seth Klarman.
In the article, Klarman excoriates common investors for being “yield pigs” blindly piling into common stock. Low yields having driven them into a frenzy for return… as they hoof their way to the slaughterhouse to be ground into some expensive breakfast sausage.
Hopefully some of you more astute readers caught this line, “What if you depend on a higher return on your money and can’t live on the income from 4% interest rates?”.
4% rates isn’t a typo. This article sounds like it could’ve been written today (it’s actually a lot more applicable now), but Klarman wrote it all the way back in 92’.
Klarman made some good points. Back in 92’ stocks were overvalued on a historical basis and investors were chasing yield.
What Klarman got wrong was the timing… he was 8 years too early to be exact.
The “yield pigs” got to enjoy a 269% return in the S&P and a not too shabby 840+% run in the Nasdaq before they were led to the “slaughterhouse”.
Not to pick on Klarman — despite his error in 92’ he’s managed to do just fine (massive understatement) — but he fell victim to a common misunderstanding of how to assess valuations and future returns from a macro perspective.
At this point you may be thinking to yourself, “Jesus, Alex… just how full of yourself are you to think that you can teach Seth Klarman something about valuation?”
Yeah, yeah. I get it. That’s a more than reasonable response and I wouldn’t blame you if you’re somewhat skeptical of my sanity (you’re hardly alone). But just hear me out. Keep an open mind and come to your own conclusions.
What I’m going to show you is that valuations matter a lot but not in the way that most people use them. To do this, we’ll discuss the following theory that’s central to how we at Macro Ops determine macro valuations:
- Relativity Theory: Valuations can’t be looked at in a vacuum but only relative to other asset classes
Afterwards, we’ll look at where relative valuations are today and how we want to be positioned going forward.
Back in 1992…
Let’s start at the beginning and go back in time to 1992 when Seth Klarman warned readers about the impending “stock market disaster”.
It was a contentious presidential election year between the incumbent George H.W. Bush and his opponent Bill Clinton.
The US military had ended the Gulf war a year earlier and the economy had just come out of a mild recession in the middle of 91’.
US GDP growth was hovering around 4%. Inflation was at just over 3% and the 10-year was yielding a whopping 7.25%. (Can you imagine getting over 7% on a government bond? Must have been nice.)
If one were to open the NYT they would see articles such as:
- MARKET WATCH; A Clinton Win: Good for Stocks, Bad for Bonds?
- Next It May Be Economy Up, Stocks Down
- Stocks Surge, And Wall Street Is Surprised
Newspapers were filled with concerns over stock market valuations, debt levels, a coming boost in fiscal stimulus driving up inflation, and political risks from a new presidential administration. Just a lot of dour pessimistic views on the economy in general — sounds somewhat familiar, huh?
The S&P had a PE ratio of 25.93 (today it’s at 25.56) and a cyclically-adjusted price-earnings (CAPE) ratio of 19 (today it’s 28).
Valuations were high (average historical PE is 15 and CAPE is 16), debt levels were high, we’d just come out of a war, and like today there were a lot of things to be worried about.
Under these circumstances it was very reasonable to be if not bearish, then at least pragmatic about future stock market returns.
Seth Klarman probably sounded pretty smart and responsible admonishing those yield chasing pigs who were destined to pay for their investing gluttony.
And yet… 92’ happened to mark the very beginning of the longest economic expansion and greatest equity bull market in US history — one that would last for 3,452 days…
The S&P’s CAPE went from 19 to a high of 44 and its price-to-earnings climbed from 25 to the nosebleed levels of 34 (and those pale in comparison to the multiples on the Nasdaq which were at 175).
So why did this happen?
How were extremely talented value investors like Klarman and Buffet left sidelined and befuddled by market valuations that seemed to go from stupid to “you gotta be kidding me” levels?
The most common explanation comes from nobel laureate economist Robert Shiller — the market entered a period of “irrational exuberance”. Basically… we all lost our marbles and entered a collective hysteria culminating in a massive stock buying orgy.
Okay, that’s kinda like what ole’ Keynes said about how the market can stay irrational longer than the investor can stay solvent.
Now it’s true our animal spirits may certainly
The post Why Equities Are NOT Overvalued: The Relative Risk-Premium Spread appeared first on ValueWalk.
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