Relative vs. Absolute Value
As I watch valuations on stocks soar higher and higher into the stratosphere, I keep asking "where is the value?" The problem for most is confusing "relative" value vs. absolute value. Stocks may be "cheap vs. bonds" but what does that matter if bonds are ridiculously overpriced?
Fair Value Has Three Digits
John Hussman has an interesting post this week entitled Fair Value on the S&P 500 Has Three Digits. The last time I quoted Hussman, a manager for a prominent investment firm emailed something on the lines of "Mish, please do yourself a favor and stop referring to Hussman". Actually, that was likely good advice. The problem I have with the advice is simple: I happen to agree with Hussman.
Right, wrong, or in between, I say what I believe. I do not say things I disagree with to get blog traffic up, investments up, or page hits up. I say what I believe, and I suspect it has cost me traffic. I upset Republicans and Democrats, equity bulls and bears, and US treasury bulls and bears.
Life would be so much simpler for me if I was obnoxiously one sided, if I never offended anyone ever, or if I purposely offended everyone all the time. There's value in being universally despised, value in being hated by half the people all the time, or in never saying anything to offend anyone (being universally liked). Traffic-wise, those three models make perfect sense. It's a tough business to annoy half the people half the time, when the half constantly switches.
Nonetheless, here we go again.
Value Investing: Is it Possible? What Does it Mean?
Take a look at this excerpt from Hussman:
Last week, the Nasdaq Composite finally clawed its way to breakeven, 15 years after its spectacular bubble peak in 2000. It’s a testament to the overvaluation of technology stocks in 2000 that it has required the third equity bubble in 15 years to reclaim that 2000 high, at least briefly.
Where is “fair value” today? We have to be careful here because the concept of “fair” depends on your assumptions about what a reasonable investment return should be. If I show you a security that’s expected to pay out $100 ten years from today, and I tell you that the current price is $82, you can quickly calculate that the expected return on that security is 2% annually – and you don’t need to know anything about interest rates to do that arithmetic. Interest rates come in after you do that arithmetic. Interest rates then matter only because they give you something to compare with that 2%. Now, if you decide that a 2% annual return over the coming decade is just fine with you, in view of competing alternatives, then it’s fine to call that security “fairly valued.” But even if you decide that the security is fairly valued, you should still expect a 2% annual return over the coming decade. If you viewed a 10-year return of 8% as reasonable, you’d peg “fair value” at $46.32.
On the basis of valuation measures best correlated with actual subsequent market returns, we can say with a strong degree of confidence that the S&P 500 would presently have to drop to the 940 level in order for investors to expect a historically normal 10-year total return of 10% annually. That 940 figure for the S&P 500 would not represent some extreme, catastrophic outcome. It’s not a level that would even represent undervaluation from a historical perspective. It’s the level that we would associate with average, historically run-of-the-mill long-term equity returns. As we observed at the 2000 peak, “if you understand values and market history, you know we’re not joking.”
Last month, Stan Druckenmiller recounted his own experience with capitulation and performance chasing when he was the lead portfolio manager for George Soros and the Quantum Fund:
“I’ll never forget it. January of 2000 I go into Soros’ office and I say I’m selling all the tech stocks, selling everything. This is crazy... Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day, and I’m out. It’s driving me nuts. I mean, their little account is like up 50% on the year. I think Quantum was up seven. It’s just sitting there.
“So like around March I could feel it coming. I just – I had to play. I couldn’t help myself. And three times during the same week I pick up a – don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You ask me what I learned. I didn’t learn anything. I already knew I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”
These are Not Predictions
Please note that 940 is not a prediction by Hussman or by me. It is a value judgment. The S&P "fair value" number would be higher at an eight percent discount and even higher at a six percent discount. And regardless of the discount rate, stocks can overshoot or undershoot. Stocks can also go sideways for 8 to 10 years doing much of nothing. Japan is proof enough. Please don't tell me "It cannot happen here". It can.
Pension plans would be destroyed if stocks go nowhere for eight years. Moreover, I suspect the Fed would be relatively pleased at such a benign outcome (assuming that was the only adverse outcome).
Where is the Value?
Value is always in the eyes of the beholder. People saw value in dotcom companies in 2000, in housing in 2006, in gold in 1980, in Japan in 1990.
Today people see value in negative yield government bonds, in junk bonds that pay interest in debt, and in equities that have a smoothed valuation as high or higher than 1929, 2000, and 2007.
Maybe I am Crazy...
I see value in gold and gold miners, in yen-hedged Japanese equities, and in Russian equities at a PE of 6 (see Readers ask "How Does One Invest in Russia?") But hey, maybe I am crazy. Maybe we see government bonds trading at -5.0% yield and smoothed PEs at 35, topping valuations of 2000 and 1929. Things are nearly always cheap "relative" to something else. There's a chance the "something else" of the future refers to peak valuations, not now, but rather in 2016.
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