I felt pretty good after writing the post on Absolute Valuations a few days ago. It felt like a nugget of useful insight that had come out of forcing myself to write down my thoughts–exactly why I was hoping would come out of this exercise. It has been on my mind a lot since and while I still believe the idea has value, I am coming to think it may be overly biased by the current state of the market.
I am relatively young, and I did not experience what it was like to invest in the 70s and 80s, when long term rates were 10% or higher. The idea of getting a 10% risk-free return is completely foreign to me. Granted, inflation was a much more significant factor then, but event account for that, real rates were significantly higher than than anything I have seen in my investing career. Here is a helpful chart from a Paul Krugman post:
So when I say to myself that any investment must meet a basic level of absolute return for me to consider it interesting, I am inadvertently comparing it to what might be the “prevailing market rate of return”. The more interesting thing however–and what I think led me to write the original post–is that the prevailing market rate of return is so close to zero today. And zero is a special number because cash earns a return of zero. I may say I am unwilling to make an investment unless I am comfortable I will get a minimum return of 5%–that 5% is my absolute floor. But if I could get 5% risk free by buying government bonds, wouldn’t that be a silly floor to have?
There is merit in having an absolute floor, especially when valuations are high and prospective returns at historical lows. I admit, however, that as overall returns become more attractive, engaging in a more selective comparative process has a lot of merit.