1994

Read “Risk in Today’s Markets” by Howard Marks. It reads like it could have been published this week, but it was published on February 7, 1994. The market took a hit a few weeks later (prompting Marks to publish”Risk in Today’s Markets: Revisited“) and it was generally mixed for most of 1994. But who remembers 1994? It certainly doesn’t evoke the images of overpriced markets and subsequent busts that we associate with ‘2007‘ or ‘1999‘.

Part of the reason is the end of 1994 was the beginning of the 5-year long bull market that led to the 1999 tech bubble, with PEs expanding for around 15-20x (well within historical norms) to more than 30x (a level never before seen). Stock market valuation multiples expanded at a rate of over 10% per year for the subsequent 5 years–earnings and the macro-economy can do whatever they want and you will still be in the black with that kind of tail wind.

Does having 5 years of incredible, irrational multiple expansion justify paying elevated prices today? Seems like a classic case of ‘greater fool’ theory, or what little kids call a game of hot potato. It seems easy to answer ‘No’, but that begs the questions of what is one to do at a time like 1994. There are great benefits to staying invested over the long term; continuing to own stakes in good businesses will generate a return, even if it is a moderate one, while holding cash will not. Staying out of the market between 1994 and the bottom of the tech bubble (i.e. “waiting for valuations to come back to a reasonable level”) would have been a big mistake. If you bought a broad index in 1994 and sold it at the worst possible time at the bottom of the market in mid-2002, you would have made an 89% return. It would have been a wild rollercoaster ride, but that is actually a pretty decent return! Sustained periods of both overvaluation and earnings growth like the 1990s really accentuate this issue.

Another easy answer is to say we should only invest in undervalued assets, even if the broad market is overvalued. There is certainly some truth to that, but as it turns out, that is easier said than done. It is especially hard, given that a generally overvalued market has a tendency to push up all prices in unison and reduce the dispersion of valuations. See chart below:

 

Multiple Dispersion (Source: Business Insider)
Multiple Dispersion (Source: Business Insider)

While the tech bubble was an exception (high overall market value was mainly driven by astronomical valuations in the tech sector), generally elevated pricing environments tend to exhibit lower dispersion in valuations. This is certainly the case today, with valuation dispersion at their lowest point in over 20 years. A difficult task becomes harder.

So what is a prudent investor to do in a time like this? I try to maintain some discipline with the following goals in mind:

  • Buy securities that are fairly priced: You may not find absolute bargains out there, but if you buy the securities of companies with a solid business at a price where you feel comfortable you can earn a decent return over a long horizon,  then you protect yourself on the downside.
  • Stay invested: I struggle with this, but a little struggle can be a healthy thing. If you can avoid taking excessive risks, then making sure you earn some return on your capital will pay off in the long term. As Albert Einstein said “Compound interest is the eighth wonder of the world”.
  • Know where you stand: Just because we can’t predict where the market will go next, doesn’t mean we should pretend like all times are the same. There are times to be cautious and there are times to be courageous–It is usually best to do the opposite of what everyone else is doing (yet another difficult task!).

Let me book-end this post with one more Howard Marks memo, as he has some great comments on the very last point I made:You can’t predict, you can prepare, published on November, 2001.

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Everything Boom

Reading this article the other day got me thinking: Welcome to the Everything Boom, or Maybe the Everything Bubble

What to do in an overall low return environment? We can just go to cash and earn basically zero returns. Buying short duration treasuries will get you to the same place. 10 yr. yields at 2.6%, near its lowest ever–so you can get some ‘safe’ yield of 2.6% but not without bearing big interest rate/duration risk as the central banks tighten and raise rates. It is worth noting that you could have said the same thing 10 years ago: in 2004 with 10 year yields at 4%–lowest since the 60s–rates have nowhere to go but up right? they have been in steady decline since. Who is to say that we can’t get another 10 years of currency debasement and nominal 10-yr rates dropping to 1.5%? where does that leave real rates? Either way, the last 10 years were a good time for fixed income.
Equities are about as expensive as they were in 2007, and we can’t even argue about ‘normalized profits’ with profit margins higher than ever. The Price/Sales multiple of the S&P 500 stands at 1.77x–at the peak of the market in 2007 it was 1.52x. You have to go back to the crazy days of the tech bubble in 1999/2000 to see levels like we see today.
Real Estate is also expensive and getting bid up based on cheap financing. Furthermore, Real Estate is not an asset class that has delivered long term return, with the exception of the latest bubble. It is a good inflation hedge, and ‘buying low’ following crises has been a good strategy, but hard to argue you would be doing that now. Commercial real estate is arguably ‘cheap’ today, but you have to wonder if the structural demand for retail (especially low-middle end retail, like malls) is ever going to come back given how much shopping is done at home/online. Blame the weather all you want, but last Christmas season may have well-marked a turning point. Teenagers don’t hang out in malls any more (See: all teenage specialty retailers which are really struggling: Abercrombie (ANF), American Apparel (APP), Aeropostale (AEO), etc.). High end / ‘experience’ retail may be here to stay, but I think that kind of ‘fifth ave.’ retail is not cheap (not really sure if there is a good vehicle to invest in that specifically).
I am sitting here with 30% of my assets in cash and maybe that is the right thing to do. I have 37% of my assets in passive index funds (pretty much the S&P 500), and I guess I have to be OK with the possibility of losing 50% of this value over a year (As happened in 2008). The remaining 32% is in actively managed , which could lose significant value as well. In the long term it should beat just holding cash and we will never do well timing the markets.
Howard Marks said it best: “You can’t predict. You can prepare” or more specifically: “We may never know where we’re going, or when the tide will turn, but we had better have a good idea where we are.” So here I am trying to think of what is a sensible investment opportunity in this market, besides just buying defensive stocks (I am loaded up in consumer goods and dividend payers and also a little too much technology but mostly old names that look more like services/consumer companies like Xerox, IBM and–dare I say–Apple).