Macro is probably a waste of time, but I can’t help myself
Everywhere I turn in discussions of the stock market, everyone seems to have made a similar conclusion: (1) The stock market is in a bubble, (2) the Federal Reserve created the bubble, (3) When the bubble bursts, we will be faced with financial Armageddon.
The mood among value investors looking at a historically high CAPE ratio is something like this:
I love talking and thinking about Macro, but I suspect it is mostly a fun waste of time and not entirely useful. Peter Lynch offered the following advice about these matters:
Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.
Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.
I think living through 2008 might have polluted everyone’s minds, the same way 1929 poisoned the minds of a generation of investors and made them stay out of the market for life to their own detriment.
Unlike the 2000-02 meltdown, in 2008 there was nowhere to hide. This is because the 2000 collapse was driven by an overvalued stock market falling apart. 2008 was different because it was an economy-wide credit contraction that caused everything to decline.
This left investors with a kind of financial PTSD. As for myself, I had hardly any money at the time, so I wasn’t concerned about my financial assets going down, but I was still consumed by fear.
By day I am an operations nerd for a bank, so I was acutely aware of what was going on. I had very little savings (I was in my mid-20’s and had just started making decent money), a pile of debt and I was mostly worried about basic survival if I lost my job and faced a Depression job market. My main personal lesson from the crisis was about the dangers of being in too much debt and not having sufficient savings. Today I have zero debt and an emergency fund if I lose my job. I sleep better at night.
If anything, this is why the simple low-PE low-debt Graham strategy intuitively appeals to me. Financial problems facing a company or a person are always manageable . . . Unless you’re in heavy debt.
Post-crisis, everyone is consumed with trying to predict the next meltdown after getting burned so badly.
We look at investors who made the right call — people like John Paulson — and are in awe that they made the right call. They knew what was going to happen. We want to be able to predict what is going to happen. We become obsessed with finding tools that will help us prevent losing money.
Post-crisis hindsight also puts the permanent bears in a positive light. They are lauded for getting it right in 2008, but how much money has been lost listening to them since then?
Prediction is Hard
As small investors, I think we may have to just accept the fact that if we want equity-sized returns, we need to take equity-sized risks. A 25% drawdown a couple times a decade is pretty standard. A 50%+ drawdown 3 or 4 times a century is also typical. The average person lives about 80 years, so when they see these events happen a couple of times it looks extraordinary in the context of our lives and permanently affects our thinking. In the grand scheme of things, these events are not uncommon and we should expect them.
Charlie Munger gave this great advice about the subject:
This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long-term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.
We can’t invest like 1929 or 2008 are going to occur tomorrow. It’s not a useful long-term strategy for building wealth. We need to accept the fact that we will face those kinds of drawdowns and face the fact that there will be more minor drawdowns frequently (or the 20-25% variety) and don’t give into our emotional need to panic. If we constantly live in fear that a big drawdown is imminent, then we should stay out of the market and won’t earn equity sized returns.
Using valuation tools to time to the market
There are tools to predict future market returns (like the CAPE ratio, the average equity allocation, market-cap-to-GDP, etc.) that give us clues as to where we stand in the cycle, but timing the market using those tools isn’t particularly effective either. I’ve talked about them on this blog.
You can use these tools to predict market returns 10 years out, but it doesn’t tell you if a correction is going to happen tomorrow and they are not particularly useful for timing the market.
The 10-year S&P returns predicted by valuation tools don’t happen in a straight line. My favorite indicator (the average equity allocation), suggests a 10-year rate of return for the S&P 500 of 3.34%. With the 10-year treasury yielding only 2.361%, that actually makes sense. We are likely in store for a decade of low returns across all asset classes. “Low returns over 10 years” does not mean “We are facing Old Testament biblical meltdown.”
(Hell, if we were facing an Old Testament Mad Max kind of situation, what good is your 401(k) going to do you anyway?)
You can use market valuation tools to get a fair understanding of what returns will look like, but it is not a crystal ball. It doesn’t predict if a crash will happen tomorrow or what the road to those returns will look like.
Current valuations are basically where we were around 1973 and 1998. The 10 years after ’73 and ’98 were not particularly good for the indexes . . . but they were great for value investors, the indexes still delivered a small return, and the world didn’t end. Value stocks had an excellent bull market from 2000-2003 and 1975-1978.
The difference between the two eras is that in 1973-74, value stocks went down with everything else before their bull market in 1975 and in 2000-03 value experienced a bull market during the decline of everything else.
This happened because the 1973-74 event was caused by a real economic shock, while the 2000-03 meltdown was the stock market coming back down from crazy valuations. The 2000-03 collapse was unique in that the market caused the economy to contract, while most meltdowns (like ’73-’74 and ’07-’09) are the economy causing the market to contract. The stock market wasn’t overvalued in 2008, the real estate market was. The decline in real estate caused the economic contraction, which ultimately impacted stocks.
Whether the current situation is like the ’70s or the early 2000s is tough to predict. I suspect that it will be more like the ’70s (value will go down in the bear market with everything else, but then perform nicely). Hopefully I’m wrong and it pans out more like the 2000-03 event. This is discussed in depth in this blog post.
It’s also tempting to short stocks in this environment, but that’s not something I do. You shouldn’t do it, either (unless your name is David Einhorn). Shorting is a dangerous game. For instance, tech shorts in 1999 were correct in their analysis. Even though they were right, most were completely wiped out when tech stocks doubled in 1999. They were ultimately vindicated but, as Keynes warned us, markets can stay irrational longer than you can remain solvent.
It’s tempting to try to time the market with macro valuation tools. I found a great post at Tobias Carlisle’s blog exploring this issue of timing the market using CAPE ratios. You can read the post here and here. The conclusion is simple: timing the market using valuation tools is a waste of time. He makes the following point:
The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns.
Japan in the 1980s is the common comparison among bears to today’s market. There was a similar sentiment among bears in the late ’90s.
In the 1980s, the success of Japanese firms combined with an easy monetary policy caused a massive asset bubble. There was a widespread perception that Japan was going to take over the world.
Easy monetary policy and rising asset prices are where the comparison ends, however. Valuations in late 1980s Japan were genuinely insane. In 1989, the real estate around Japan’s imperial palace was worth more than all the real estate in the entire state of California.
During the 1980s, the Nikkei rose from around 6,600 in 1980 to 38,000 by 1989. Everyone thought that Japan had figured it out: their management was superior, their workers were better, their processes were more efficient. The zeitgeist was captured in the Ron Howard movie “Gung Ho.”
Like all bubbles, the Japanese bubble collapsed. The Nikkei fell from its high of 38,000 in 1989 to 9,000 in 2003. This is the nightmare scenario that the bears fear will happen to the United States stock market.
Valuation puts this in context. Today’s investors fret of a Shiller PE around 30. In Japan circa 1989, the Shiller PE was three times that at 90. Indeed, there is no comparison between US stocks today and Japanese stocks in the 1980s. Valuations today suggest bad returns in the future for US stocks. Valuations in Japan indicated that a complete collapse was inevitable.
Lost from the typical talk of Japan’s lost decade is a discussion of its actual economy. The focus is solely on the markets. Japan’s economy continued to chug along despite the complete meltdown in markets. Its central bank scrambled to contain the collapse, but likely merely prolonged the pain as the market was destined to return to a normal CAPE. Their unemployment rate has never even gone above 6% during the meltdown!
It took nearly 20 years for Japan to go from a Shiller PE of 90 to a more normal Shiller PE of 15. Markets are worth what they’re worth and they will eventually fall to normal levels of valuation. That’s what happened in Japan. Very little changed in their real economy, it just took a long time to work off their crazy 1989 valuations.
Value in Japan
Even if the US is in a Japanese style asset bubble (even though it is nowhere near those levels), I was curious how a value strategy performed in Japan during their asset meltdown if this were the future for the United States.
It’s encouraging that value-oriented strategies actually performed very well during the Japanese market collapse. In James Montier’s epic The Little Note That Beats the Market, he observed that Joel Greenblatt’s magic formula returned 18.1% from 1993 to 2005 in Japan. EBIT/EV alone returned an excellent 14.5%.
This suggests that as long as you stick to a value framework, even in a market that is in long-term decline, a value strategy should hold up over a long stretch of time.
My apologies if this post is a bit of a mess, but it summarizes many of the things that have been on my mind lately. To summarize my conclusions:
- It is probably best for most investors to not obsess over macroeconomics. The smartest people in the world are playing that game . . . and they’re bad at it. We cannot do any better.
- Market valuation tools are useful for predicting returns over the next decade but aren’t particularly helpful in predicting short-term market moves.
- The United States is not in a Fed-induced, Japanese-style asset bubble. Our market is high, but a definite return is still likely over the next 10 years.
- Even if we were in a Japanese style asset bubble (which we’re not), a disciplined value-oriented strategy should still perform very well in the United States.
- 50% drawdowns 3-4 times a century and 25% corrections are standard. They’re the cost of earning equity returns. If equities went up by their historical 8% average every year in a straight line, they would eventually stop delivering those returns. If you can’t handle corrections of that magnitude, you shouldn’t invest in stocks.
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