I’ve written a lot about how the market is really expensive, no matter which way you slice it.
Meanwhile, we are facing a grim economic reality in which 6 million people are losing their jobs every week and cash flows are evaporating for American companies. Some estimate that unemployment will hit 20% (Great Depression levels) and GDP will take a massive hit, making the Great Recession look like a footnote.
Call me crazy, but I think valuations should be a lot lower in this environment.
My theory about market valuations is simple: the higher they are, the harder they fall.
Valuations don’t matter until we have a recession. When expensive markets run into a recession, they get annihilated. Because we can go for a decade without a recession, that’s a lot of time for valuations to run up to unsustainable levels. It’s also plenty of time for investors to get complacent and think valuations don’t matter. That was the prevailing attitude at the end of the ’90s and it has been the attitude recently.
The history of markets shows that markets move with earnings and cash flows over the long run and then exhibit speculative extremes in the multiples that investors are willing to pay for those earnings and cash flows.
Markets tend to extrapolate the present and assume current conditions will last forever and then get surprised when the environment shifts.
My goal (in my active account, anyway) is to take advantage of these sentiment shifts for individual stocks and the broader market. I want to buy from Mr. Market when he is depressed and sell to him when he is euphoric.
With market cap/GDP presently at 131%, macro valuations suggest that the market will deliver a negative return over the next decade. History suggests this negative return doesn’t happen in a straight line and that there will be a big bull market and a face-ripping bear somewhere in there. I think that the face-ripping bear is happening right now and we’re in the middle of it.
Right now, the markets are rallying because investors are realizing that the Fed won’t allow the system to collapse (I agree with this). They also think that the Fed they can engineer a quick and rapid recovery and pepper over rich valuations (I don’t agree agree with this).
Everyone seems to be getting very bulled up and cocky.
I think they are making a mistake.
It’s also possible that I’m making a mistake, so I decided to take a look at some additional data to figure out if that’s the case.
Value Investing Vs. The Market
Value purists would say that I shouldn’t pay attention to all of this nonsense.
They would argue that I’m not investing in the market. I’m investing in individual businesses. I’m not investing in the stock market, I’m investing in individual value stocks.
Unfortunately, it is impossible to assemble a group of 20-30 stocks that are not correlated with the market. Whether I like it or not, my stock portfolio is correlated with the market. The market matters.
To get around this and be less correlated with the market, I could concentrate in 5-8 of my “best ideas.”
I think this is a path that can cause permanent impairments of capital. A blow up in one or two positions can endanger the entire portfolio.
I’m also skeptical that I really have any “best ideas.” The best ideas of the best investors in history often blow up.
This is why diversification is the path I’ve chosen and I think 20-30 stocks is the best way to prevent portfolio blow ups while still offering the opportunity for outperformance.
The disadvantage of diversification is that I am more correlated with the market’s returns.
The Value of Value
With all of that said, I am worried that my focus on the valuation of the overall market is blinding me to the bargains within the deep value universe.
For this reason, I decided to take a look at the absolute valuation of the cheapo segment of the market. To do this, I used Ken French’s free data available on his website.
I restricted the data to the post-1990 universe. I’m considering the post-1990 period to be the modern era in which valuation multiples have been elevated.
I’m not expecting to be able to buy stocks at 1980 single digit CAPE valuations, for instance.
Let’s start by looking at cash flow/price.
At the end of 2019, the value segment of the market was close to its mean.
Not particularly exciting.
VBR (the Vanguard small value ETF) is down about 30% year to date, so I’d estimate that this is probably close to 20% now from 15% at year end 2019. That’s really encouraging, as it implies that the value segment of the market is close to its 2009 and early 2000’s levels. Those high levels will probably set the stage for tremendous performance in the upcoming years.
Interestingly, value was very expensive for most of the 2010’s. I think this is the key factor in value’s under-performance in the last decade. Value was expensive versus its long-run mean.
Meanwhile, in compounder-bro-land, the market is more expensive than it was during the internet bubble. No surprise there.
Something interesting to note: this glamorous segment of the market was cheap in 2010 and the early 1990’s, likely setting up the excellent performance for glamour in the 1990’s and the 2010’s.
Book to Market
In most environments, last year’s cash flows are a good proxy for what’s happening next year.
In Quantitative Value, Wes Grey and Toby Carlisle found that trailing-twelve-month earnings work better than normalizing them. It’s a very surprising result, but it suggests that last year’s earnings tend to be a good proxy for next year’s.
Of course, we are not in a normal environment. Many businesses are seizing up and revenues are collapsing with economic lockdowns in place. This makes this current environment unlike any recession we have experienced since World War II.
For this reason, I think book value is useful in this kind of environment. When earnings disappear, different metrics of value are useful even though earnings-based metrics work better in the backtests.
From this perspective, the value segment of the market was very cheap relative to its mean in the early 1990’s, the early 2000’s, and 2009. This makes sense, as those periods coincided with tremendous performance for value.
Like cash flow to price, this was also expensive through most of the 2010’s, explaining value’s woes during the last decade.
By this metric, at the end of 2019, value stocks were expensive.
With VBR down 30%, I estimate this is probably up to 190%. That is pretty good. It’s not as cheap as it was in 2009 or the early 2000’s, but it’s getting there.
Meanwhile, in compounder-bro-land, the market was more expensive at the end of 2019 than it was during the internet bubble.
Interestingly, it’s also evident that this segment of the market was cheap at the dawn of the 2010’s. This likely drove the tremendous performance of this segment of the market for the last decade.
Considering that QQQ is flat year to date, this segment of the market likely still beyond internet bubble extremes.
Good luck, compounder bros. I think you’re going to need it.
Looking at this data, it suggests to me that I might be too cautious right now.
While the broader market is overvalued, the value segment of the market is approaching levels of cheapness last experienced in 2009.
On the other hand, this can get a lot cheaper, especially if the broader market tanks. This is particularly true considering that cash flows are about to disappear for a lot of businesses.
I could be allowing my emotions to blind me, which is a classic behavioral investing mistake. I am concerned about losing my job, for instance. I have a sizable emergency fund, but the idea of losing my job still worries me and can be clouding my thinking.
Earlier this year, I was contemplating selling my house and moving in search of another opportunity.
Now, I worry if I will be able to sell my house at a decent value. What job opportunities will even exist with the economy in lockdown?
Emotional stress might be interfering with my ability to see things clearly.
When I launched my blog, my hope was that I could build a portfolio of net-net’s when the next bear market arrived. During the boom, I’d stick to low price-to-earnings stocks and then shift my focus to net-net’s and negative enterprise value stocks.
There were net-net’s two weeks ago, but many of those bargains have since disappeared.
Is it possible that the opportunity to buy net-net’s emerged and disappeared in two weeks?
My gut tells me this is not the case and I will have an opportunity to purchase a portfolio of 20-30 high quality net-net’s and negative enterprise value stocks, but this French data makes me second guess that.
During this meltdown, I’ve been tempted to simply throw everything into my asset allocation which is down only 7.9% year to date. This allocation doesn’t try to predict the future and has caused me no stress.
If this market truly has passed me by and I’m wrong about everything, then I need to do some serious soul searching and re-evaluate my approach.
For now, I’m not ready to give up on my active account just yet. I do think there will be an opportunity to buy net-net’s and negative enterprise value stocks at some point during this bear market.
If not, I may need to simply pursue my asset allocation strategy and stop trying to pick stocks and predict the future.
It could also make more sense to focus more on arenas of the market where I can have more of an advantage, such as dark stocks and international net-net’s.
With that said, I don’t think I’m wrong, even though I’m open to that possibility.
I think it’s a bit of a fantasy to think we’ll have a 1987-style decline and 1988-style bounceback. After all, during 1987 and 1988, it was a time in which the economy was booming and we didn’t have a recession. Mr. Market was just being crazy. We faced a similar outcome at the end of 2018 and throughout 2019, another period in which we didn’t have a recession. Mr. Market was just being crazy.
This does not strike me as a comparable situation.
We’ll have to see, I guess.
This is a hard game, indeed.
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