The S&P 500 (SPY, Financial) delivered a more than 30% total return so far this year. With only one trading day left, stock investors will harvest one heck of a bull market for 2019. Anyone could have easily turned each dollar into a dollar and 30 cents within the past year simply by buying shares in all the largest 500 U.S. companies, without knowing anything about finance, accounting, business or management.
However, when looking at the market in terms of the long run, we see 2019 as the most painful year in more than a decade. The primary reason is simple – hefty valuation has gotten heftier.
Take a look at the Warren Buffett (Trades, Portfolio) Index, which hit an all-time high for the past 50 years and surpassed the previous high set up during the Internet Bubble (see below). An over 150% level implies significant overvaluation and high possibility of a scant equity return moving forward.
Some investors may want to bring up the concept of international diversification here, but when looking around the globe, we observe similarly pricy (if not pricier) markets in other major developed economies. The only silver lining (with the Indicator below 90%) is in Germany (see below). Otherwise, it appears that investors seeking value have nowhere to go after 2019.
Now some other investors may point out that higher quality deserves a higher price and that American businesses have probably never been more robust. We would certainly agree with the former point. At Urbem, we focus a lot more on business fundamentals than on valuation, firmly believing in “buying wonderful businesses at fair prices” instead of “fair businesses at wonderful prices.” However, at the same time, we are not quite sure about any material improvement in business quality. The average corporate margin fell back to the 2016/2017 level this year, as displayed below. Investors are paying more significant premiums on quality these days compared with any year since the end of the Financial Crisis.
What adds to the worry here is that not only are investors paying “unfair” prices here, American businesses are doing the same using shareholders' money. Throughout the year, U.S. companies have spent a record-setting amount of cash to repurchase their own stocks at a hefty valuation, resulting in possible value destruction for long-term owners. Additionally, the trend in buying back shares expensively implied that corporate managers are having difficulty finding attractive reinvestment opportunities elsewhere (both internally and externally) due to a low rate of return or increasing macro-economic risks.
In the meantime, corporate insiders have steadily switched from net buying to net selling since the market downturn last year, echoing a lack of confidence regarding future returns.
Lastly, we also notice that the investor margin debt stayed near the record-high level (see below), indicating crowded speculations that have driven up the stock price, and hence, a vulnerable bull market.
At Urbem, we feel blessed to have accumulated shares over time in a few genuinely great businesses around the world at prices that we believe are attractive. It should be acknowledged that no one can predict market movement, but we believe that patience is particularly crucial at a time like this.
As 2019 comes to a close and the longest bull market in history continues, we would like to wish everyone a happy new year as well as a rewarding 2020!
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We do not own any security mentioned in the article.
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