A quick search on Bing News for “market overvalued” will show a few dozen articles on the first two to three pages (all written in the past two weeks or so) that agree with that conclusion; the consensus has shifted, and the majority now seems to agree that the market is fully valued or overvalued.The interesting thing to watch is how people react to that conclusion.
Let’s start with the viewpoint of the value investor (or how it is so often painted). Value investors are generally focused on one thing: bottoms-up stock selection. A fairly or overvalued stock market isn’t an issue except to the extent that it diminishes the stream of potential investments. Naturally, that’s a likely outcome of a rising market – especially among the large cap, blue chip stocks that are the primary focus of sizable market participants.
Value investors, if true to their craft, only have one choice when they can’t find anything worth buying: wait for better days. Wally Weitz of the $1.1 billion Weitz Value Fund is a great example of such an investor - in a recent Bloomberg Businessweek article, Mr. Weitz noted that a full 29% of his funds’ assets are currently allocated to cash and Treasury bills:
“It’s more fun to be finding great new ideas - but we take what the market gives us, and right now it is not giving us anything.”
Of course, this brings up the average market participants greatest fear: what happens if the markets keep moving higher? This question alone is what separates the value investors from the herd. As Mr. Weitz noted, there isn’t much to be done if the market isn’t giving you any opportunities; if it continues to move against you – and those opportunities become even more scarce – there’s now even less reason to act.
The individual investor simply cannot accept that line of logic; they don’t view equity price movements as a continuing process, one that swings from depression to euphoria and back again, all without signaling when the next change will occur. They see higher stock prices as one thing, and one thing only – missed opportunity; with the benefit of hindsight, they judge their prior action (or lack of one in the case of buying) in the context of a single week or day’s price change – as if they could’ve (or have reason to believe they should’ve) known what would happen before hand. In many cases, they convince themselves that they DID know – and should have trusted their instincts.
This perverse reasoning disregards the fact that stock prices represent partial ownership in a business, with that value dependent upon the future cash that business will bring to its owners. They have no chance of being around a year from now, and don’t care about what the business will earn over the coming decade – they’re more focused on the stock’s trading pattern over the previous 50 days. It’s hard to overstate how much this change in perspective will affect the way you look at stock price movements.
This individual cannot take a 5% price movement higher or lower in stride; the most recent change in equity prices is telling them something important, and will guide their future actions. Let’s return back to our value investor: imagine you’ve found a security where you believe the current valuation implies a forward rate of return of 15% per annum.
Our hypothetical stock is trading at $100 per share – meaning you expect it to reach more than $400 per share ten years down the road ($404.56 to be exact). Now, what happens if the price suddenly jumps 5%, as outlined above? Well, from a starting point of $105 per share, a move to $404.56 in ten years’ time results in a compounded rate of return of 14.44%. Even a move 20% higher – to a starting price of $120 per share – would result in a CAGR just shy of 13% per annum.
Think about that in the context of this year; to date, the S&P 500 has moved higher by a bit over 20%. A move that many are characterizing as quite sizable would only cause our implied CAGR to fall by about two percentage points per annum; and while that certainly is a meaningful difference (especially over time), the impact of that 20% move isn’t as life-changing as recent market commentary might have you believe.
Of course, this could become a slippery slope – and you must set a level where you’ll stop sliding; if you require an ex-ante return of 15% per annum, then this move has just priced you out of the market. With what we’ve experienced in the past few years (in my personal experience, with names like JNJ, PEP, and others), valuations that were implying solid double digit rates of return now appear closer to high single digits per annum – and while that continues to blow away the expected returns on the long bond, it’s not too enticing on an absolute basis.
All that is a lot of rambling to bring me back to the main point: as a value investor, there’s nothing to do but to buy undervalued securities; when you can’t find undervalued securities, then you have no real option but to suck your thumbs. Other market participants cannot stand to underperform; they don’t view rising equity prices as temporary and expanding excess that will one day revert to reality – they see it as missed opportunity.
They are under the illusion that markets will see what they see, and react as such now; reality is much different. Many calling for fully or overvalued markets seem to believe the slowdown or reversal must happen quickly (this can’t go on); while I’d love to see that happen, I understand that the market doesn’t care what I think (you don’t have to look further than the late 1990’s to see that markets can get far more optimistic for a long, long time). The near future is unknown – trying to guess which is more likely (continued gains, a sideways market, or maybe a present day “Black Monday”) and when it will happen is a fool’s errand; accepting the movements and acting when they give you a chance to intelligently do so is a much more promising route.
So, on sitting on the sidelines, I've never been satisfied with my approach. I choose cash (or sometimes bonds), always have, and have sat for years with uncomfortable levels of cash if not raising cash levels (eg. 2004-2008). A year ago I started moving to cash and by May I'd gone substantially to cash. Lately I've bought a couple positions but still sit mostly in cash and short term fixed income instruments. If instead of cash I'd bought a market equity index I'd be substantially ahead. For decades I've wondered whether my shifts to cash were a sensible strategy. In fact years ago I asked on this board why Buffett would go to cash and not a market index, but didn't get much in the way of considered opinions.
So, correct me where I'm wrong.
The future is uncertain so all attempts at valuation are almost certainly flawed. (Hence one of the reasons behind the need for a margin of safety.)
All value investors have, or like to think they have, a circle of competency. Many investors regularly stray from any circle of competency (leakage) as they try to expand that circle.
Correctly judging whether a stock or sector is over or under valued requires competence in valuing that company or sector (or cross-sector aspect of business).
Value investors that can't find undervalued stocks are necessarily looking only at stocks within their circle of competence. Thus individual investors can't say with much certainty whether the market itself is under, over or fairly valued only that they can't find value in their circle. The fact that they also stray means that even composite measures of value investor positions can't truly determine whether such value investors in aggregate see the market itself as under, over or fairly valued.
When value investors can't find value they often sit in cash so they gain optionality, etc. but they are quite likely to incur the opportunity cost mentioned above.
As a result of choosing cash over market indexes, value investors are essentially (overtly or covertly) market timing as well as making a forecast that companies within their circle of competence will within a reasonable time return to value.
That said, I look to other sources and metrics to assess the condition of the overall equity market(s) Plus as those metrics align, I look for companies that will behave opportunistically in a declining market. (This hasn't worked out well, as they freeze up too.)
Now as a long term investor wouldn't it make more sense to me to move between individual 'value investments' and market indexes - rather than cash?
:-)