As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favour of value. Still, in the long run, it is a weighing machine.”
For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.
At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.
Consider their outline of the “science” of prediction:
- People predict by making up stories
- People actually predict very little, but stories ‘explain’ everything
- People live under uncertainty whether they like it or not
- People believe that they can tell the future if they work at it hard enough
- People will accept any explanation as long as it appears to fit the facts
- The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
- People often work hard to obtain information that they already have, and avoid new knowledge
- People mistake the delay of consequences with the absence of consequences.
This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.
- Man is a deterministic being thrown into a probabilistic universe
- In this match-up, surprises are (or should be) expected
- Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?
A Self-Perpetuating Do-Loop
What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.
Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.
The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.
What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.
Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.
Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.
As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the
ETFs to which you are being compared.
This Time is Different?
Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.
One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.
Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!
As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).
Plus Ça Change, Plus C’est La Même Chose?:
What Now for the Market?
Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.
In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.
We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!
Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.
Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.
The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.
It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.
For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.