Safe Ice? – Part III
“I’m completely comfortable when you get to those rare moments. I’m pretty comfortable calling all in, but you have to be in those rare moments. It only happens probably once every dozen years or so. It takes all the patience in the world to wait, wait and wait for the prices to just drop, drop, drop…but you get to a point where it’s virtually impossible to not get more money back than where the market is actually willing to sell you these securities.” – Jeff Gundlach, Real Vision interview October 9, 2020
Jeffrey Gundlach, the CEO and founder of DoubleLine, a $100B+ investment management firm, dubbed the “Bond King” by Barron’s magazine, described the investment world as being comprised of two different environments – alpha and beta markets in a Real Vision interview in late 2020. Financial alpha refers to the returns above expected benchmarks for an asset. An investor or money manager is considered to generate alpha when they select investments that outperform statistically-evaluated performance expectations. This statistically expected return for an asset is considered to be beta.
In Gundlach’s description, a beta environment is one in which asset prices have fallen significantly and the psychology of most market participants is extremely negative. This provides the opportunity to make significant allocations to chosen investments with limited worry about future performance. Hedging and careful risk management strategies can be eliminated, as the opportunity for future performance is so much greater than the risk of loss. It’s the time to “push the pedal to the metal” and allocate funds aggressively, as these opportunities are quite rare and do not last. Aggressiveness is the hallmark of a proper strategy here, rather than caution. Alpha environments, on the other hand, are those in which assets are fairly or excessively priced, volatility is low, and investors are making investment choices as if the current and future prospects are guaranteed. This is a time where the market is very competitive. High return opportunities are, therefore, limited, and generating excess returns requires much more skill. Such periods require exercising strong risk management through hedging, smaller position sizing, or other means. Caution is the wise approach in these circumstances.
I believe that we are currently in an alpha environment, as Gundlach goes on to claim in the same interview. There are several common approaches to determining whether or not a market or environment is worth participating in. These include technical analysis, where chart patterns are used to time entry and exit points; genius-match investing, where a talented investor with public holdings is identified and imitated; trend-following, which involves capturing significant sections of extended market moves(up or down); and buy-and-hold investing, in which shares of a company with expected long-term viability are purchased and held for periods of several years or decades. The approach that is most simple and direct in understanding whether a market is in an alpha or beta environment is looking at valuations vs historical benchmarks. If valuations are at highs or lows seen once in a generation, or even longer, then you can feel fairly confident that you know whether it is time to go all-in or sit on the sidelines.
Technical analysis and trend following approaches have shown that if a market hits a new all-time high, it is likely to continue pushing higher, at least for the short-run. The S&P 500 and Nasdaq 100 both set new all-time highs within the past few days. As those highs have recently been exceeded, then further price rises are quite likely soon.
Given this caveat, what does valuation analysis indicate about the current market environment? I am not aware of any valuation metrics or serious commentaries that indicate U.S. stocks to be cheap at current levels. In fact, many stock index valuation measures indicate that current price levels are near or have exceeded historical price extremes. Seasoned and highly regarded investment managers from Charlie Munger, Jeremy Grantham, and Howard Marks, to newsletter writers such as Stansberry Associates’ Steve Sjuggerud, have all made statements or published remarks presenting evidence that recent price levels are near historical extremes.
For instance, Meb Faber of Cambria Investments, aggregated several charts and articles demonstrating current valuation and investor sentiment data earlier this year. One of the most arresting images was a graph showing U.S. CAPE ratios from 1980 through 2020. The CAPE ratio is a calculation of the price/earnings ratio determined by using average earnings, adjusted for inflation, across a 10-year time period.
At the time of the graph being charted, the level had only been exceeded one other time during the given timeframe- the tech bubble of the late 1990s. This metric currently sits at 38.
One of the easiest to understand measures of relative stock market valuation is the so-called Buffett Indicator, a measure named after Warren Buffett, who referred to this calculation in an interview many years ago. The Buffett indicator is a ratio of total U.S. stock market value to total annual economic production(GDP). In a very rough sense, a reading much over 1 indicates overvaluation and a reading significantly below 1 indicates undervaluation. Many websites track this measure and provide the results for free. One of the best is CurrentMarketValuation.com, from which the following charts were taken. The first shows the Buffett Indicator vs an exponential trendline.
The second contains further analysis through the addition of ±1- and ±2- standard deviation lines to the indicator’s historical trendline.
The second graph is particularly compelling, as it can be clearly seen that the current level exceeds two standard deviations and that this has happened only twice in the past 30 years. The prior instance being the internet stock bubble of the late 1990s.
An argument can be made that these metrics, though eye-opening, are backward looking, and therefore an off-center guide to understanding the current environment, as opposed to what educated estimates of future performance might indicate. John Hussman, creator of and advisor to the Hussman Funds, a collection of value-focused funds with a market cycle risk management strategy, is well-known in financial circles for successfully anticipating the internet bubble of the late 1990s and the Great Recession of 2007-2008 and consistently and frequently releases market commentary that is available to the public. This research typically contains graphs showing valuation estimates that he and his team have found to be best correlated with future expected returns, as well as estimates of those future returns. I’m not quantitatively inclined enough to recreate these calculations and graphs, but I find them to be worth examining. Of these graphs, the depiction of market valuation vs subsequent 12-year returns is striking. Based on current market valuation, next 12-year returns are projected to be negative 6%.
Explanations of and justifications for these metrics are available on the Funds’ website.
I have come across 1 or 2 commentators who claim that valuations are not excessively stretched on a standard-deviation basis vs a selected baseline. I can’t fathom that there are any market followers who make a legitimate case that broad market valuations are currently inexpensive. Now that my take on the current situation is synopsized, I am looking to explore potential options for profiting from a major shift in the market landscape. Future articles will focus on those opportunities.
If ice breaks while you are away from shore, it will be much too late to run to safety.
Disclaimer: I own put options on SOXX, which are expected to go up in value if a market correction occurs, and expect to sell or add to the position at any point in time.