In this past weekend’s missive entitled “Market Hits New Highs, Now What?” I stated that:
“It has been a quite phenomenal year in the markets so advancing 16.5% through the end of last week. At the current run rate the markets will advance 28.5% for the year to finish at 1832. This would put the valuation of the markets, based on current trailing twelve month reported earnings, at 20x earnings. The P/E 10 model of valuations would exceed 25x earnings if current earnings estimates are not lowered further from current levels by the end of the year.
From a price momentum basis we have been, and remain, at extremes normally associated with market peaks rather than beginnings of cyclical bull markets.
With all ‘buy signals’ currently in place the markets could reasonably advance to 1730…based on current price trajectory and momentum.”
It is important to understand the complexity of this statement. In the short term it is likely that market prices could rise further as the Fed continues its injections of liquidity in the financial markets. However, those same actions are leading to a dislocation between prices and underlying fundamentals. This was something that was recently addressed by Martin Feldstein of the National Bureau of Economic Research:
“The danger of mispricing risk is that there is no way out without investors taking losses. And the longer the process continues, the bigger those losses could be. That’s why the Fed should start tapering this summer before financial market distortions become even more damaging.”
Market valuations are historically terrible market timing devices, however, they are very important for long term investors. Valuation has a direct impact on long term returns. The higher the multiple at the time of investment the lower the long term return. This is the basic concept behind Benjamin Graham’s “Margin of Safety” when evaluating investments. Currently, that “margin of safety” has been dramatically reduced as the Fed’s ongoing interventions have inflated valuation levels as prices have soared while earnings growth has slowed.
Just recently John Hussman commented on this specific topic stating that:
“The U.S. equity market is now in the third, mature, late-stage, overvalued, overbought, overbullish, Fed-enabled equity bubble in just over a decade. Like the 2000-2002 plunge of 50%, and the 2007-2009 plunge of 55%, the current episode is likely to end tragically. This expectation is not a statement about whether the market will, or will not, register a marginal new high over the next few weeks or months. It is not predicated on the question of whether, or when, the Fed will, or will not, taper its program of quantitative easing. It is predicated instead on the fact that the deepest market losses in history have always emerged from an identical set of conditions (also evident at the pre-crash peaks of 1929, 1972, and 1987) – namely, an extreme syndrome of overvalued, overbought, over bullish conditions, generally in the context of rising long-term interest rates.
Despite individual features that convinced investors in each instance that ‘this time is different’, the corresponding handful of truly breathtaking market losses in history have a single source: the willingness of investors to forego the need for a risk premium on securities that have always required one over time. Once the risk premium is beaten out of stocks, there is no way out, and nothing that can be done about it. Poor subsequent returns, market losses, and the associated destruction of financial security (at least for the bag-holders) are already baked in the cake. This should have been the lesson gleaned from the period since 2000, but because it remains unlearned, it will also become the lesson of the coming decade.”
“Smart Money” Sells
The commentary by John Hussman is interesting because, while he confirms my issues with rising valuation levels, it appears that the “smart money” is lining up to exit the markets by selling their investments off to unwitting retail investors as a “good deal.”
“In a recent Bloomberg article it appears that Private-equity managers from Fortress Investment Group LLC (FIG) to Blackstone Group LP (BX), which made billions by buying low and selling high, say now is the time to exit investments as stocks rally and interest rates start to rise.”
And to whom are they going to be selling to? Let’s keep reading:
Fortress, the first publicly traded buyout firm in the U.S., is preparing holdings for public offerings while struggling to find attractive new deals,Wesley Edens, who runs Fortress’s $14.3 billion private-equity business, said on a conference call with investors yesterday.”
‘It’s almost biblical: there is a time to reap and there’s a time to sow,’Apollo’s Black said at a conference in April. ‘We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down in our portfolio.’
‘Within the five-year period between 2008 to today, we witnessed one of the best times to be a buyer to one of the best times to be a seller,’ said DavidFann, CEO of TorreyCove Capital Partners LLC, which advises buyout managers and investors.”
The problem for individual investors is that if this is the best time to be a “seller” then what is the “margin of safety” in putting investment capital to work at today’s levels? That answer was provided by another recent Bloomberg article discussing the views of some of the top“value oriented” mutual fund managers:
“The $1.1 billion Weitz Value and $980 million Weitz Partners Value funds each have cash stakes that are close to 30 percent. At the $10.6 billion Yacktman Focused fund, cash has crept up from 14 percent a year ago to 19 percent. The $1.3 billion Westwood Income Opportunity has about 16 percent in cash, more than double what it had at the start of the year. Cash makes up about 28 percent of assets in the $8.9 billion IVA Worldwide Fund, up from 10 percent a year ago, and is 33 percent of the $508 million GoodHaven fund, up from 19 percent a year ago.
‘After taking profits on stocks that have risen close to what we believe is their value, we aren’t finding enough mispriced securities to redeploy that cash into,’ says IVA Worldwide co-manager Charles de Vaulx.”
With the majority of equity based mutual funds holding near record lows of cash these “value based” managers are certainly not the norm. However, their basic investment discipline of“buying low and selling high” should be the basic philosophy of all investors. After all, as stated above, this is how long term returns are created. With valuation levels now “rich” by historical measures it is no surprise that the”smart money”is lining up to sell their investments off to retail investors. Of course, this is why retail investors continue to perform poorly over the long term by continuing to overpay for investments as euphoria drives the decision process but fail to buy, due to fear, when prices are truly cheap.
While the current environment is different than what we saw in 2008; there are many similarities to past market peaks. As John Hussman wrote:
“In short, we have one of the most overvalued, overbought, overbullish equity markets in history, but one where investors are under the illusion that stocks are appropriately priced, because they are being sold a valuation benchmark (forward operating earnings) that reflects profit margins 70% above historical norms – a direct result of unsustainably large deficits in combined government and household savings. As government deficits recede from the historic extremes that marked the post-crisis response to the worst economic downturn since the Depression, and household savings rebound from among the lowest levels in history, corporate profit margins cannot and should not be expected to persist at anywhere near recent record levels. A century of economic data provides evidence on both corporate profit margins and broader valuation measures.
Wall Street is enthusiastic, once again, to argue that this time is different. I’m reminded of a decades-old passage from John Brooks, writing about the late-1960′s “Go-Go” market that ended with the 1969-70 plunge, and ushered in more than a decade of market weakness. Brooks was struck by the speculative recklessness of the time, even among those who should have known better. Didn’t the knowledge and integrity of Wall Street professionals protect the public?
‘Indeed, it had not – not when the nation’s most sophisticated corporate financiers and their accountants were constantly at work finding new instruments of deception barely within the law; not when supposedly cool-headed fund managers had become fanatical votaries at the altar of instant performance; not when brokers’ devotion to their customers interest was constantly being compromised by private professional deals or the pressure to produce commissions; and not when the style-setting leaders of professional investing were plunging as greedily and recklessly as any amateur.’”
While I suspect that the market will continue to rise from here in the short term to achieve our target of 1730 – the longer term fundamentals are no longer conducive for over exposure to equity risk. The problem is that, as has always been the case, if the market doesn’t crash tomorrow then all of this analysis is “wrong” and the “logic” is discarded and forgotten in favor of the emotional high achieved from continued rises in asset prices. Unfortunately, like a roller coaster, the view at the top is “amazing” the plunge that follows is “terrifying.”
Why is the “smart money” selling? Only they know for sure but maybe that is why they are considered the “smart money” in the first place. As the old saying goes:“If you can’t spot the pigeon at the poker table – odds are it’s you.”