There are a lot of tradeoffs in life, a balancing act so to speak. Assuming oxygen is plentiful and free, objectively, the human person has three needs that must be met to sustain life and thrive: water, food, and shelter. Medicine, education, transportation, and recreation are also needs, which can enhance the quality of life, but those can be prioritized subjectively, whereas water, food, and shelter cannot.
The human person is a complex organism with a nature that has desires for things beyond needs, however, which, for lack of a better term I will call wants. Wants is an extremely broad category, but for the purpose of this musing I will define a want as anything that generates a feeling of contentment or fulfillment. This is where the tradeoff, or balancing act if you prefer, comes into play. We have needs, but we want the wants. My, oh my, quite the conundrum indeed.
I am going to go out on a limb and opine that when and where possible, the want for wants wins out. Think about it, how many times have you cast your eyes on some object, and wham! Emotionally you own it, done, game over. Now all that is left is for your heart to rationalize with your head how to pay for it.
What the heck just happened here? You saw something, it made you feel good, and you had to have it. Now, the it, whatever the it is doesn’t matter. What matters is how the it makes you feel.
I have been wrestling with this theme in these commentaries the last few months to flesh out how this impacts the investment thought process, particularly since the market, meaning its participants, insists on pursuing the Magnificent Seven, which is my term for the “AI” focused tech glamour stocks, with no apparent concern with whether they offer/represent good value or not. My conclusion is as the prices for said stocks continue to climb it acts as a reinforcement mechanism for the decision to buy said stocks, which makes the buyer feel good about their buying decision, an emotional “at a boy” if you will.
There is a term for buying a stock solely because you believe its price will continue to climb simply because it has been climbing without forethought of any fundamental basis for buying the stock; it is called speculation.
Price, without any other information, only reveals what a willing buyer and a willing seller agree on to affect a transaction. Yes, this is what makes a market, but it doesn’t make for an informed investment strategy. For some reason the phrase “feeding the beast” comes to mind.
Clearly, this foray into rabid speculation has paid off quite handsomely for the NASDAQ and S&P, and over the last few weeks has begun to pull the Dow Industrials along with it, which, I suspect, is the result of rotating some gains out of tech into the Dow as a hedge.
I have heard a great deal of commentary that the surge in stock prices is indicative of a strong economy. That is either ignorance, naiveté, or a combination of the two. The stock market is not the economy, and the economy is not the stock market. What the stock market can tell you is something about investor sentiment, sector allocations, and technical indicators, but not so much about economic forecasts. In case you have forgotten, the stock market suggested in September 2000 that there was nothing but blue skies ahead, and the same thing in October 2007, which were followed by recessions six and two months later respectively.
To be clear, I am not making a forecast, I am just pointing out that history has not been kind to the stock market’s economic prognostications. History also hasn’t been kind when valuations are at their current levels, which except for just prior to December 2020 and around the 1929 market peak, are the most extreme, ever.
Based on some of your emails and voice mails I haven’t done a good job of explaining what I am referencing when I write about valuations. When you purchase a stock you are purchasing a stream of future cash flows, specifically price appreciation and dividends, which are the elements of total return. The total return you actually receive is determined by what point in the stock’s cycle you make your purchase.
Obviously we want to buy when the stock offers the maximum upside, which means you must have a reference point that indicates historically whether the stock price is high, low, or somewhere in between. In our approach we use the historically repetitive areas of high and low dividend yield to make this determination, and attempt to limit purchases within 10% of its repetitive high yield area.
When dealing with the broad market, specifically the S&P 500, our dividend yield approach is not an apples to apples equivalent to identifying where the index is in its historically repetitive cycle. The most historically reliable measure we know of is a ratio of price (market capitalization) divided by revenue.
At the onset of a new bull market, it is widely accepted that the S&P will average a 10% annual return over the next 10 to 12 years. Assuming this is the beginning of a new bull market, and using the current price/revenue ratio, to generate 10% average annual total returns over the next 10 to 12 years the S&P is almost 3 times historically above where it would need to be to generate that 10% annual return.
For context, in IQ Trends speak, this would be the same as buying a stock well in the Overvalued area and projecting it will deliver a 10% average total return over the next 10 to 12 years. Impossible? No. Improbable? You bet. Could the S&P deliver a 10% average annual total return from the present area? I suppose if peak earnings and peak growth continues forever, sure, why not. I guess the question is do you want to bet against the long-term history of mean reversion, you know, like before QE when there was a real interest rate curve?
Since I’m doing clean up on aisle three as it pertains to valuations, I should just go ahead and head this one off at the pass. “If, as you say valuations are so out of line, then why isn’t the stock market falling? Valuations, shmaluations. I think you’re living in the past and your metrics are fubulated.”
Wrong! Valuations don’t tell us a thing about short term market movements in either direction. What valuations tell us is the probability of long term returns and the degree of potential losses over a complete trough to peak to trough market cycle. My point is if this is the beginning of a new cycle, based on long term history, this is going to be one rough patch for long term total returns.
The seven largest companies by market cap are Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta Platforms and Tesla, which on average have delivered about 94% year to date. If you own those you are feeling pretty good about the project. The rest of the S&P 500, about 72% of the weight in the index, on average have delivered about 2% year to date. The term for this condition is poor breadth. Generally, when investors are in a risk-on mood, they tend to be risk-on across the board, otherwise known as uniformity.
Given the previous paragraph, show me the uniformity in the S&P. “Yeah, so what Wright. Those techy stocks have that AI thing going on and their earnings keep going up. Why shouldn’t we be buying them?” I don’t know, I guess it’s okay if you know how to value them, which I don’t, but you do you. All I’m saying is historically it hasn’t been a great outcome when you combine nosebleed valuations with poor breadth.
I get it, there is a thing known as recent bias, which lends to the belief that what is present will continue indefinitely. Perhaps that is why the present generation is comfortable in either ignoring or rewriting the past. When the wind appears to be at your back history is of no importance, but when the wind reverses 180 degrees we can look to history for clues on how to navigate the present.
Clearly, the mechanics of investing has changed over time with the advance of technology. This was true fifty years ago too, however, and the market participants of that time were not very different from us. What has not changed are the fundamentals of value, which the generations before us learned from trial and error, success, and failure. Through it all they found a way to survive and prosper. We need to understand how they did it.
That is all, now solider on.
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