Dear reader, if you are overcome with fear of missing out on
the next stock market move; if you feel like you have to own
stocks no matter the cost; if you tell yourself, Stocks
are expensive, but I am a long-term investor; then
consider this article a public service announcement written
just for you.
Before we jump into the stock discussion, lets quickly
scan the global economic environment. The health of the
European Union did not improve in 2016, and Brexit only
increased the possibility of other exits as the
structural issues that render this union dysfunctional went
Japans population has not gotten any younger since the
last time I wrote about it it is still the oldest in the
world. Japans debt pile got bigger, and it remains the
most indebted developed nation (though, in all fairness, other
countries are desperately trying to take that title away from
it). Despite the growing debt, Japanese five-year government
bonds are paying an interest rate of 0.10
percent. Imagine what will happen to its governments
budget when Japan has to start actually paying to borrow money
commensurate with its debtor profile.
Regarding China, there is little I can say that I have not
said before. The bulk of Chinese growth is coming from debt,
which is growing at a much faster pace than the economy. This
camel has consumed a tremendous quantity of steroids over the
years, which have weakened its back we just dont
know which straw will break it.
S&P 500 earnings have stagnated since 2013, but this has
not stopped analysts from launching their forecasts every year
with expectations of 1020 percent earnings growth . . .
before they gradually take them down to near zero as the year
progresses. The explanation for the stagnation is surprisingly
simple: Corporate profitability overall has been stretched to
an extreme and is unlikely to improve much, as profit margins
are close to all-time highs (corporations have squeezed about
as much juice out of their operations as they can). And
interest rates are still low, while corporate and government
indebtedness is very high a recipe for higher interest
rates and significant inflation down the road, which will
pressure corporate margins even further.
I am acutely aware that all of the above sounds like a
broken record. It absolutely does, but that doesnt make
it any less true; it just makes me sound boring and repetitive.
We are in one of the last innings (if only I knew more about
baseball) of the eight-year-old bull market, which in the past
few years has been fueled not by great fundamentals but by a
lack of good investment alternatives.
Starved for yield, investors are forced to pick investments
by matching current yields with income needs, while ignoring
riskiness and overvaluation. Why wouldnt they? After all,
over the past eight years we have observed only steady if
unimpressive returns and very little realized risk. However,
just as in dating, decisions that are made due to a lack
of alternatives are rarely good decisions, as new
alternatives will eventually emerge its just a
matter of time.
The average stock out there (that is, the market) is very,
very expensive. At this point it almost doesnt matter
which valuation metric you use: price to ten-year trailing
earnings; stock market capitalization (market value of all
stocks) as a percentage of GDP (sales of the whole economy);
enterprise value (market value of stocks less cash plus debt)
to EBITDA (earnings before interest, taxes, depreciation, and
amortization) they all point to this: Stocks were more
expensive than they are today only once in the past century,
that is, during the dot-com bubble.
In reference to this fact, my friend and brilliant
short-seller Jim Chanos said with a chuckle, I am buying
stocks here, because once they went higher . . . for a
Investors who are stampeding into expensive stocks through
passive index funds are buying what has worked and is
likely to stop working. But mutual funds are not much better.
When I meet new clients, I get a chance to look at their mutual
fund holdings. Even value mutual funds, which in theory are
supposed to be scraping equities from the bottom of the stock
market barrel, are full of pricey companies. Cash (which is
another way of saying, Im not buying overvalued
stocks) is not a viable option for most equity mutual
fund managers. Thus this market has turned professional
investors into buyers not of what they like but of what they
hate the least (which reminds me of our political climate).
In 2016 less than 10 percent of actively managed funds
outperformed their benchmarks (their respective index funds) on
a five-year trailing basis. Unfortunately, the last time this
happened was 1999, during the dot-com bubble, and we know how
that story ended.
To summarize the requirements for investing in an
environment where decisions are made not based on fundamentals
but due to a lack of alternatives, we are going to paraphrase
Mark Twain: All you need in this life [read:
lack-of-alternatives stock market] is ignorance and confidence,
and then success is sure. To succeed in the market that
lies ahead of us, one will need to have a lot of confidence in
his ignorance and exercise caution and prudence, which will
often mean taking the path that is far less traveled.