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“Asphyxiation is a condition in which the body doesn’t receive enough oxygen.”
That’s how I started a column a while back, in which I explained how the recent U.S. equity market highs have been creating “altitude sickness,” or value asphyxiation, for investors. If you look down from 30,000 feet, the market is trading at a significant premium to its average long-term valuation, especially if you normalize earnings for sky-high profit margins.
The view from the trenches is not much different. I spend a lot of time looking for new stocks, either by screen or by reading or talking to other value investors. We are all having a hard time finding many stocks of interest. In fact, we’ve been doing a lot more selling than buying.
A Bubble?
I often get asked a question: Are we in a bubble? Bubble is a word that has been thrown around a lot lately. There may be an academic definition of what a bubble is — probably something to do with valuations at least a few standard deviations from the mean — but I don’t really care what it is. (Only academics believe in normal distributions.)
From the practitioner’s perspective, a bubbly valuation occurs when the price-earnings ratio of a company is so high that its earnings will have a hard time growing into investors’ expectations. In other words, the stock is so expensive that investors holding it will find it difficult to realize a positive return for a long time (think of Cisco Systems, Microsoft and Sun Microsystems in 2000). There are some bubbly stocks in the market today. Most years you see some, but today there are probably a few more than usual.
A murky line
We see a lot of overvalued or fully valued stocks. Expectations (valuations) of those stocks have already more than priced in rosy earnings growth scenarios. If these scenarios play out, investors will likely make very little money, as earnings growth will merely offset P/E compression. But, here is where it gets interesting: The line between overvalued and bubbly stocks is often very murky. If the economy’s growth is lower than expected or corporate profit margins revert toward the mean (or, in the situation we have today, decline), the return profiles of these stocks will not be substantially different from those of the bubbly ones. Unfortunately for the value-asphyxiated investor, there are a lot of stocks that fall into this overvalued bucket.
It is very hard for investors to remain disciplined and stick to an investment process. Selling overvalued stocks is hard, because every sell decision brings consequent pain as overvalued stocks that are not aware you’ve sold them keep on marching higher. Just as Pavlov’s dog responded to a bell, the pain of selling teaches us not to sell.
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More pain
If that pain were not enough, cash keeps burning a hole in our portfolios. Cash doesn’t rise in value when everything else is rising; thus investors feel forced to buy. When you are forced into a buy or sell decision, the outcome will usually not be good. Forced buy decisions are usually bad buy decisions. Just because a stock looks less bad than the rest of the market doesn’t make it a good stock. Maybe its peer is trading at 23 times earnings and your pick is trading at “only” 19. Such relative logic is dangerous today, because it anchors you to a transitory environment that may or may not be there for you in the future (most likely not).
An annoying phase
We are in the most annoying phase of the investing calendar: the month when every market strategist and his dog have to make a prediction as to what the market will do next year. To be right in forecasting, you have to predict often. And market strategists do. In fact, they predict so often that no one remembers how often their predictions worked out. I am not knocking the prognosticators: That is their job. They predict and sound smart doing it — just like it’s the barber’s job to cut your hair and pretend he is concentrating on not cutting off your ear.
It is your job, however, not to pay attention to the predictors. They simply don’t know. They may have a gut feeling, but that feeling is worth as much as you pay for it — very little. To time the market, you have to forecast what the economy will do, which is also very difficult. The Fed has 450 economists working full time on that (half of them are Ph.D.s, but I am not going to hold it against them), and they have an amazingly poor track record. Then you have to figure out how other market participants will respond to the economics news — and that is incredibly difficult. Let’s say you nailed both of these tasks. You still need to predict the multitude of random events — a few of which may be very large black swans — that will show up in the next 12 months. There is a reason why they are called “random.”
Assessment
Though it is dangerous to drink the market’s Kool-Aid and celebrate, it is not time to be gloomy either. There is good news for all of us: Cyclical bull markets are here to absolve us from our “buy” sins. Not every stock in your portfolio is marching in rhythm to its fundamentals. Indeed, this market has lifted many stocks while divorcing them from their weak fundamentals. This absolution is temporary: Take advantage of it.
ABOUT
Vitaliy N. Katsenelson CFA is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley 2007) and The Little Book of Sideways Markets (Wiley, 2010). His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”.
Conclusion
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Front Matter with Foreword by Jason Dyken MD MBA
“BY DOCTORS – FOR DOCTORS – PEER REVIEWED – FIDUCIARY FOCUSED”
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Filed under: Investing, Portfolio Management | Tagged: Cyclical bull markets, equity market highs, stock valuations, Vitaliy N. Katsenelson CFA |
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A System?
Over 25 years of writing, I have often discussed the value of a static buy-and-hold asset allocation with periodic rebalancing. This means investing specific percentages of your portfolio in several asset classes (a few of which are stocks, bonds, commodities, and real estate). Then, at least once a year, you buy or sell gains or losses to readjust each asset class back to the original target allocation.
Doing this can keep you from making “the big mistake” of investing. Maybe I should say “the big, lethal, fatal, mistake” of investing.
An April 8, 2015, article in Advisor Perspectives by Lance Roberts of Streetalk Live sheds some new light on the real value of maintaining a static buy-and-hold strategy. Roberts cites data from the 21st annual Quantitative Analysis Of Investor Behavior done by Dalbar, Inc. It shows that investing in a static buy-and-hold strategy, allocated 60% to stocks and 40% to bonds, in 2014 would have earned an additional $6,830 on every $100,000 invested, compared to the average amounts such portfolios actually earned.
The Dalbar study found the average return (for both do-it-yourself investors and investment advisors) on a 60/40 portfolio from 1984 to 2014 was a dismal 2.56% a year. The average annual return of the buy-and-hold strategy was 9.68%, meaning the average investor and investment advisor left 7.12% of return on the table every year.
Put into dollars, investors and investment advisors earned about $25,000 on every million invested in the stock market. Had they simply put that million into a buy-and-hold strategy allocated to 60% stocks and 40% bonds and left it alone, they would have earned $96,000 a year. That’s a loss of $71,000 annually.
Why do so many investors and investment advisors do so poorly?
The biggest reason listed by Roberts, which is supported by my own observation, is psychology. Investors exhibit behavioral biases that lead to poor investment decision-making. Dalbar listed nine irrational investment behavior biases that reduce returns and found two of them were the most significant: the “herding effect” and “loss aversion.” It’s human nature both to want to follow what everyone else does and to be afraid of losing what we have. Taken together, these can lead to investing disaster.
Roberts explains that as markets rise, investors come to believe that “things are better” and the current upward trend will continue indefinitely. The longer the trend lasts, the more ingrained this belief becomes. Eventually, the market enters a euphoric time of price increases when the last of the unbelieving holdouts finally buy in.
When the market inevitably declines, investors first view the dips as buying opportunities. As markets drift lower, there is a slow realization that the decline is something more than a “buy the dip” opportunity. As losses mount, fear of loss increases until investors can’t stand the heightened feelings of anxiety and seek to avert further loss by selling. This whole process results in most investors “buying high/selling low” and runs counter to the buy low/sell high investment rule.
Put in more basic terms, the reason most investors and advisors do so poorly is they try to “time” or beat the market. The study found that while most investors and advisors guess right 67% of the time, they were not able to come close to equaling a buy-and-hold strategy.
What can you do to keep from sabotaging your own investment strategy? It becomes imperative to put a system in place which will make it difficult for your brain to panic in a downturn. Soon, we will explore some options for such a system.
Rick Kahler MS CFP®
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