There is the saying “time heals all wounds,” which has likely been around for centuries, and for good reason. Whether it is an injury, or a broken heart, time truly is a great healer. When it comes to investing though, time can create a mental fog of sorts, as recency bias can outweigh the realities that we know to be true. Markets do go down, just as they go up, and valuations inevitably do matter. The bull market that started in March of 2009, has now gone on for ten years. Signs of froth are fairly obvious.
We are in a period where companies are executing multi-billion dollar IPOs at valuations that can only be justified if the rosiest of financial projections are met. Stocks being valued at 10-15 times sales are far too common. The unemployment rate is at a paltry 3.6%, while wages have finally begun to show a little bit of growth, so the economy is reasonably strong. The stock market is not the economy though, which is something that is often forgotten by market participants. The game is to buy securities when the intrinsic value is greater than what the price paid is. Conversely, one should be selling when prices exceed those intrinsic values. If you are in an index fund, that is not what is occurring, and capital has flooded into that arena at an unprecedented level over the last decade. The impact and the distortions that this is causing, have yet to be fully felt, but I do think it will be notable.
At T&T Capital Management, we spend the vast majority of time researching investments. I will tell you that at this period, valuations as a whole in most sectors offer very little margin of safety. Fortunately, we only need a few good securities out of thousands, which is one of the major benefits of active management.
If you are heavy into mutual funds or ETFs, you are going to end up owning many of these overvalued securities. It is very unlikely that the next ten years are going to be nearly as fruitful as the last ten years have been for equity or fixed income returns, because we are no longer emerging from the sheer devastation of the Financial Crisis, and its extremely low valuations. Interest rates are already so low, that its tailwinds can no longer be counted on to drive prices higher.
For us to succeed we must be willing to take a different approach than others with our investments. We need to identify securities that can still produce growing earnings, even as economic conditions become more challenging at some point. We need to find those esoteric “workout” opportunities such as Puerto Rico bonds were, that can produce returns even if the stock market doesn’t continue upwards. We must employ our alternative tools such as cash-secured puts and covered calls to enhance income and reduce risk.
It is so easy to just stay invested in mutual funds and ETFs at this point in the cycle, because every selloff has ended up being a tremendous buying opportunity. If you have a 30-year time frame, this strategy is fine but likely sub-optimal in my opinion. If you are depending on assets invested in index funds to provide for your living needs over the next 5-10 years, than not paying attention to valuations will likely be a very costly decision. Many things work until they don’t, and we end up getting a fat-tail event. Housing prices nationally only went up since WW2, until prices absolutely crashed during the Great Recession.
One of my favorite author’s is Nassim Taleb, writer of the Black Swan, Fooled by Randomness, Skin in the Game etc. Taleb has a great analogy of a Thanksgiving turkey. “Consider a turkey that is fed every day,” Taleb writes. “Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.
On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”
We don’t want to be the turkey! Every single investment decision we make should be based on a careful analysis of the facts, which provide us with the rational that the investment is likely to be profitable. We can’t blindly put our hope on history repeating itself, when the starting line is completely different than it has been in the past.