I stumbled upon an interesting article that I thought you might enjoy and is relevant to today’s environment. I, like most people am quite optimistic on the U.S. and global economy. Job creation has been strong, and I believe we should see wage growth accelerate. In addition, lower corporate tax rates will increase earnings for most companies by a good amount, which is bullish for stocks and the economy. The problem I have though, is that all of this good news is so well known and reflected in the markets. Even cyclical businesses such as Caterpillar (CAT) and Boeing (BA) trade at price to earnings multiples that you’d typically see on a high-flying tech stock, as opposed to relatively boring industrial companies. These high multiples are based on close to peak earnings too, which is generally when multiples are compressed for these types of firms.
“I can tell you that our investment strategy is built to counter these risks as much as possible. Our largest positions have 50-75% upside and/or offer very sizeable dividend yields.”
At T&T, we aren’t invested in these types of stocks that offer no margin of safety. We’ve owned both CAT and BA at much lower prices in the past, but at today’s prices we see far more risk than reward. That is important because they are two of the larger components in the Dow.
With all the euphoria we see pervading through the market, I see three primary risks that could potentially upset the applecart!
1. If inflation picks up, we should see a sharp selloff in bonds due to higher interest rates. This could cause a shift from equities into fixed income. Stock valuations are negatively impacted by higher interest rates,
so while current prices might be justifiable if one assumes current rates will stay this low for years, higher rates would devastate this paradigm. One need not look further than oil and housing prices to see that inflation is percolating through the system.
2. North Korea……………..needs no explaining, unfortunately.
3. A bear market in stocks becomes a self-reinforcing phenomenon. Most people believe that stocks are overvalued but that they should continue to go up. Because of this belief they have piled into index and mutual funds in record amounts. We have had absolutely no volatility over the last year and market participants are very complacent. If we see a large market drop, the narrative of economic growth could change, causing people to panic out of long-only investments such as most funds. Being that index funds have gotten almost all of the recent additions to the market, they would be hurt badly by an exodus.
I can tell you that our investment strategy is built to counter these risks as much as possible. Our largest positions have 50-75% upside and/or offer very sizeable dividend yields. They don’t need much growth at all to be big winners but instead need a reversion to the mean. All are at low valuations relative to intrinsic value. We also have various types of hedges in place such as covered calls and cash-secured puts. Any hedge seems moronic when stocks do nothing but go up, but it is when markets drop that hedges are nearly impossible to implement, that the value of this type of strategy is proven tenfold. I hope that you enjoy the below article!