Perspective

[DamienC]

Dear All,

 

Something I wrote 2 days ago which might or not be of interest. The message is that when the cycles turns down there will be no place to hide, no factor will be spared. In 2000-2003 value investors fared well as they did in the 70's because the overvaluation (Nifty Fifty, TMT bubble) was concentrated in a few large companies. Being big and grossly overvalued they pushed the markets valuation to unsustainable highs (the joy of market cap weighted indices) while if looking at the average stock valuation or even better median stock valuation, the markets were far from bubbles. It was different in 2007 where almost everything was overvalued and hence even the best value managers were crushed. This time is going to be the same. While large cap quality stocks (strong BS, low earning volatility,.. are the cheapest (but Sun was cheap compared to etoys.com no?), dividend stocks are now very expensive on a relative basis and so are low volatility stocks. Small caps are the worst of the bunch reaching level where we can say with a straight face, without laughing or moving our ears, that they will probably lose more than 60% in real term during this phase.

 

For the context, one our biggest client fired us in July 2007 because of a similar note we sent in May of 2007 and of the daily e-mails following to press our case. How could we pretend that investors were paying to take risk.

 

What if we are indeed only now reaching the top of the secular bull market... What if

 

Dear All,

 

It is no secret that we view the US stock markets as grossly over-valued. In recent meetings, as in the Spring of 2007, we have insisted that not only markets are more overvalued than what they seem, the overvaluation is also general. E. Easterling wrote a provocative article not long ago on the subject. Those who have read his 2 book, "Unexpected Returns" and "Probable Outcome" know the quality of his research.

 

In 2000 while TMT companies where reaching absurd valuation, small caps and quality value stocks where cheap. Remember that Berkshire H. made its low the same day as the Nasdaq made its top or the same month as J. Robertson, one of the best value stock picker of history, liquidated his fund.

 

In 2007, the overvaluation was general but here again you had a sector distorting the various valuation ratios, financial companies. In the bear market that ensued, nobody who was long, even the best conservative value stock pickers made money if they were long-only. This was a carnage.

 

Today our contention is that markets are more overvalued than in 2007.

 

There will be no place to hide when the tide turns. No place. The best value managers will lose a lot of money, factors which have historically worked well will suffer a lot too (small caps will be crushed and could loose more than 60% from current levels, high dividend paying  and shareholder yield stocks too as they are expensive relative to an expensive markets, quality stocks will outperform but not by much and given the concentration of hedge fund investor in some of them will be liquidated without mercy when blood will run in the street). Short factors are also the most expensive against the markets they have been  since we have data in the early 90's (and we doubt they were more expensive on a relative basis before).

 

In the graph below you can see 3 different valuation ratios where we try to remove the margin and sector overvaluation effect. Data is based on Point in Time S&P 500 constituents since 1990. The red line is the median PS ratio. The light blue line is the average of each components PS (an equal weighted PS if you want) where the overvaluation of 2000 still stands out because of the SUN Micro of the time. The dark blue line is the average of the and and third quartile PS (we used Bloomberg for the components and the PS data).

 

Remember A. Greenspan irrational exuberance? It was in December 1996 and at the time it was indicating that the market were extremely expensive compared to history. Well in December 1996 the 3 ratios where 40% below current levels.

 

40%

 

Picture

 

 

Today, the big difference with 2000 and 2007 is that government and central banks have already spend a lot of firing power to "make believe" that everything is fine again.

 

The current environment is structurally deflationary and real trend growth is much lower than what the Fed and most analysts are believing. For many, many years we have talked about this (demography, overindebtness, oversupply,...).  It means that inflation rate will be lower and unemployment higher than what the Fed is predicting. It also means that this is structural and not cyclical. It also means that the Fed, as long as it does not realize this, is going to continue what it has been doing for a very very long-term.

 

We have long said that we sometimes struggle to see the world and it is instead of as it should be. We are too naive. Current policies are not what they should be (productive investment, deleveraging to move away from this culture of speculation and easy money) and we need a trigger to make this change. Could it be a more hawkish Fed with new governors nominated next year and/or realizing that they have created a fantastic bubble in the equity and corporate bond markets (both linked as most of the borrowing is done to buyback shares or other companies and hence the productive capital base is not increased further lowering long-term growth potential ceteris paribus).

 

With regard to the short-term markets movement we can only repeat what we said recently:

 

"Market short-term volatility (intra-day) has increased markedly in the past few weeks. Important tops (cyclical) are made when valuations are extended (check), important divergences are forming (check), market uniformity decreasing substantially (check), exuberant optimism (check and congrat to R. Shiller...), markets overbought (check but could be more extreme on the daily time frame) and, finally, increased short-term volatility (check). You can use some pattern (serie of small range days) if you really want to be cute.

 

The only ingredient missing here is a sell signal from our cyclical models which have stayed stubbornly positive since 2009 with the exception of a  short-lived sell signal during the  2011 route. By definition, those cyclical signals will miss the first part of the decline which make a 10-12% drawdown at the beginning of an cyclical bear market a rule rather than the exception. The above checks are all warnings that cyclical signals could turn down during the next correction (or at least in the near-term)."

 

Kind regards,

 

Damien

[stahleyp]

Thanks for the thoughts, Damien.

 

Another way to look at it.

 

Bearish camp is:

 

Klarman

GMO

IVA

FPA

Munger (I think)

Watsa

 

Neutral camp:

Cooperman

Buffett

 

Bullish camp:

Not a value guy I can think of, but Tepper is the one guy with a good track record I can think of.

I saw a video for Clearbridge and they are bullish...soooo...yeah.

 

People are not nearly as crazy as 2000. In 2007 people were somewhat bullish but not abnormally so. I still remember people taking about how high gas prices would push us into another recession. Markets can stay crazy for a long time though. We'll see what happens. There are a pretty good amount of bargains out there though.

 

[Palantir]

This is not aimed at you personally, but why waste energy trying to figure out this stuff? I thought value investing was about keeping your eyes on the ball, focusing on finding undervalued investments, and holding them patiently, staying focused, and not worrying about extraneous events. Instead now I see supposed value investors whining about QE, Ben, deleveraging, inflation, debt, public finance, blah blah, and usually, their comments come out as pretty foolish. (eg. Einhorn and Klarman complaining about QE pushing up prices etc etc.)

[stahleyp]

http://www.marketfolly.com/2012/12/warren-buffett-on-hedge-fund-managers.html

 

"Buffett mentioned a few hedge fund managers who were successful like Julian Robertson (Tiger Management), and he mentioned that he liked Seth Klarman (Baupost Group). "

 

If he's good enough for Buffett, he's good enough for me.  :P

 

I believe he was "wrong" from around 1996 to 2000 the first time. I don't recall when he was bearish for the 2007 crash though. This time around, I believe he started to become bearish in 2010 (around april i think). So, that tells me if he's right again and a similar time frame lines up (pure speculation), we might have a decent ride over the next several months, maybe even the next year, but that lines up nicely with his history. It also lines up nicely with board member gio's thought process of bear market cycles and how this one is shorter than average and from a higher peak (bear market of 9 years with valuations from 2000). No one knows what will happen, but it's fun for me to think about it (yes, I need a life!) I do wonder if we'll ever have low valuations like the 1970s again. It'll be interesting to see with all this debt if we can get down to those valuations. Pure speculation, of course.

 

[Green King]

http://investinginknowledge.com/info/2010/05/munger1-harvard-westlake-school-video/

 

Here is a series that Matt pauls @ http://investinginknowledge.com/ posted 

 

done by Munger were both Munger and Howard Marks agreed the problems that have caused this problem are not solve and it will likely take another for these problems to be fixed.

 

Careful about seeing the future. Its what gets smart people killed historically and causes smart people to lose their shirt nowadays.

 

 

[DamienC]

"This is not aimed at you personally, but why waste energy trying to figure out this stuff?"

 

Be reassured I do not take it personally...

 

The reason is the same as the one we spend all a lots of time finding undervalued securities.

 

While micro-managing its exposure to markets is almost impossible, history teaches us that you have long cycles pushing the markets from overvaluation to undervaluation and back up again.

 

As I said recently, US markets are currently priced to produce max 2% real total return in the next 10 years. This won't be 2% a year but more like 1 and probably 2 40% more decline followed by rallies. Small caps are likely to produce negative 3-4% return.

 

Why, in this case not simply hedge the beta portion of the portfolio with futures (which are the worst kind of asset, capitalization weighted...) and a plan. A plan like when we get to fair value for the market I cut half of the hedge and the other half when the 200 days moving average slope turns up again once fair value has been reached (which might be far below fair value). This is not My plan but just a oversimplified example.

 

Isn't Prem Watsa doing it?

 

[Packer16]

The reason is you are making factor bets which appear simple in theory but in practice are very difficult.  I agree with Palantir, Buffet and Graham that spending time trying to make macro factor bets is more trouble than it is worth.  Prem has also lost alot due to the hedges and is making a bet (with hedges) that the USD is not going to appreciate more than stocks, a bad bet in my opinion.  What about the scenario that the market continues to go up via QE and the debt is monetized and the USD goes down - stocks have small real returns but large nominal returns versus other assets.  In that case the hedge pulls down you return because the hedge is implicitly long USDs but short real assets (stocks).

 

Packer 

[compoundinglife]

"This is not aimed at you personally, but why waste energy trying to figure out this stuff?"

 

Be reassured I do not take it personally...

 

The reason is the same as the one we spend all a lots of time finding undervalued securities.

 

While micro-managing its exposure to markets is almost impossible, history teaches us that you have long cycles pushing the markets from overvaluation to undervaluation and back up again.

 

As I said recently, US markets are currently priced to produce max 2% real total return in the next 10 years. This won't be 2% a year but more like 1 and probably 2 40% more decline followed by rallies. Small caps are likely to produce negative 3-4% return.

 

Why, in this case not simply hedge the beta portion of the portfolio with futures (which are the worst kind of asset, capitalization weighted...) and a plan. A plan like when we get to fair value for the market I cut half of the hedge and the other half when the 200 days moving average slope turns up again once fair value has been reached (which might be far below fair value). This is not My plan but just a oversimplified example.

 

Isn't Prem Watsa doing it?

 

According to what Prem said at the annual meting their hedging is a safety net that is required at the moment to give them flexibility. They don't want their business to be paralyzed (or worse) if the market declines significantly. Prem also stated that he would like to get to a point where their cash cushion is large enough that they could withstand the worst of times without hedges in place like Berkshire is able to do. Something to take into consideration.