With the market down over 15% (as I write this) from February 20, it is a good time to reflect and see what we might have missed in the past. For us at Cornell Capital Group and for me as a contributor to Valuewalk, the story starts an article published back in August of 2019, Why These are Such Hard Times for Investors. In that article, I noted that the investment environment was becoming increasingly more difficult to navigate, saying that “In the forty years that I have been studying and participating in investment markets, the current conditions are among the most challenging. . All the past good news is the reason that times are so perilous today.” My concern was that valuations for all asset classes, particularly equity, were becoming so rich that it was difficult to find reasonable investments.
Those concerns were further developed in a follow up article in December 2019, Why is Warren Buffet Sitting on $128 Billion in Cash? The article asked, what was an investor to do, sit on cash like Mr. Buffet? I concluded that, “One way to manage the situation, especially considering the overall high level of stock prices, is by careful use of stock options. For instance, selling call options in the proper proportions can provide added income and downside protection . . .in current circumstances the benefits provided by thoughtful option selling may well outweigh the costs.”
In a related article, Apple’s Stock Price Massive Run-up in 2019: Future Implications, I looked at one bellwether company, Apple. I noted that Apple’s run-up in the past year was impressive, but that it was all due to expansion of the multiple not an increase in earnings. As a result, I observed that, “When the increase in a stock price is due to expansion of the multiple caused by expectations of future growth not reflected in current operations, it’s permanence is much less secure. Just as enthusiasm can wax, as it has for Apple in the last 12 months, it can wane. If sentiment changes and expectations turn down, the stock price can drop precipitously.” As I stated in the article Apple was not alone in this respect, “Apple is by no means unique. There are dozens of companies in the current market who have seen their stock prices jump due almost exclusively to expansion of the P/E multiple. Investors would be well advised to inquire as to the source of that expansion. If, as was the case with Apple, the expansion cannot be explained, caution should be the order of the day.” What was troubling about the multiple expansion was that stock prices were running up based on future expectations, not current performance. What if those expectations were to change?
One aspect of the multiple expansion-based run-up was the tendency to tell stories to justify prices rather than doing detailed discounted cash flow analyses. An example of that I pointed to was treating Tesla as a tech company. In Is Tesla a Tech Company, I noted that, “The auto business cannot scale up like tech. It cannot add millions of users overnight at close to zero marginal cost like Facebook or Netflix. Growth in the auto business requires massive amounts of cash to build factories, service centers, and infrastructure support.” This led to the conclusion that, “If Tesla loses its tech halo and starts trading more like a car company, its current stock price cannot be justified.”
Lest you think it was all worry and hand wringing over the level of asset prices, there was another side to it – the low level of interest rates. Low interest rates mean low discount rates, often denoted by “k” relative to expected growth given by “g.” Using that notation, I observed that “The chart below explains two features of the current stock market. First, the combination of record low k’s in conjunction with somewhat typical g’s means that the difference is small. That implies high stock prices relative to earnings on average and that is certainly the case today. . Second, the low k’s imply that firms with relatively high expected growth rates are going to have particularly high stock prices.” I concluded the article by saying that, “If rates remain near record lows, then stock prices will remain high. A colleague from Wharton, Prof. Jeremy Siegel, believes that rates will stay low, so he is telling his clients to allocate a larger fraction of their portfolios to stocks even at the current high prices.” One ray of sunshine in the current correction is that interest rates have fallen even lower.
So where do I stand with all of this? Despite the correction, equity prices relative to earnings remain on the high side by historical standards. For instance, the Shiller CAPE ratio is still above its historical average. On other hand, the yields on long-term Treasury bonds are at record lows. Putting the two pieces together, it is my view that stocks are close to fairly priced. This is not to say the market could not drop another 10% or bounce back to where it was before the drop but is no longer the most challenging investment environment I have seen in forty years. There are stocks out there that are priced well relative to reasonable estimates of future cash flows. The challenge for every rational investor is to find them.