“Economic Confidence In March Highest Since January 2008”, “Small-Business Owners' Optimism Rises to Best Since July 2008”
With Headlines Like These, Is It Time To Worry?
René Descartes’s “Cogito, ergo sum” is usually translated as “I think therefore I am” but one of my old philosophy professors insisted that what he really had meant to say was: “I doubt therefore I am”. As a contrarian investor fighting today’s deluge of indiscriminate information and gratuitous opinions, I even prefer “I question, therefore I am”.
The Market Is Not The Economy
The news we get from the media may be distorted by bias or ignorance and ideas we take as “generally accepted” often would deserve a second look. Financial markets, for instance, should not necessarily be considered a faithful mirror of the economy, as they often are. In fact, most of the time, the two do not even move in tandem. One reason is that financial markets are importantly driven by crowd psychology, which means that they periodically succumb to excesses of optimism or pessimism that grossly magnify, or even caricature, the ups and downs of the economy.
Note - I write this paper on the day after Francois Hollande, the candidate who proposed to raise the top tax bracket to 75% to finance his ambitious anti-austerity measures, was elected to the French presidency. On my screen this morning, the French stock market is the only one in positive territory: Quid erat demonstrare about generally accepted ideas.
If it were possible to measure the exact value of a company, that value would be illustrated by the dotted line in the graph below. It would fluctuate with cycles in interest rates, inflation, profit margins, etc. and would probably increase a bit over time, along with the company’s sales. But it would do so with relatively low volatility – as does the economy in general. [What goes for one company goes for the market as a whole, since it is made up of all publicly-traded stocks].
In the same graph, the full line would depict the market price of our company’s stock: its fluctuations are much more pronounced because investors, who collectively determine this market price, have the bad habit of extrapolating recent trends both up and down. As they do, they eventually convince themselves that these trends will continue forever. Thus, for example, many investors find it justified to pay a higher premium over the current value of a company whose stock has been rising, since that premium promises to be even higher in the future. For a stock whose price has been in a down trend, the psychological spiral goes the other way: the premium shrinks to the point where it may even become a discount to the company’s calculated value. That, of course, is when value investors become interested.
Another reason financial markets move independently from the economy is that they react instantly to such things as political elections, and changes in monetary conditions and liquidity, whereas the economy responds to such changes with a lag and in a more complex manner. As a result, as I tried to illustrate in the earlier graph, financial markets tend to turn up and down before the economy does, and by the time the economy itself finally turns, much of the move by financial markets may have been already spent or reversed.
Investing Is Not Only About Being Right
Investors are in a different game from commentators. As Nassim Taleb colorfully explained in “Fooled By Randomness” and “The Black Swan”, for investors, it is not how often you are right that counts: it is how much you make when you are right and how much you lose when you are not.
It’s no use having made the right guess on the economy if, when the predicted event actually happens, the prices of stocks and bonds do not react or, worse, move in the wrong direction. Yet, this is likely to be the case when a majority had expected the same outcome as you did, because widespread expectations tend to be already baked into asset prices, so that there is little money to be made on the actual news. In fact, the greater the premium becomes of price over value, the smaller the potential for long-term gains and the greater the risk of loss if investors’ hopes are disappointed.
To make money investing, it is not enough to be right on companies or the economy: others must be wrong.
Importance of Being Contrarian
Broadly, contrarian investing can be opposed to momentum investing, which assumes that trends that have recently been in force will continue – at least until they stop doing so. Despite my skepticism about the long-term returns from momentum investing, I should stress that the approach works most of the time. It is only at extremes and around major turning points (when it really counts, as far as I am concerned) that a contrarian bias helps investors make better decisions, even if the timing of the implementation is not always surgically precise.
The recent financial crisis-cum-recession and its aftermath illustrated the usefulness of a contrarian bias quite well. On May 14, 2007, for example, I wrote:
Many investors whose judgment and long-term performance I respect have been warning for a while that some kind of serious trauma eventually will be the price to pay for the excesses and complacency of recent years. But, as in “The Boy Who Cried Wolf” tale, their warnings have become progressively discredited as economies and financial markets brushed off successive crises.
Under pressure from public opinion, the number of boys crying “wolf” has been melting like ice under the sun. But, as Victor Hugo wrote in a pamphlet against Napoleon III, “If but one remains, I shall be that one”. (The Boys Who Cried Wolf)
And then, on November 26, 2008, after a 40% collapse of the S&P 500 Index and less than three months before its ultimate bottom in March 2009, I concluded:
The unprecedented panic liquidations of October and November are clear evidence that investors around the world have fully apprehended the gravity of the economic and financial situation and may even have over-reacted to it. For my part, I believe that it is too late to sell quality investments and probably a better time to accumulate them. (Too Late To Sell)
Since its March 2009 low, the U.S. stock market measured by the S&P 500 Index has nearly doubled. Other indexes also have recovered in various proportions, but most remain well below prior highs.
At the low end of performance,
- Japan’s Nikkei remains almost 58% below its 1996 high;
- France’s CAC 40 remains 49% below its 2007 high, while
- Germany’s DAX and London’s “Footsie” are down only 18% and 14% respectively over the same period.
And what about the much touted “BRICs”?
- China’s Shanghai stock exchange, while 67% above its 2000 high, is down 59% from its 2007 bubble peak;
- Russia is down 40% from its 2007-2008 high; India 20%
- And the winner is… Brazil, down only 5%.
Trust Your Déjà vu
Generally, to be contrarian is more an art than a science. One thing that helps me question the consensus is that I believe in cycles – in nature, in history, in human moods, practically in everything. Of course, nothing is perfectly repetitive – not even cycles: the world, society and nature evolve. Mark Twain said it best: “History does not repeat itself, but it often rhymes”. As it applies to the economy, history’s rhyming might look a little like the following graph:
As time passes, technology progresses and societies evolve. Point in time B, for example, will exhibit many differences with point A. In fact, if we keep our nose close to the graph, the two points might seem completely different. Yet, we may get a sense of déjà vu. And when we step back, we lose some details but gain perspective, and we then discover how similar the two points are in their broad characteristics.
To interpret the news differently from the crowd, history can be a useful guide in selecting the broad lines of apossible (though not guaranteed) scenario against which to evaluate the significance and meaning of current developments.
The New Normal Is The Old Normal
In the last few years, one such scenario that I found particularly useful was based on the book by Carmen Reinhart and Kenneth Rogoff (This Time Is Different – Princeton University Press, 2009), which I was fortunate to discover early, thanks to a paper the authors had written for the National Bureau of Economic Research in 2008. Their research on eight centuries of financial crises, and particularly of these crises’ aftermaths, has allowed Prof. Rogoff to since assert that this recovery was “remarkably normal for a post-financial-crisis recovery”.
After major financial crises, an economic return to normal usually takes years. This is true for GDP per capita, employment, housing and many commodity prices, for example. It is also true for government debt, which will “normally” continue to increase for several years despite efforts toward budgetary restraint, simply because government tax revenues will keep falling short of projections. In fact, even the likelihood of sovereign defaults was anticipated by the authors. In other words, the current economic recovery, slow and halting as it has been, is generally progressing on schedule.
In terms of investments, since the bear market had started from historically high valuations, I assumed that a long period of consolidation in stock prices must follow the often powerful initial rebound, in order to bring valuation criteria such as price/earnings ratios down to levels that had historically preceded strong, secular advances. In fact, this had begun shaping up even before I adopted my scenario of reference.
Secular Market Cycles and Valuation
To try and figure where we stand today, let’s look at the following chart.
Many serious historians of the stock market define bull and bear markets, not in terms of stock prices (upper graph), but in terms of stock valuations, which more directly reflect the crowd’s hopes and fears (lower graph). The price of a stock does not tell you anything particular and its comparison to another stock price is meaningless. On the other hand, a stock’s price/earnings ratio (a common measure of valuation), tells you how much investors are willing to pay for one dollar of that company’s earnings and how much more or less optimistic they are about the prospects of that company vs. those of another company.
The same historians identify “secular” bull and bear markets as trends typically lasting many years and encompassing several shorter-term cycles of 2-4 years. During these secular markets, price/earnings ratios typically go from very low to very high (secular bull market) and back again (secular bear market).
On the basis of these definitions, the S&P 500 Index of U.S. stocks, for example, remains in a secular downtrend that started in early 2000, twelve years ago, rather than in 2007 as many assume.
Specifically, as can be seen from the earlier chart:
- The S&P 500 never materially surpassed its high point reached in 2000;
- Its price/earnings ratio has been in a fairly steady downtrend since the 30-plus level reached in early 2000.
Some observers may object that while the S&P 500 Index has stalled, the NASDAQ Index did make a new high. That has been true recently with that index about 5% above its 2007 high of 2860. But that is still nearly 40% below the index’s peak of just over 5,000 in 2000.
In addition, much of the NASDAQ recent performance has been due to the shares of Apple which, until its weighting was reduced somewhat last year, accounted for up to 20% of the index. Since the price of Apple’s stock has multiplied by six in a little more than three years, it can be deemed to have been responsible for much of the NASDAQ’s recent outperformance.
To return to the kind of undervaluation that historically has preceded the onset of secular bull markets, the price/earnings ratio on the S&P 500 Index, for example, would have to decline from its current 14-15 times earnings to 7 or 8 times earnings. Skeptics will argue that at the 1974 and 1982 lows, interest rates were very high, and since many investors look at bonds and deposits as the natural competition for stocks, the argument has some credibility.
Financial Repression Boosts Price/Earnings Ratios… Temporarily
However, today’s low interest rates are increasingly viewed as the result of “financial repression”, which Strategas Research describes as a set of policies that result in artificially low interest rates, thus allowing inflation to chip away at a nation’s debt. Some economists make a parallel with the period after World War II, when interest rates were capped by the U.S. government at low levels to help the country manage the debt accumulated during the War. When the economy recovered and interest rates began to turn up, in the late 1940s, a rapid rebound in earnings was offset by a steep decline in price/earnings ratios into single-digit territory. This, of course, was the prelude to the big, secular bull market of the 1950s and early 1960s. So, the very low price/earnings ratios prevailing at the 1974 and 1982 market troughs were not isolated events due only to very high interest rates. They did reflect the capitulation of investors on equities after long declines.
Timing vs. Potential Return
Historically, the attraction of value investing has been that, by purchasing stocks whose price does not incorporate a large hope premium over “intrinsic” value, the downside would be muted. Conversely, the potential for the premium to increase should investors’ perceptions change would promise worthwhile returns even in the absence of spectacular growth by the company. These assumptions suffered a severe setback in 2007-2009, when practically all stocks were caught into the same panic-driven downward spiral. But it does not entirely negate their validity.
Still, I prefer the approach taken by a few strategists of estimating what type of long-term return an investor can hope for, historically, by investing at certain valuation levels. Today, at slightly under 15 times earnings, the S&P 500 is selling about in line with its long term historical median — neither very expensive, nor very cheap. But long-term studies project 7-to-10 year returns from current valuations, profit margins, etc. in the very low single-digit range.
Investment involves a constant comparison of potential risks and potential returns. While not particularly pessimistic about the economy’s future (just realistic, I guess), I don’t find the potential returns compelling, except in some individual cases.