Market Commentary August 2016
Over the past year, on a micro level, it has become exceptionally tough to find fairly valued assets by traditional valuation metrics. On a macro level, it seems that our leaders never solve any of the root problems that cause extreme financial disruptions. Instead we feed our economy remedies that will only lead to the next bubble. I can feel your restlessness to put money to work, but my message today is this: patience and tread lightly. There are red flags that need to be considered.
Over the past 2 years the S&P 500 has been unable to break out above 2200. It has tested the 2200 level 9 times, and has failed each time. This shows what is called “buying exhaustion”, meaning that at this level buyers disappear from the market. At the moment we are on the top of this range. Earnings have flattened, and investors are showing they are no longer willing to pay a higher multiple for stocks. I believe there is a heavier risk to the downside then missing out on the upside. “Buying now is like jumping in front of a high speed train to pickup a dime,” is the best analogy I have heard to represent the market at this point. The downside risk of this market outweighs the upside reward.
Brexit was very important, not because of the financial effects Brexit brings to the global marketplace, which have proven to be minimal, but because Brexit showed us what happens when an unexpected market event occurs. It showed us that the market is very shaky, and that just a small market disruption will send markets into a selling frenzy. Again, the downside risk outweighs the upside reward.
The US stock market has been seen as the “safe place to invest”, and this idea has inflated our stock market. Because of a weak Euro zone, economic chaos in regions like Brazil and Venezuela, and uncertainly in China’s future growth and financial transparency our markets have attracted heavy investment from all over the world. This has pushed up our market, not on the basis of higher earnings, but because it is considered safe. This can be highlighted by the Shiller P/E ratio (or CAPE), which is a valuation method for regional stock market indexes. It takes the price of a major index (S&P 500 for the US) and divides by the 10 year moving average of company earnings within that index. The higher the number, the higher multiple investors are paying for investments in that region. Due to heavy inflows of investment, the US is at the high end of the range, signaling overvaluation.
The extended period of low interest rates have inflated the price of assets and has distorted capital allocations within businesses and the economy. In the short term, low interest rates help stimulate the economy because money is cheap to borrow, but over a long period of time this will over stimulate and create bubbles. Rates have been hovering at zero for 8 years. This is unprecedented. Furthermore, interest rates have been driven down over the past 28 years as the Fed panders to the stock market and housing market rather than do the job it has been mandated to do. Each major market sell off over the past 30 years has been met with the Fed driving down interest rates. This policy has helped the stock market and housing market recover each time, but in consequence has created inflated asset prices. Inflated prices can be seen in stocks, bonds, real estate, art, and collectables. Households looking for interest income to live off of have been pushed out of bonds due to low interest levels and into stocks, raising stock prices past fair value. Many housing markets are back to 2006 levels and have been pushed into unaffordable levels for many. On the radio I hear “How to Flip Houses” seminars being advertised, reminiscent of 2006. Brokerage margin accounts (borrowing money to buy stocks) has more than doubled since 2010. Corporations are borrowing money to buy back their stock, which shrinks the outstanding shares in the company, but does nothing to increase revenue and productivity. Furthermore, as the natural business cycle completes itself (recession to peak to recession) the Fed will have very little room to accommodate the economy since it has not raised interest rates fast enough.
We can not let the fear of missing out outweigh prudent investing fundamentals. There will be market corrections coming, and we will use the cash we have in the portfolio to take advantage of opportunities. We will be extremely selective in buying fairly valued companies, that have proven strong free cash flows over a long period of time, low debt, does not need the credit markets to succeed, and their business is not interest rate sensitive. This is a time to be defensive, so let’s be patient and and seize opportunity when it comes to us.
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