Winding your way down on Baker Street
Light in your head and dead on your feet
Well, another crazy day
You’ll drink the night away
And forget about everything
This city desert makes you feel so cold
It’s got so many people, but it’s got no soul
And it’s taken you so long
To find out you were wrong
When you thought it held everything
You used to think that it was so easy
You used to say that it was so easy
But you’re trying, you’re trying now
Another year and then you’d be happy
Just one more year and then you’d be happy
But you’re crying, you’re crying now
-Baker Street, by Gerry Rafferty
. . . . .
Jesse Livermore was an early twentieth-century investor who made and lost several fortunes. As speculators go — and speculation and investing are distinctly different pursuits — Livermore ranked among the finest. He made fortunes short selling stocks when everyone else was long during the crashes of 1907 and 1929. The consummate market historian, much of Livermore’s success was attributed to his dedicated study of the human condition.
Livermore wrote, “All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance and hope. That is why the numerical formations and patterns recur on a constant basis.”
In other words, history repeats itself. Because human beings never change. Our emotions, and the means by which they drive behavior, remain as much a part of us as they were thousands of years ago.
As equities slid more than 16 percent in Q4, investors reacted as Livermore might have anticipated. Fearfully. Is the EU breaking apart? Will China’s slowdown affect portfolios? Has the Fed lost control? Is something more sinister afoot?
Anecdotally, investors shoot first and ask questions later. Following Q4’s route, the ICI reports revealed that mutual fund outflows dramatically increased. Nervous investors were going to cash. Which was the opposite tract to take.
Let’s begin by looking at valuations.
Analysis of traditional S&P 500 valuation metrics reveals that the market is not drastically overvalued, as some nattering nabobs report. The S&P 500 began 2018 with a PE ratio of 18.5 times earnings. Well above the 25-year average of 16.4x. Yet, following last February’s 10 percent drop, continuing improvements in economic growth and earnings, and the Q4 market cataclysm, the index’s PE ratio fell to a reasonable 16.1x, below the 25-year average.
Following Q1’s massive rip higher, the P/E ratio sits roughly 30 basis points above the 25-year average, which doesn’t rank as a wild overvaluation. The price-to-book and price-to-cash-flow ratios also remain near their 25-year averages. And the index’s earnings-yield spread (earning yield minus Baa bond yield) is 1.5 percent. Revealing a favorable disposition for allocating capital to stocks over bonds.
American companies have proven themselves to be extremely capable of getting the most from their income statements. Cost cutting and technological advancements have seen companies enhance margins. And given improving GDP growth, we’ve reason to believe that they will do more of the same.
Investors, practicing the herd mentality, tend towards the worst activities at the most inconvenient times. In this case, investors got out of the markets even as stocks become more attractive.
As stocks become cheaper, investors become more pessimistic. Equities fall in price, dividend yields become more attractive, yet the public piles out of stocks and into bonds, even as 10-year Treasuries yield a scant 2.51 percent. Stocks may be the only product around in which consumers become more comfortable the pricier they become.
Currently, one can buy Disney stock, which recently hit an all-time high, and get paid a 1.60 percent dividend for owning one of the great American content and entertainment companies at a 32 percent valuation discount to the broader market. Even as the company’s Avenger’s movies shatter box office highs. Theme park attendance continues to increase. The next Star Wars film prepares to launch. And a streaming service with Disney content has been announced. That service will provide access to Star Wars, Marvel super heroes, ESPN, ABC, Pixar, The Simpsons, and some of history’s most-watched films, on top of so much else. Or, one can buy the 10-year Treasury and make 2.51 percent annualized.
Warren Buffet recently said that “Bonds today should come with a warning label.” They yield nothing. And when interest rates inevitably rise, investors will be trapped as the value of their funds drops like a Luis Castillo sinker.
“But, isn’t debt safer than equities right now?”
The fixed income market place has improved. Some bond classes appear attractive. But not to the exclusion of ownership in some of the world’s great companies. Especially not after having been laid low during the Q4 decline. Google. Johnson and Johnson. Procter and Gamble. Disney. Republic Services, NVIDIA. Each saw valuations project to much more reasonable levels as investors suddenly confronted buying opportunities in companies that appeared expensive earlier in the year. Still, markets had been crazy. So investors felt comfortable leaving equities. Going to cash. Buying fixed income. Though owning the growth of great enterprises will always be preferable to lending to them.
“But aren’t risk-free Treasury bonds a safe bet during unsafe times?”
Last time I looked, McDonald’s was turning record profits. The U.S. government was running a $19 trillion deficit. Hardly a flight to safety.
So, will markets rise or decline from here?
Short term, who knows? Markets are a pricing mechanism, constantly reconfiguring to adjust to the current fiscal and economic realities. They are capable of drifting lower. Markedly so if geopolitical trouble erupts. But one cannot proactively game that out. One must invest according to the most probabilistic odds.
Yet investors, losing sight of that fact, will continue to suffer from data disconnect. The public, confronted by bad headlines, trouble in D.C., Trump’s tweets, will sell stocks every time CNBC reports weak news. Yet stocks have proven indifferent to D.C.’s vanities. Having recently achieved all-time highs. Leaving investors who’d lightened up, or gotten out to ponder: is it too late to put investment capital back to work?
While the world is, at the moment, economically challenged, investors believe that every data point will send them headlong back to Q4 2008. Though such cycles of panic get us nowhere. In order to create wealth and maintain our fiscal independence, cooler heads must prevail.
Do yourself a favor. Utilize the fear and paranoia to your advantage. Take the ICI fund flow data, and when the public is piling out of equities, buy. When the public is pouring into equities, sell (or hedge).
Run opposite the herd. Because the public is much like every horror movie heroine you’ve ever known. Running into the darkest, most sinister basement closet at every opportunity. Forever doing the wrong thing at the worst time.
The best financial advisors are those who bolster the courage of clients during difficult times. Who can convince clients to do that which they should be doing, as opposed to that which their frayed nerves want to do. Who can steer clients’ thoughts away from the media frenzy, and back towards long-term objectives.
Even in the darkest of times, opportunities arise.
During the carnage of 2008, Treasury bonds. Managed futures. Cash. These asset classes prevailed. As did McDonald’s (+5%), Wal-Mart (+15%), Dollar Tree (+57%), Ross Stores (+15%), EZCorp (+31%), DeVry (+10%), Amgen (+24%) and Genentectch (+23%), among others.
As Jesse Livermore said, the human condition will never change. Investors will continue to vacillate between despair and euphoria. Markets will rise and fall. As in all things, your response to such circumstances will determine your fate.
Because lemmings never die alone. They follow each other, one by one, over the cliff. Yet, for those forward-looking, independent thinkers, opportunity awaits. Opportunities to step away from the herd. To back away from the cliff. To take advantage of the opportunities that arrive with every sunrise. Always recalling that the darkest hour occurs just before the dawn.