Photo: Henning Schlottmann. Source: Wikipedia
One of the most reliable ways to perform well in our unpredictable markets is to find something that everyone believes and take a position outside of that consensus. In other words, to find a contrary opinion. Because when everyone believes something, and it’s priced accordingly, there’s often profit to be made on the other side.
For example, everyone knew in 2006 that housing prices don’t come down. If the price falls, people just take their homes off the market and the supply goes down, allowing the market to clear. But that logic didn’t take fraudulent liar-loans and massive foreclosures into account. The housing crisis was the result.
Another example comes from the bond market. Ten years ago many investors were convinced that rates just couldn’t fall much further. The long-term trend towards lower yields seemed to have been broken. Bond guru Bill Gross announced that he was a “bear market manager,” as 10-year US Treasury yields topped 5%. We know how that story went. 2007 may have been last chance for investors to purchase 5% bonds in a long, long time. Bonds may not be in a bull market any more, but the bears have yet to come out of hibernation.
What’s the consensus opinion now, that everyone is convinced must be true? In my view, it’s the so-called overvaluation of everything. Whether we look at book values or cash flow or long-term core earnings, the experts are all complaining about how there’s no value left in the market, that future returns have to be lower, that everything is overpriced. But what if we’re on the verge of an earnings and cash flow renaissance?
The 10-year Cyclically Adjusted PE Ration (CAPE) puts the S&P 500 at 31.5 times its average earnings over the last decade, a measure designed to smooth out economic booms and busts. The market hasn’t seen these levels since the late ‘90s or late ‘20s, not very encouraging signs. But we all remember what happened ten years ago: the worst financial crisis since the Great Depression and a long, slow, L-shaped recovery – combined with a double-dip recession in Europe. What happens when the years of recession and recover roll off the 10-year CAPE calculation? What’s so special about 10 years? Why not 7, or 20? Economies change.
Shiller CAPE Ratio. Source: Multpl
The market’s 15% rise thus far in 2017 has been supported by solid fundamentals. Revenues are growing by over 5%, and earnings by over 10%. Margins are improving, driven by more efficient production and innovative designs. And this has nothing to do with politics, tax reform, the Fed, or other click-bait headlines. This is just dull, boring corporate earnings, the kind of news buried on page B24 in the newspaper, or page 5 of a Google search.
Mark Twain noted that it’s not what we don’t know that gets us in trouble, it’s what we know for certain that just isn’t so. Always remember that the stock market represents real businesses. All the complex ratio analysis and talking heads won’t change that. We do have to be careful being contrarians, though. A hundred years ago, the market for buggy-whips never came back.
Douglas R. Tengdin, CFA