Stocks entering dangerous zone
I don't know if others get the same feeling but stocks appear to be entering a dangerous zone. Valuation just doesn't seem to be attractive. This has been the case for more than year but now it's much worse IMO. The following chart from dshort.com of the 10-year cyclically-adjusted P/E (CAPE) ratio (aka Graham-Dodd P/E ratio) shows the present state (as of April 2011):
Some people don't believe in CAPE but I think it is a better measure than most. It can't be used to time anything in the short to medium term but it likely allows you to avoid the extremes.
CAPE of around 23 is quite high from a long-term historical point of view, although bulls argue that profit margins are higher now than the past and interest rates will be persistently lower.
Another rough indicator of valuation is to gauge the opinion of classic value investors (who follow the Benjamin-Graham-style of investing). Classic value investors tend to have very conservative, strict, criteria for selecting stocks and hence their investment universe tends to be a small sub-set of the whole universe. Most of their selections tend to be in penny stocks and microcaps. Many microcaps and smallcaps are trashy businesses with dubious corporate governance, poor profitability and/or long-term market strength.
If classic value investors see their universe shrink (i.e. market bids up the value of their stocks and out of their criteria range) then it is possible the market is reaching serious overvaluation. Rising tide tends to lift all boats, and when low-quality boats start rising, it may be time to avoid fishing in the ocean.
I notice some early signs from two classic value investors that their investment opportunities are drying up.
Jonthan Heller blogs at Cheap Stocks and tends to focus on stocks trading below NCAV (net current-asset value). He commented earlier in April that net-nets are "rarer than a blue moon."
ShadowStock also casually mentions how opportunities have dissapeared:
Some people don't believe in CAPE but I think it is a better measure than most. It can't be used to time anything in the short to medium term but it likely allows you to avoid the extremes.
CAPE of around 23 is quite high from a long-term historical point of view, although bulls argue that profit margins are higher now than the past and interest rates will be persistently lower.
Another rough indicator of valuation is to gauge the opinion of classic value investors (who follow the Benjamin-Graham-style of investing). Classic value investors tend to have very conservative, strict, criteria for selecting stocks and hence their investment universe tends to be a small sub-set of the whole universe. Most of their selections tend to be in penny stocks and microcaps. Many microcaps and smallcaps are trashy businesses with dubious corporate governance, poor profitability and/or long-term market strength.
If classic value investors see their universe shrink (i.e. market bids up the value of their stocks and out of their criteria range) then it is possible the market is reaching serious overvaluation. Rising tide tends to lift all boats, and when low-quality boats start rising, it may be time to avoid fishing in the ocean.
I notice some early signs from two classic value investors that their investment opportunities are drying up.
Jonthan Heller blogs at Cheap Stocks and tends to focus on stocks trading below NCAV (net current-asset value). He commented earlier in April that net-nets are "rarer than a blue moon."
Just when you think that the ranks of net/nets can't get any smaller, they do just that. This site was originally dedicated to the identification and research of companies trading below net current asset value, and at the time of launch in 2003, was the only site, at least that we were aware of, that covered net/nets.Jonathan Heller ascribes the rarity of net-nets to increased investor interest in the segment. No one is investing in these companies because they hot and popular. In fact, they are rarely ever mentioned in the press and hardly anyone will ever hear of them. If investors are seeking these companies, it is likely because investors are reaching for yield/returns anywhere they can. I would find it hard to believe that many are seriously interested in this segment.
Since then, interest has grown, and there are several websites that now cover net/nets. All of this coverage has brought the concept more into the mainstream. Ten years ago, net/net was a foreign term, even to some value investors. That's not so much the case any longer.
We believe that all of the additional coverage along with rising markets, have acted in tandem to reduce the universe of net/nets.
At ths writing, we can only identify 2 net/nets with market caps above $100 million, ADPT Corp (ADPT) and perennial net/net Audiovoxx (VOXX).
It's not much better between $50 million and $100 million. There, we find Myrexis (MYRX), Gencor Industries (GENC), Parlux Fragrances (PARL), Heely's (HLYS), Integrated Electrical Services (IESC), Trans World Entertainment (TWMC), and Planar Systems (PLNR).
We are starting to sound like a broken record, but that's the fewest number of net/nets we ever seen above $50 million in market cap.
ShadowStock also casually mentions how opportunities have dissapeared:
Leading Indicator ?: Scarce Supply of Deep Value OpportunitiesAll this is just anecdotal evidence but it pays to be cautious.
couple this with no real insider buying for value based micro cap stocks.
I’m not a macro base stock market prognosticator but I can’t ignore the data I’m working with and insider buying and deep value opportunities are far less available. Ben Graham spoke about this and recommended when lack of value opportunities become more obvious its time to think about asset allocations. He meant consider raising your cash level.
I’m not recommending raising cash but recently I’ve been developing techniques to mine data for short opportunities.
I agree. Stocks as an asset class look un-attractive, and near the high side of historical norms. Stocks could fall 50% or more before they reached the low side of historical norms.
ReplyDeleteI am not sure, however, if stocks are irrationally priced, since I would still rather hold stocks than cash or bonds (whether gov't, corporate, or municipal).
The only asset class that looks cheap is real estate (at least in certain areas of the US).
If you want to know why stocks are somewhat irrationally priced, it's because people, in this case some gentleman whose initials are PB ;) , says stuff like this: "I am not sure, however, if stocks are irrationally priced, since I would still rather hold stocks than cash or bonds (whether gov't, corporate, or municipal). "
ReplyDelete(nothing personal ;) )
One of the popular ways bubbles are justified is to use relative valuation; compare them to other assets. Just because others are overvalued doesn't mean the least overvalued is safe. Although not an easy decision to make, I still think cash is the safest asset.
Unfortunately, cash is a terrible asset class if held for the long term.
ReplyDeleteIf you had to hold an asset for 10 years, which would you choose? Cash? Stocks? Bonds?
I think stocks, while not attractive, are still the obvious choice for a 10 year holding period.
It seems to me that cash is a rational alternative primarily for its option value. No one wants to be in cash long term, and the idea of being in cash now is to get a better deal on other asset classes within the next few years.
I used to think holding cash is kind of lame, but have since come around to liking the option value that you cite. The option value is very powerful (although I have never used the power of cash yet).
ReplyDeleteFurthermore, if you are a contrarian-type investor, holding cash is consistent with your strategy. The reason is because your execution, if successful, almost guarantees that you will buy something cheap. In contrast, if you were a passive investor, holding cash doesn't mean anything. Or if you were a growth investor relying on the Greater Fool Theory, high cash levels doesn't really assist your investment strategy.
Parker BohN: "I think stocks, while not attractive, are still the obvious choice for a 10 year holding period."
ReplyDeleteI have a horrible record of late but for what it's worth, I don't share your stance. I would definitely not say stocks are the better choice for the next 10 years.
If you look at someone like Jeremy Grantham, he is forecasting something like 3% real return for the next 7 years or so (US large-cap stocks; for smallcaps it's even worse). Grantham isn't always right and even if he is off, his number probably a good guess. From a long-term point of view, this is a horrible number.
The interesting thing to me is that Grantham is forecasting around 3% for US large-caps yet large-caps are not that expensive on a trailing & forward P/E basis. In contrast, bears were forecasting low returns in the late 90's but valuations (P/Es for instance) were sky-high.
It seems like deja vu... almost as if we are back in 2006.
Given all these question marks, I prefer cash over stocks. STocks look very dangerous to me. In fact, I can see the whole commodity complex collapsing 50% within a short period of time (like in 2008).
Hmm.... let's say that Grantham is right and 3% real is the correct number for stocks over the next 7 years. That's maybe 6% nominal return.
ReplyDeleteOn cash you're getting what, maybe 1% or 2%? The risk of cash is that it is priced to trail stocks by 4-5% per year and give a probable negative real return.
But then I do agree that stocks look very risky, and cash does have a terrific option value, so its not an easy decision. You just need to realize that you are paying a premium (just like in the actual option market) of reduced expected return in order to capture that option value.
It is interesting to see that the option market arrives at the same number. The annualized premium to completely hedge the S&P 500 on the long-dated contract is about 5%.
ReplyDeletehttp://quote.morningstar.com/option/options.aspx?ticker=SPY®ion=USA
Parker Bohn: "But then I do agree that stocks look very risky, and cash does have a terrific option value, so its not an easy decision. You just need to realize that you are paying a premium (just like in the actual option market) of reduced expected return in order to capture that option value."
ReplyDeleteExcept the cash, at least IMO, is an out-of-favour, contrarian, position. Chances are the market is "undervaluing" cash. Holding cash now would be very different from holding it during crisis periods.