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I Have One Question For Warren Buffett At The Next Berkshire Meeting

I’ve been dying to ask this question of Mr. Buffett for the past few months. After reading his 50th annual letter to Berkshire Hathaway shareholders over the weekend I submitted it to Carol Loomis in hopes she would ask it at the upcoming shareholders meeting:

In November 1999 in Fortune magazine you wrote that you believed the coming decade couldn’t possibly witness returns in the stock market similar to those of the prior decade. That forecast proved very prescient as it preceded what is now called the “lost decade.” Considering the fact that stocks are just as highly valued today as they were then, in terms of your market cap-to-GNP valuation yardstick, do you feel the same about the coming decade for the stock market as you did then? If not, why?

Fingers crossed.

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Don’t Kid Yourself: Stocks Are Just As Overvalued Today As They Were In 2000

As the Nasdaq approaches its 2000 highs people are talking about the similarities and the differences between the market then and now. Most seem to be focusing on the differences, on how much more attractively-priced stocks are today than they were then. From Barron’s:

“What was propelling the Nasdaq in the year 2000 was a dream. What’s driving the Nasdaq today is reality,” says Gavin Baker, who runs the Nasdaq-focused Fidelity OTC Portfolio fund (FOCPX). “The current valuation is very well supported by earnings and cash flows and if those earnings and cash flows continue growing, the Nasdaq should continue going up.”

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The article continues by predicting the index not only surpasses the 5,000 mark but surges as far as 7,000 in “coming years.” This is certainly possible but using the table above to make the case that the Nasdaq, or stocks generally, are cheaper today than they were then is just faulty.

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The internet bubble was characterized by incredible euphoria and unbelievable valuations in just one group of companies. What investors fail to recall is that at the same time there were incredible values to be had in other sectors. The “old economy,” “bricks and mortar” companies had been left for dead as investors believed the internet revolution would put them out of business.

We don’t have a sector today that is nearly as overvalued at the tech/internet sector was in 2000 but we also don’t have any sector that is significantly undervalued:

In fact, virtually every sector is historically overvalued. This is why active managers and value investors are pulling their hair out right now:

Rather than prove that stocks are cheaper today, that first chart above from Barron’s merely demonstrates why the stock market appeared to be more expensive back then even if it wasn’t. Because the indexes are market cap weighted, that relatively small number of incredibly overpriced companies in 2000 skewed the overall valuation of the market much higher than was true for the majority of stocks in the market and obscured the segments of the market that were actually cheap.

If we look at median valuations of the market then and now we see a completely different story. The median number, rather than the aggregate number, is a much better indicator of the valuation of the average stock in the market because it eliminates the bias of market cap weighting toward only the biggest companies. Whether you look at price-to-earnings or price-to-cash flow, the average stock in the market has never been more highly valued than it is today:

Screen Shot 2015-02-24 at 1.12.15 PMScreen Shot 2015-02-24 at 1.12.32 PMCharts via Wells Capital

So don’t kid yourself. Stocks aren’t any cheaper today than they were at the height of the internet bubble. What’s truly “different this time” is that, rather than seeing incredible overvaluation confined to just one segment of the market, it is far more pervasive than it was back then. In my view, this also makes it far more insidious.

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Investors Are Still Not Impressed With The Long Bond

Everyone’s talking about how the stock market has recently broken out to new highs. I’ve heard no mention, however, of the breakout in the long bond. In fact, this might be the most hated breakout I can remember.

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What I find most fascinating is that even with this recent pullback, the long bond has absolutely crushed the stock market in terms of performance over the past year or so and it continues to be scorned while stocks continue to be loved!

We regularly see panicky headlines like this:

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…and this:

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The latest survey from BAML shows fund managers are still way overweight equities and way underweight bonds.

Screen Shot 2015-02-19 at 5.09.26 PMChart via Fat Pitch

Retail investors are also very bearish. Take a look at the top bond ETFs by assets and you’ll see that the two most popular funds are bearish funds. Between the two of them they have more assets than the top ten bullish funds combined.

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On a shorter sentiment time frame, DSI shows an incredible surge in bearish opinion of the long bond right now.

Do bull markets like this one ever end in this sort of fear and skepticism? Where’s the euphoria that typically marks the end of a bull market? Until we see it I’m still under the impression that if there’s an asset class that’s going to “blow off” it’s more likely to be bonds than stocks.

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I’m Not Trying To Scare You. I’m Trying To Help You.

I’ve been accused lately of being a perma-bear, of trying to scare people and of being downright gloomy. It is not my intention to scare people. I’ve been consistently striving to inform people so they can be adequately prepared for what is the simple mathematical reality of the markets going forward.

By now, I’m used to these sorts of responses. People looked at me funny and called me names back in summer 2005 when I started warning about the real estate market. They did so again, in March of 2009 when I told people that the “opportunity of a lifetime” was staring them in the face.

And it’s not just me trying to share the bleak message of the markets today. Nobel prize-winner, Robert Shiller, has written as much in the latest edition of his seminal book Irrational Exuberance. Jeremy Grantham, Ray Dalio and others have also recently  informed us of their depressing forecasts for both stocks and bonds over the coming decade.

The reason I seem so bearish today is that I feel the current risk/reward equation in the stock market presents investors with all risk no reward. Valuations, across a variety of metrics, suggest stocks are roughly 80% above their long-term average.

valuation-indicators-arithmeticChart via Doug Short

This means the best possible return from stocks is roughly, 3.5% per year, in line with long-term earnings growth as valuations and profit margins remain at elevated levels for the foreseeable future. The worst case scenario sees stocks falling roughly 40% by 2025 as valuations contract to historically low levels. Before you dismiss the latter possibility you should know that the San Francisco Fed sees it as a real possibility.

In fact, owning equities today, even as a passive investor, can’t even be called “investing.” In The Intelligent Investor, Ben Graham defined it this way:

An investment operation is one in which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

With valuations so high and potential downside so great, you simply can’t argue that there is any “safety of principal” in stocks today. In addition, the most valuable measures, including Warren Buffett’s favorite, suggest returns from stocks going forward will be roughly 0% in real terms so they provide inadequate return.

Ultimately, owning stocks today is speculating the market will do well in spite of the overwhelming evidence to the contrary. If you want to play that game, of course that’s your prerogative. But you should do it with your eyes wide open and knowing the truth, not by deluding yourself into believing you’re investing or some similar sort of notion. And that’s all I’m trying to do, inform you of these realities.

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“The Wisdom Of Insecurity” In The Stock Market

Over the past few years, the idea of “passive investing” has increasingly resonated with the general public. Money has rushed out of actively-managed mutual funds and into index funds at a rapid rate. Most recently, the passive investing ethos has grown so strong it now reminds me of some hard-core religions that take an unwaveringly literal interpretation of their founding texts.

In the case of passive investing, these founding texts are the “efficient-market hypothesis” (EMH) and “modern portfolio theory” (MPT). Created and developed by ingenious men with noble intentions, these theories put forth wonderful arguments for the wisdom of the crowd and the incredible value of diversification, among others.

Like most religious texts, however, the main problems arise in their interpretation and implementation. As Alan W. Watts explains in The Wisdom Of Insecurity, “the common error of ordinary religious practice is to mistake the symbol for reality, to look at the finger pointing the way and then to suck it for comfort rather than follow it.” Investors, too, must think critically about the effectiveness of these theories when it comes to practical application rather than take them literally on blind faith.

It pays to remember that blind faith in these sorts of mathematical models leads even nobel prize winners to disastrous results. As my friend Todd Harrison likes to say, “respect the price action but never defer to it.” Clearly, there is value in understanding and incorporating the ideals of these theories. There is also danger in simply deferring to them because the costs of their shortcomings can, at times, overwhelm the benefits of their wisdom. Like the Long-Term Capital boys learned, as soon as you really need to lean on them they vanish like a cheap magic trick.

Where these theories go wrong in their practical application is that they both assume there are only rational participants in the markets. While the crowd may be right most of the time, there are clearly times when the crowd is not rational (note the preponderance of manias throughout the history of finance). In fact, the proprietors of these models have acknowledged this Achilles’ heel themselves.

The most successful professional investors like Warren Buffett, Paul Tudor Jones, John Templeton, George Soros and Jim Rogers, know this well. Their methodologies are even built upon the idea that an intelligent investor can get ahead by taking advantage of those times the crowd becomes irrational, the antithesis of the EMH and MPT.

So saying you believe in passive investing is fine and, in fact, I’ll grant it’s better than most of the alternatives. It will work great most of the time. But know that, just like some fanatics deny evidence that disproves the idea that cavemen and dinosaurs coexisted, you are denying the overwhelming evidence that suggests its foundations are simply not to be relied upon during those rare times when market participants abandon rational thought for panic or euphoria.

Make no mistake, those selling this idea of passive investing are selling a very good product. I firmly believe it’s a large step above most of the alternatives out there, more so in the case of those selling it at a minimal cost. But I fear investors are also being sold a false sense of security today.

I believe investors passively buying equities today are doing so under one of two false assumptions. They either believe that future returns will look something like they have over the past 40 years or that because the market is totally efficient it’s currently priced to deliver risk-adjusted returns that are acceptable given the current low-yield environment.

The first assumption is something I have called the “single greatest mistake investors make” and it’s a trap even the Federal Reserve admits it regularly falls into. The second assumption runs into the problem of the evidence which suggests there is a very good likelihood returns from current prices will be sub-par, if not sub-zero over the next decade.

And the reason returns are likely to be poor going forward is investors have pushed prices to levels that nearly guarantee it. In my view, passive investors have irrationally relied upon the idea that the market is rational, and therefore attractively priced, in pouring money into equity index funds, sending equity values to heights never before seen (on median valuations) virtually guaranteeing themselves they’ll be disappointed.

Just because the future of the stock market is bleak doesn’t mean investors should ignore these facts or have them withheld from them. Ignorance may be bliss but it is not a valid investment methodology. Those with a religious sort of belief in passive investing and its main tenets need not abandon it to acknowledge its limitations. In fact, a little insecurity would go a long way for the growing hoard of passive investors in today’s market.

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