Pants down in the melt up
The investment strategy that defies markets.
A few weeks ago, after two largely fruitless hours removing the pedals from my bike, I packed it away with my helmet and a pile of books and headed for the airport, eyes fixed on a distended Christmas gut and a steely determination to ride it off.
New Zealand's south island was my destination, a kind of CGI-land so impossibly beautiful it makes one's heart first sing and then stop, just as the path you're riding turns near-vertical. It hadn't rained in months and the teal-tinged waters of the lakes and rivers were lower than usual, the snow melt supplying enough fresh juice to keep the jetboats happy.
Whilst contemplating the views, it occurred to me how the latter stages of every bull market produce a new vocabulary to justify it. The dotcom boom delivered “first-mover advantage”, “monetising” and a new metric – “profit before marketing costs”. Good one that.
Caption: The view from Middle Earth
In the manner of ardent crypto investors now, non-believers were quickly dismissed with a knowing smile and a parting phrase about “not getting it”. And bankers prior to the GFC were constantly manufacturing bull**it new phrases to justify the bull**it new products they were flogging.
This bull market has produced “the melt up”, to assuage the fears of investors contemplating a meltdown, not of snow from Otago's wonderous peaks, but of richly priced stocks.
The phrase implies we should sit back and hang on for the next upswing. And why not? This is, after all, what many market commentators recommend.
But in a classic case of Wall Street cognitive dissonance, they also think stocks are expensive. Goldman Sachs' David Kostin, for example, towards the end of last year produced this table showing eight valuation metrics for the S&P 500:
Gulp. On almost every measure, US stocks have rarely been as pricey as they are now. So, what does he think investors should do? Hang on of course, because they're going to rise another 10 per cent this year.
Bank of America Merrill Lynch is playing the same game, warning of a major market fall, but not just yet (second half of this year apparently - put it in your diaries). And Wharton School professor Jeremy Siegel, author of Stocks for the Long Run, thinks “we're clearly near to a top” and that returns this year will be less than 10 per cent. “Oh no! Less than 10 per cent! That's a crash isn't it?”
You don't have to go to New Zealand to get away from this stuff, but it helps. Let's set aside Wall Street's self-evident dilemma of having to make silly forecasts at a time of expensive valuations to get media attention, whilst being terrified of calling anything a “sell” in case it jeopardises an investment banking deal.
Let's turn instead to the latest sermon delivered by Howard Marks, not the infamous Welsh drug smuggler, but the High Priest of Oaktree Capital:
“The market seems extremely comfortable with the proposition that as long as the macro-environment remains benign, stocks prices can continue to appreciate at rates that far outstrip the growth of their issuers' profits, and thus the growth of their intrinsic value. Few market participants seem concerned about appropriate valuation levels – the relationship between assets and their prices – and this is a condition that we think must eventually have negative consequences …,” Marks said.
“Today's combination of a stable economy, low interest rates, enormous cash flows and strong investor optimism has created a climate in which capital is available for both good investments and bad, and in which risk is rarely seen as something to be shunned.”
That was written in 1997, three years before the dotcom bubble burst. Which sort of makes the point. Risk is on right now because “few market participants seem concerned about appropriate valuation levels.” That doesn't make it a bubble, but it could be a step on the way to something that must “eventually have negative consequences.”
How should one respond?
Well, you can follow the advice of 1980s fund manager Peter Lynch and “invest with your pants up.” Lynch was always fully invested, aware of the risks of a meltdown but equally aware of the dangers of holding too much cash for long periods. The former is a call on the long-term trend of markets to rise; the latter effectively a call on when a crash might occur.
The second option is like dropping your pants to, say, your upper thighs. The benefit is a cash pile to take advantage of market falls if and when they occur, and avoiding the fall if it does; the opportunity cost is the rise once you've sold and a public display of your underwear.
Wall Street prefers the pants up version because it's more profitable, at least as far as the next quarterly bonus is concerned. But brokers have this in the back of their minds, too:
The last few years of a secular bull market tend to deliver the biggest returns. If the inevitable crash entails a market fall of, say, 30 per cent and for the past three years you've made 20 per cent a year, as long as you can deal with loss aversion, why worry?
Now for the reveal. I'm a pants up sort of bloke – a position fully endorsed by my partner all the time – but not for the reasons suggested by Peter Lynch.
After buying into Apple in mid-2013, I've recently sold down half my holding. Apple was a great example of how Wall Street – obsessed with quarterly numbers at the expense of an understanding of its lock on customers and the power of hardware/software integration – can fundamentally misunderstand a business (see Efficient markets, rotten Apples).
With the stock up 175 per cent since then, I recently halved the size of my holding. I've also sold out of ResMed and South32 and will soon sell out of Computershare. The result is a big increase in my cash holding.
None of these decisions were premised on the idea that markets are expensive, that we're due a recession and that it therefore made sense to sell out.
The macro environment plays a very small part, if any, in our stock analysis. The reason is that if you like to buy cheap stocks, as we do, then it makes sense to offload them when they reach fair value (or come to represent too large a portion of your portfolio). Whether markets are going up, down or sideways makes no difference.
This has a number of benefits. First, it's easier to establish the intrinsic value of a stock than it is to forecast the future direction of markets as a whole.
The former is an imprecise and sometimes fraught process, part art, part science, that works, but not every time. The latter is like asking Aunt Zelda to gaze mystically into her milk-white crystal orb and offer a sign. Better an educated process based on facts and reasoning than a shot in the dark that could knock off your auntie.
The second is that not having to worry about market direction is a wonderfully liberating thing. Removing the need to act on Wall Street commentators' latest brain fart is a real time saver, freeing you up to research actual investment opportunities.
The third is that concentrating on stock valuation effectively resolves the pants up/pants down debate. I like to be fully invested, but not if it means holding a swag of over-priced stocks, or being forced to buy shares that aren't in my opinion cheap. This is what determines the extent of my cash holding, not any notional figure pulled from thin air.
If I can find stocks that I think are attractively priced - and we're still finding them - I'll put the cash released from recent sales to work, regardless of what the market forecasters say. If not, I won't. And if the crash comes, as it inevitably will, and I'm fully invested I'll sell cheap stocks to buy even cheaper ones.
Of course, this entails accepting that your portfolio will take a hit but it also offers a profitable way out. For me at least, it feels like a simpler, more sensible way to go about things, concentrating on what I can control rather than speculating on what I can't.
As we head full steam into reporting season, I hope these random thoughts help. If not, try New Zealand.
Enjoy the weekend.
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