The author of that post suggests that the CAPE is useless for comparisons since FAS 157 changed accounting for fair value. A review of other posts recently made by the author indicate that he is fairly bullish on not just the market, but also the economy.

I am a rational optimist and I would like to be as optimistic as “valueplays”, but he is wrong to assume that the reason for the concern about market valuation is merely because of the level of the CAPE. As I have written in more detail before, and even indicated in that last post, it is the other statistics that consistently corroborate the CAPE that indicate there is not something fundamentally different about this period compared with prior periods.

Consider, for example, Tobin’s Q ratio, which measures the market’s price relative to the replacement cost of the assets for all of the companies in the market. It is higher than at any time in history bar the dot com bubble when investor psyche went overboard on “it’s different this time” thinking.

Notice that Tobin’s Q is not a straight measure of corporate book value, for which it is possible that one component–retained earnings–could be distorted by FAS 157. Tobin’s Q is an estimate of the cost to replace the assets that are already in productive use. It may not be perfect, but it corroborates the implications of the CAPE.

Consider, also,  Warren Buffett’s favorite indicator of market valuation known as Buffett’s P/E given by the following ratio:

(Market capitalization) / (Nominal GDP)

Notice FAS 157 would have little influence on nominal GDP. Buffett’s P/E is more than two standard deviations higher than it’s average since 1950. Again, the only time it has been higher was during the ridiculous dot com bubble.

I have also written that the recovery has been weak based on my favorite employment statistic. But, earlier this month ”valueplays” saw “Positive Signs Everywhere“. I certainly hope he is correct, but this market looks to me like it is one misstep away from a long fall based on the above statistics and:

1. Total debt is higher than at any time in history (there was no de-leveraging);
2. Interest rates are lower and the Federal Reserve Balance Sheet is higher than any time in history. The Fed is practically out of bullets; and
3. Corporate profits–the most mean-reverting statistic in finance according to Jeremy Grantham at GMO–are as high as they have been in history;

Invest accordingly.

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We still have some way to go before asset prices normalize for the S&P 500 index, which makes up about 90% of US stock market capitalization. The CAPE and all price-to-fundamental ratios like it (e.g. Tobin’s Q, Buffett’s PE, etc.) are still high and they are all higher than their long-run averages by about the same percentage. That consistency reinforces the notion that it’s the market’s price that is the issue and not that there is something fundamentally different this time with respect to earnings, free cash flow or the replacement cost of business assets.

The CAPE is 24.90 after (last week’s) drop in the S&P 500 to 1970.89. Even if we generously assumed that real S&P earnings for the most recently available month (March 2015’s $100.57) was the proper figure to use in the denominator (as opposed to the lower real $79.13 S&P earnings over the last ten years), the S&P 500 index could still fall another 15% before the CAPE reached its long-term average (16.63). Unfortunately, no one knows when it will regress back to that level. It is impossible to predict it.

In addition, few consider that maybe the current CAPE average is too high. Both the numerator and denominator in the CAPE are adjusted for CPI inflation, so it reduces the ratio to long-run fundamental market and business activity. The CAPE averaged 14.78 from January 1881 through December 1994, which is 11% less than today’s CAPE average since 1881, largely because today’s CAPE average includes the greatest bubble in the market’s history (the dot com bubble). That suggests the S&P could fall 25% from 1970.89 even with the generous earnings figure used for the denominator.

PAR does not care about the market as a whole when it invests client funds in its Separate Account Value Investing (SAVI) strategies, so PAR is not investing as if the market were going to drop another 25%. PAR is still looking from the bottom up for SAVI  clients because that is the way to uncover opportunities that have an MOS, but there should be no surprise that there are far fewer opportunities when the CAPE is 24.9, like today, than when the CAPE is 13.3 as it was in March of 2009.

March 2009  was the last time PAR became fully invested. Most of those new positions in which PAR invested in 4Q08 and 1Q09 to become fully invested were gradually liquidated over the subsequent twelve- to eighteen-months and have largely sat in cash  since. PAR’s SAVI strategies are only a small part of PAR’s clients’ portfolios.

PAR Wealth Management also offers traditional wealth management services as a fee-only fiduciary. PAR Wealth Management is a goals-based financial adviser. Once a client’s goals are quantified and prioritized, PAR Wealth Management allocates that client’s capital to investments with qualities that match those specific goals and how a client feels about risk. Capital for short- and intermediate-term goals are generally allocated to safer, more-liquid investments. For a large percentage of a client’s long-term goal allocation, PAR Wealth Management generally chooses external managers who demonstrate an ability to capture factor premia.

Update 8-24-15: I do not want to leave the impression that the only way for the CAPE to normalize is for the S&P 500 to drop precipitously. The other way is for the denominator–earnings–to rise considerably. But, the denominator will not rise without growth in value-creating economic activity in the private sector, and that takes time. Value-creation has been stagnant since 2008 and there is little on the horizon to suggest that the private sector will turn robust. In any case, the numerator (the level of the S&P 500) would have to rise much slower than the denominator. So, either way, whether it is a numerator that falls or a denominator that rises or some combination, it portends low stock market returns over the next decade. As I have written before, invest accordingly.

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The first statistic is a macroeconomic indicator called the Employment-to-Population Ratio (E/Pop, to distinguish it from E/P or earnings yield). I prefer E/Pop to all other employment-health indicators because, unlike the unemployment and labor force participation rates, it takes the least amount of manipulation to calculate it.

E/Pop is simply the number of adults (16+ YO) employed in the US divided by the number of people 16+ living in the US who are not in institutions (jail, mental health facilities, etc.) or in the military. No one has to guess whether these people are “looking” for work or really “participating”. It measures the  number of people truly working relative to the number of us relying on those who are working to pay our collective bills. After all, the money that pays our bills can only come from people who produce; it is not created from thin air.

If there is a weakness in this indicator, it is that it overestimates economic strength by including in the numerator those who work part time, especially now when the proportion of part time workers is elevated.

http://www.advisorperspectives.com/dshort/updates/Full-Time-vs-Part-Time-Employment.php

Robust economic conditions are indicated by relatively high E/Pop ratios and weak conditions by relatively low E/Pop ratios.

The E/Pop has indicated that the economy is weak and that this “recovery” since 2007 could easily be labeled “stagnation”. The E/Pop plummeted in the housing crisis and despite unprecedented fiscal and monetary stimulus, it has barely gotten off the mat since. May’s reading announced today is 59.4%. The last time (before the current stagnation) that it was this low was in April 1984 when the economy was still digesting Paul Volcker’s attempt to choke off the inflation debacle of the late 1970s.

The second statistic–one that continues to worry me about the stock market–is Robert Shiller’s Cyclically Adjusted PE (CAPE) ratio. The latest reading shows that the stock market’s price equals 27.38 times its trailing ten-year earnings. The last time it was this high was July 2007, almost to the day that the housing crisis began and about one year before the stock market plummeted in response. It was higher only twice before in history, just before two of history’s most terrifying market crashes.

I write about these “macro” themes because, as Howard Marks says, it’s important for “intelligent investors” to know where the economy and market stand as they go about their business of evaluating businesses one-by-one and determining whether they can purchase those businesses at prices that deliver a Margin of Safety. Since 2011, the level of the CAPE helps explains why investors have found so few opportunities that possess a Margin of Safety. Invest appropriately.

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The S&P 500 Index delivered a 13.69% return in 2014 as the market continued to reach new highs after reaching new highs in 2013. This year, for the first time, I have highlighted the years corresponding with the inflation and bursting of the DotCom bubble (grey) in addition to the Great Depression (yellow) and the Housing bubble (blue).

Clearly, there were more extremes and more years of extreme results during the Great Depression than the two most recent crises. In eight of the years from 1928 through 1938, the market either lost or gained more than 30%. In contrast, in each of the DotCom and the Housing bubble periods, the market had just one year of such an extreme.

There were obviously more extremes and more years of extreme outcomes during the Great Depression than the two most recent crises. Over the eight years from 1928 to 1938, generic cialis sales grew by 40% and you can read more about these successes on the main page of our website.

In half of all years since 1825, the market delivered a return between -10% and +10%. So, if we narrow the definition of extreme to losses or gains of more than 10%, the Great Depression experienced nine such years, the DotCom bubble five, and the Housing bubble five.

Many argue that the Federal Reserve is getting better at managing crises, and the above data would seem to agree. The Great Depression was the first crisis that the Fed experienced and many recent policy makers, including Ben Bernanke, went to school on Great Depression policy. On the other hand, others argue that the mere awareness of a Federal Reserve “put” is creating crises that future Fed policy will be unable to fix. I guess we will know who is right soon enough.

The return mode is still 0% to 10%. In a large majority (71%) of years, the market is positive. And, the market experiences declines of 10% (20%) or more in a mere 13.7% (4.9%) of years. So, an outsider’s perspective indicates that investing in the broad market is clearly in your favor, in part because of natural inflationary increases, and in part because of real increases in productivity and earnings due to technological and human capital advances.

The insider’s perspective is a different story. As of January 19, 2015, Shiller’s CAPE sits at 26.7, which is 61% above the average CAPE of 16.6 since January, 1881. The only periods in which the CAPE was higher than today were 1929 – 1930, immediately before the Great Depression; late 1996 – 2002, immediately before and after the DotCom bubble burst; and from late 2004 – late 2007, immediately before the bursting of the housing bubble. So, the CAPE is not a great short-term timing mechanism because recent extremes were able to persist for long periods, but it is an excellent indicator that the piper has to be paid eventually.

Other market indicators including Tobin’s Q and Buffett’s PE confirm the implications of Shiller’s CAPE. Investors who were cautious in periods like this had dry powder to exploit market declines. Investors who chased returns in periods like this rode the market without a brake (a hedge) and often only got off the ride by jumping off at market lows.

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Hire advisors who understand risk and know how to manage it well.

The Market from the Top Down, the Federal Reserve, and the Economy

PAR’s pessimism is due to a dearth of bottom-up bargains. (Few businesses can be purchased at prices that deliver a margin of safety.)

A top-down analysis reveals a significantly overvalued market, which merely confirms the dearth of bargains. Shiller’s CAPE, Buffett’s PE, Tobin’s Q, and profit margins are at or near all-time highs (other than during the dotcom bubble) while interest rates are near historic lows.

Shiller’s CAPE

As of July 3, the CAPE was 26.6, which would require a 31% drop to reach its post-war average of 18.4 (including the dotcom bubble in that average).

Shiller’s CAPE (S&P 500 Index /10-Year Average Earnings)

Source: Multipl.com and www.econ.yale.edu/~Shiller/data.htm

I have been writing about the CAPE for a while in letters and on my blog. Although it has been above its long-term average since early 2009 (and for most of the time since 1990), it is not a good indicator for short-term market timing.

At these CAPE levels, stocks are unlikely to deliver much more than low single-digit returns per year over the next decade and the market is vulnerable to large corrections. Since 1881, with the exception of the dotcom bubble, every time that the CAPE reached 24 (April 1901, November 1928, and January 1966) inflation-adjusted losses of 29% or more followed within 4.5 years and peak-to-trough losses were much higher. In this cycle, the CAPE first reached 24 in November 2013. But the market has also severely corrected when the CAPE was lower than 24.

William Poundstone wrote the following in his latest book, Rock Breaks Scissors:

“Today’s investors have every right to feel cursed. They have had few opportunities to buy at average (CAPE levels) much less low ones…The average return at (a CAPE of 23) is something like 2 percent over the coming 20 years. Never has the twenty-year stock market returned as much as 3 percent annually (after inflation) when the (CAPE) was 23 or higher.”

Largely because of the CAPE level, as of May 31, 2014, GMO thinks that US large-cap and small-cap stock real returns will average -1.5% and -4.5%, respectively, each year for the next seven years.

Market Cap-to-GDP (AKA Buffett’s PE) 

Buffett’s favorite measure of market price-to-earnings is the ratio depicted in the chart below, which indicates that the market is about 45% overvalued.

Source Listed in Chart

GMO believes that whenever a measure of market prices (relative to market fundamentals) is two standard deviations from its long-term average, then that market is in a bubble. According to GMO’s definition, Buffett’s PE indicates the market is currently in a bubble. However, Grantham prefers the CAPE (along with other measures) over Buffett’s PE and he believes the S&P 500 will not enter bubble territory until it reaches about 2,250. As of July 4, it’s only 13% away from that mark. 

Tobin’s Q

Tobin’s Q Ratio is a measure of the market’s price-to-book ratio. It equals market value relative to the cost to replace the assets of the businesses in the market. The numerator is the same as the one in Buffett’s PE Ratio. The Q indicates that the market is about 41% overvalued.

Source Listed in Chart 

Profit Margins

Corporate profit margins are at all-time highs. Because high profit margins attract competition in free markets, Jeremy Grantham of GMO calls margins the most mean-reverting statistic in finance and economics. If margins decline, EPS will decline, leading to a decline in stock prices. 

Corporate Profit Margins

Source Listed in Chart and dshort.com

John Hussman of Hussman Funds notes that investors who pay high prices for high profit margins are almost always disappointed in profit growth later.

Source: Hussman Funds

Interest Rates

Interest rates are important because declining rates translate into a higher present value of cash flow, which translates into higher asset prices. It is hard to imagine rates falling much more from here after the 33-year bull market in bonds, but it is easy to imagine rates rising, which will cause present values (and markets) to decline, all other things being equal. 

Source Listed in Chart

The Federal Reserve

“This goes down right now as the mother of all reflation strategies by the Federal Reserve…The cycle starts off with asset inflation, followed by credit inflation, followed by price inflation, and then by wage inflation.” –David Rosenberg, on CNBC’s Squawk on the Street 6/24/14

It appears that a major reason for the market’s rise since 2010 has been the extraordinary measures used by the Federal Reserve to offset the effects of the financial crisis. Quantitative Easing 1, 2, and 3 (QE) has created an environment for company stock buybacks and M&A activity largely by lowering the cost of corporate debt issuance to finance buybacks and M&A. 

In 2013, S&P 500 company buybacks totaled $477 Billion, the most since the 2007 peak. Fortuna Advisors estimates that since the 2009 lows, buybacks juiced cumulative returns from a natural 80% to a steroid-like 178% reached in the first quarter of 2014.

(http://www.washingtonpost.com/business/corporations-cant-stop-gobbling-up-their-own-stock/2014/05/09/83c8ddb0-d6e6-11e3-aae8-c2d44bd79778_story.html)

Of course, it is what happens at the margin—the last trade—that determines your portfolio value. The stock of corporate buybacks over the last three years will be of little consolation in a declining market unless you have already sold into buybacks and are holding the proceeds in cash. 

Further evidence of a Fed-fueled market include: 1) margin debt used to purchase equities is as high as in the dotcom bubble; 2) the junk bond market has been raging again; and 3) IPOs—insiders who want to cash out before the punch bowl is pulled away—are as high as in the dotcom era. 

Correlation is not causation, but there is good reason to believe the Federal Reserve’s extraordinary balance sheet expansion since the crisis (depicted below) is responsible for much of the froth.

Source: ZeroHedge.com

A 2000 publication from the CFA Institute’s Research Foundation studied asset class returns during periods of expansionary and restrictive monetary policy. It should give pause.  

The study (http://www.cfapubs.org/doi/abs/10.2470/rf.v2000.n3.3912) covered the years 1960 through 1998. The average monthly nominal stock market return in expansionary periods was 1.64%. The average in restrictive periods was 0.38%. All eleven periods of expansionary monetary policy over those 38 years resulted in a positive monthly average real return, but five out of the ten (50%) restrictive periods resulted in negative average monthly real returns. Clearly, the maxim “Don’t fight the fed” has a lot of truth in it.

David Tepper

One investor who refused to fight the Fed was the highest earning hedge fund manager in 2013. On September 24, 2010, David Tepper presciently said the following on CNBC:

“Either the economy is going to get better by itself in the next three months…What assets are going to do well? Stocks are going to do well, bonds won’t do so well, gold won’t do as well…Or the economy is not going to pick up in the next three months and the Fed is going to come in with QE (and the stock market will rise because of that).” 

Tepper repeated that analysis several times into 2013. Today, we know he was right because the Fed came to the rescue with QE several times. 

So, it should be a concern that the Fed has already begun to pull back. QE is tapering and will likely end by October 2014, and three of the seventeen Federal Reserve officials responsible for setting the fed funds rate believe it will rise in 2014. Twelve think it will rise in 2015. Only two of the seventeen believe fed funds will not rise until 2016. Nine of the seventeen believe the fed funds target rate will rise from its current 0%-0.25% to at least 1% next year. Three believe it will rise to 3% or higher, which would be a striking change. 

(http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf).

But, make no mistake, whenever the fed funds rate rises, many investors will be surprised. According to the Research Foundation’s Fed study, the average equity return following a Fed interest rate policy increase was most pronounced in the month of the policy change, indicating that it wasn’t expected. The second-most pronounced effect of an increase came in the next month following the policy change. For the first month in a tightening period, stocks declined an average 2.05%.

So, what does Tepper think now? At the SALT Conference on May 14, 2014 he said:

“…there (are) times to make money and there (are) times not to lose money. This is probably (a time when) you’re supposed to think about preserving some of your money. If you’re 120 percent invested, it’s probably too much. You can still be long, but you probably should have some cash…I am nervous. I think it’s nervous time.” 

Tepper’s fund cut its net long exposure from 100% in December 2013 to 60% in May 2014.

(http://www.cnbc.com/id/101674055) 

Employment

While the market rose 144% since January 1, 2009, the underlying fundamentals of the economy have been weak, which is further evidence that the market has been largely driven by the Fed. GDP declined in the first quarter by a whopping 2.9%. Bad weather cannot explain the long-term weakness in the ratio of Employment-to-Population (E/Pop), which has barely budged from the nadir (58.2%) since the crisis abated. The chart of this ratio does not look like an economy that can justify a 144% rise in the S&P 500 Total Return Index since January 1, 2009 or 178% since the nadir. 

Ratio of Employment-to-Population (January 2006 through May 2014)

Source: BLS

Unlike the unemployment rate and the Labor Force Participation Rate, the E/Pop ratio implicitly assumes that every unemployed person of working age is looking for work. It may be the best indicator of economic robustness. The E/Pop has not been this low since the effects of the “malaise” of the 1970s, yet the S&P 500 Index has hit all-time highs dozens of times already this year. (http://www.bls.gov/opub/mlr/1981/02/art4full.pdf) 

We probably should not anchor on the post-war high E/Pop of 64.7% in April 2000, or even the post-dotcom bust of 63.3% last reached in March 2007, but the 58.2% read in October 2013 is a post-1983 low. The latest figure is from June 2014. It is just 59%.

The Other Side of the Inflated-Market Argument

To help combat confirmation bias, I now present the other side to the top-down view that markets are inflated and approaching a bubble. Most of the counter-argument centers on four ideas: 1) there are flaws in each of the metrics outlined above; 2) after six years of anemic economic growth, the economy is due to break out; 3) forward PE ratios (today’s price relative to analysts’ earnings per share estimates for 2015) are not extraordinarily high; and 4) it’s different this time, so the Federal Reserve will not be able to tighten because the economy will not be strong enough. (Note to blog readers: the argument that stocks are the best alternative is not addressed  here because the letter makes clear that PAR believes all markets–stocks, bonds, housing, etc.–are inflated beyond levels that are justified by fundamentals.)

Point four contradicts the other points. For example, if it is different this time and the economy is not strong enough for the Fed to tighten, then it is hard to argue that forward earnings will be good or that the other metrics would point to better conditions if they weren’t so flawed. At least in the pessimistic case, all compasses point in the same direction. 

I think I understand all of the identified flaws in each metric above (e.g.  flaw: “the CAPE in 2012 was distorted by two recessions, which is unlikely to be repeated”) even if I disagree with the rationales for why they are flaws (e.g. Shiller used a ten-year horizon to capture long cycles). Also, the various flaws have always been in the measures, which make trends important. It is the trends that are troubling. 

I do not know where the economy is headed and I don’t know where earnings will be next year. But, I do agree with Steven Levitt and Stephen Dubner, who wrote the following in their latest book, Think Like a Freak:

“It has long been said that the three hardest words to say in the English language are ‘I Love You.’ We heartily disagree! For most people, it is much harder to say ‘I don’t know.’”

David Dreman demonstrated that analyst EPS estimates have been far off the mark for a long time. But, analysts have to keep on guessing because their institutional clients demand it and they cannot tell their clients the truth: that they just don’t know what forward EPS will be and that they could deliver more value to clients if clients would let them focus instead on what can be known about a business. Given analysts’ abysmal records in forecasting EPS, how can anyone find comfort in forward PE estimates? 

I hope the economy surprises to the upside and justifies today’s high stock market prices. All PAR can do is stick with its Separate Account Value Investing (SAVI)* discipline and buy stocks only when PAR finds a margin of safety, and “buy” call options that never expire on every company in the market (i.e. hold cash) when margins of safety do not exist. Those call options will be valuable one day.

Discipline is the key.

* SAVI is a separate account platform with Charles Schwab in which PAR invests client funds using PAR’s value investing processes. Clients have complete transparency into PAR’s activity in their account and clients control their separate account. Client funds are not commingled in the SAVI platform, so clients receive asset management tailored to their needs.

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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As Michael Mauboussin says, when understanding an investment idea, we should try take an outsider’s big-picture view in addition to our own expert view of the minutiae of the idea. I first came across the equity market return histogram a few years ago and I believe it offers perspective on the feasibility of return expectations.

The ranges at the bottom are the ranges of returns for each annual period. The years highlighted in blue are the years involving the recent Great Recession and those in orange involve the Great Depression. As you can see, there were many more outliers during the Great Depression. The Great Recession looks rather normal in comparison.

My opinion of expected returns is based on data obtained in the Graham-Shiller CAPE index and from Tobin’s Q ratio (plus several other metrics), so I expect low, single-digit equity market returns over the next eight- to ten-years. The CAPE, which measures long-term Price/Earnings ratios, and the Q, which measures Price/Replacement-Cost ratios for the market, are 39.1% and  40.6% higher, respectively, than their long-term averages.

But, if we believe past is prologue, then there is a 75.5% chance that returns this year will fall outside of the range of 0% to +10%. I believe I am rationally pessimistic for the near term (but a long-term rational optimist), but historically there is only a 13.9% chance that an investor will lose more than 10% of their capital in any year in the market. This kind of outsider’s perspective helps me temper my pessimism, but the best way to temper it is to invest with a MARGIN OF SAFETY. Unfortunately, few investments offer a Margin of Safety these days.

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The best way to describe the current market, then, is to say that there is “an unusually large herd of grey swans” about. It refers to an outcome–a single impactful event–that is quite possible and therefore should be anticipated but it is not because too much attention is focused on the low probability of each separate event occurring instead of the collective likelihood of any one event occurring. I guess it is another way of saying that we miss the forest for the trees. As the number of grey swans in the herd increase, the likelihood of an impactful event increases.

The conditions that make this market a herd of grey swans are as follows: The market is priced for perfection as the Graham-Shiller CAPE and Tobin’s Q ratio are near all-time highs, by which we can infer that investors are sensitive to momentum and are ignoring risk and values. At the same time, the number of low-probability events that could cause a major correction also seems to be high. This environment is different from one described by the adage that “rising markets climb a wall of worry” because those environments start at low prices relative to fundamentals. That is, there is always more worry immediately after a correction–such as in the first quarter of 2009–than after a significant rebound, which is where we stand right now (2/25/12) with the S&P 500 just 15.4% from its all-time high.

The large number of grey swans include (not in any particular order):

1. a sovereign debt default (either legally or de facto) by any one of Italy, Spain, Portugal, Japan, France, Ireland, or some other country not yet on the radar in addition to the default that has already occurred in Greece;
2. austerity throughout Europe and the US in order to pay the bills for previous overspending (US and Europe) and low productivity (Europe);
3. a collapse of the European Union or the Euro
4. a surge in inflation around the globe;
5. a war with Iran and its supporters or instability due to Iran’s development of a nuclear weapon (the collective probability of this must be close to 100%);
6. a Chinese economic implosion as inordinate government command of the economy cannot be sustained;
7. a collapse of the Russian banking system;
8. unrest in the US as a significant amount of promised public-sector post-retirement pension and health benefits must be cut or eliminated in order to balance state and local budgets;
9. significant instability in the Muslim world (excluding Iran) for many reasons, but particularly as US influence declines with US military withdrawals;
10. something unexpected from North Korea;
11. a less-than-peaceful transition of political power in the US in November; and
12. a large natural disaster–earthquakes, tsunamis, droughts, volcanic eruptions–(for example, see Nova’s excellent and recent “Deadliest Volcanoes.”  A preview:  http://www.youtube.com/watch?v=CEjnIPRuhvk)

Separately, these events are not black swans; they are grey swans–low probability events but not rare ones like black swans. Together they are a herd of grey swans where only one event need occur to cause major problems; imagine if two occur. On the surface most appear to be independent events, but what is to stop North Korea from doing something stupid if China is focused on a war in the middle east or its own economic collapse? What would happen to economic activity and political stability if lingering ash from volcanic eruptions caused a significant reduction in food production? If we add a black swan event that no one is even thinking about, the outcome could make us nostalgic for 2008-2009.

In the very long run, I am a rational optimist. In the near term, I am a rational zoologist. If you can buy cheap insurance, do so. On that note:

http://finance.fortune.cnn.com/2012/02/16/is-japan-next/

While the Japanese debt bomb isn’t expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government’s  ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.

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Today, Fink made two claims about the sustainability of current market trends that I thought were remarkable. First, he said that the so-called “risk on” trade is sustainable because many investors (presumably pension funds) have long dated liabilities and need 7% to 8% returns to meet those liabilities.

My answer to that first statement is similar to what I would tell a small child who says he needs something that he cannot have: it will not materialize just because you think you need it.

Yet, at bottom, I think Fink is correct. Pension funds will reach for 7% to 8% returns.  They will put on risk because the alternative returns look worse. And, many are likely to end up in a bigger hole than the one they were in before. Which, ironically, brings to mind Buffett’s old line: “When you find yourself in a hole, stop digging.” I say ironically because Fink uses Buffett as a crutch in these videos.

If a large number of investors did not behave this way, investors like Seth Klarman and I would be out of business. Klarman has made it clear that he would never chase a return hurdle because investors have no control over returns. They do, however, control the amount of risk that they assume. Investors can manage risk most effectively when they only invest when they have a margin of safety (MOS). Those who manage risk and avoid losses will often underperform the market in the short run but outperform it in the long run. Those who chase returns will underperform the market.

Fink’s second rationale for the sustainability of market trends is forward looking P/E ratios are as low as they have been since 1980. He reasoned that despite better looking alternatives (high bond rates) at the time, the US had a strong stock rally beginning around 1980.

My take on the latter is: first, rates have nowhere to go but up from here and if they do the value of stocks will drop. The long-run fundamental value of stocks is simply the present value of future free cash flows. If rates rise, that present value drops. Conversely, after 1980, rates were much more likely to drop than rise as Volcker and Reagan were attacking inflationary forces. Second, in 1980 the Cyclically Adjusted P/E (CAPE) ratio was near an all-time low at about 7, which further validates the CAPE, a remarkable measure first proposed by Benjamin Graham. When the CAPE is low, buy stocks. But today, the CAPE is near all-time highs  (excluding the dot com bubble) at 21.

Fink closes his appearance with the statement that “when it feels the worst” then that is the best time to invest. I agree, but do any investors really feel as if this is as bad as it gets? I certainly felt that way in March of 2009 and I found tons of opportunities with huge MOS back then. And, I feel pretty good about what transpired since March of 2009. But we have gradually reduced our market exposure since then to almost nothing today, not because it feels bad, but because there are few MOS opportunities.

One should not compare 1980 with 2011. I am sure that Fink is a smart man, which is why I suspect he is merely talking his book here. Large ships such as BlackRock cannot turn quickly even if they wanted to, and they cannot risk lagging their benchmarks by sailing into port. They are paid fees based on the size of their portfolios, not on their performance, so they just need to keep pace with their benchmarks to maintain or grow their market share. So, even when their benchmarks plummet because markets were previously inflated relative to fundamental values, BlackRock can preserve its revenue share if its portfolios only plummet as much as a benchmark, but no more. BlackRock’s investors may lose, but BlackRock does not.

I do agree with some of the other statements that Fink made during his appearance (with my qualifications in parentheses):

1. Europe is worse off than the US (but that does not mean the US is in good shape);

2. Investors should take a long-term view (which should make them less likely to take immediate action given high market prices and elevated risks);

3. Cash is a terrible long-term investment (but not when prices and risks are elevated).

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MARKET TALK: It’s 1931

DOW JONES NEWSWIRES

5:20 (Dow Jones) “I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria,” Brad DeLong writes on his blog, “that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria. The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.”

(paul.vigna@dowjones.com) (http://delong.typepad.com/sdj/2011/11/time-to-spread-foam-on-the-runway-the-federal-reserve-needs-to-act-now-to-firewall-off-the-eurocrisis.html)

I thought Mr. Market was finally coming to his senses in the third quarter, only to see him lose his mind again in October. Was that the last hurrah? The world is in too precarious a position to have equity markets rally as they did. And, we as contrarian value investors need Mr. Market to come back to reality (and perhaps get depressed again) before we can become net buyers. Today was a good day in that regard, but there is a long way to go.

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