This Time Is Different

(Zen Buddha Silence by Marilyn Barbone)

(Image:  Zen Buddha Silence by Marilyn Barbone)

July 14, 2019

For a value investor who patiently searches for individual stocks that are cheap, predictions about the economy or the stock market are irrelevant.  In fact, most of the time, such predictions are worse than irrelevant because they could cause the value investor to miss some individual bargains.

Warren Buffett puts it best:

  • Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.
  • We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
  • Market forecasters will fill your ear but never fill your wallet.
  • Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.
  • Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
  • [On economic forecasts:] Why spend time talking about something you don’t know anything about?  People do it all the time, but why do it?
  • I don’t invest a dime based on macro forecasts.

(Illustration by Eti Swinford)

No one has ever been able to predict the stock market with any sort of reliability.  Ben Graham—with a 200 IQ—was as smart or smarter than any value investor who’s ever lived.  And here’s what Graham said near the end of his career:

If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

No one can predict the stock market, although anyone can get lucky once or twice in a row.  But if you’re patient, you can find individual stocks that are cheap.  Consider the career of Henry Singleton.

When he was managing Teledyne, Singleton built one of the best track records of all time as a capital allocator.  A dollar invested with Singleton would grow to $180.94 by the time of Singleton’s retirement 29 years later.  $10,000 invested with Singleton would have become $1.81 million.

Did Singleton ever worry about whether the stock market was too high when he was deciding how to allocate capital?  Not ever.  Not one single time.  Singleton:

I don’t believe all this nonsense about market timing.  Just buy very good value and when the market is ready that value will be recognized.

Had Singleton ever brooded over the level of the stock market, his phenomenal track record as a capital allocator would have suffered.

Top value investor Seth Klarman expresses the matter as follows:

In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

If you’re not convinced that focusing on individual bargains—regardless of the economy or the market—is the wise approach, then let’s consider whether “this time is different.”  Why is this phrase important?  Because if things are never different, then you can bet on historical trends—and mean reversion; you can bet that P/E ratio’s will return to normal, which (if true) implies that the stock market today will probably fall.

Quite a few leading value investors—who have excellent track records of ignoring the crowd and being right—agree that the U.S. stock market today is very overvalued, at least based on historical trends.  (This group includes Rob Arnott, Jeremy Grantham, John Hussman, Frank Martin, Russell Napier, and Andrew Smithers.)

However, this time the crowd appears to be right and leading value investors wrong.  This time really is different.  Grantham admits:

[It] can be very dangerous indeed to assume that things are never different.

Here Grantham presents his views: https://www.barrons.com/articles/grantham-dont-expect-p-e-ratios-to-collapse-1493745553

Leading value investor Howard Marks:

The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious—on which everyone agrees—turn out not to be true.

 

THIS TIME IS DIFFERENT

The main reason is not possible to predict the economy or the stock market is that both the economy and the stock market evolve over time.  As Howard Marks says:

Economics and markets aren’t governed by immutable laws like the physical sciences…

…sometimes things really are different…

Link: https://www.oaktreecapital.com/docs/default-source/memos/this-time-its-different.pdf

In 1963, Graham gave a lecture, “Securities in an Insecure World.”  Link: http://jasonzweig.com/wp-content/uploads/2015/03/BG-speech-SF-1963.pdf

In the lecture, Graham admits that the Graham P/E—based on ten-year average earnings of the Dow components—was much too conservative.  (The Graham P/E is now called the CAPE—cyclically adjusted P/E.)  Graham:

The action of the stock market since then would appear to demonstrate that these methods of valuations are ultra-conservative and much too low, although they did work out extremely well through the stock market fluctuations from 1871 to about 1954, which is an exceptionally long period of time for a test.  Unfortunately in this kind of work, where you are trying to determine relationships based upon past behavior, the almost invariable experience is that by the time you have had a long enough period to give you sufficient confidence in your form of measurement just then new conditions supersede and the measurement is no longer dependable for the future.

Because of the U.S. government’s more aggressive policy with respect to preventing a depression, Graham concluded that the U.S. stock market should have a fair value 50 percent higher.  (Graham explains this change in the 1962 edition of Security Analysis.)

Similar logic can be applied to the S&P 500 Index today—at just over 3,013.  Fed policy, moral hazard, lower interest rates, an aging population, slower growth, productivity, and higher profit margins (based in part on political and monopoly power) are all factors in the S&P 500 being quite high.

The great value investor John Templeton observed that when people say, “this time is different,” 20 percent of the time they’re right.

By traditional standards, the U.S. stock market looks high.  For instance, the CAPE is at 29+.  (The CAPE—formerly the Graham P/E—is the cyclically adjusted P/E ratio based on 10-year average earnings.)  The historical average CAPE is 16.6.

If the stock market followed the pattern of history, then there would be mean reversion in stock prices, i.e., there would probably be a large drop in stock prices, at least until the CAPE approached 16.6.  (Typically the CAPE would overshoot on the downside and so would go below 16.6.)

But that assumes that the CAPE will still average 16.6 going forward.  Since 1996, according to Rob Arnott, 96% of the time the CAPE has been above the 16.6; and two-thirds of the time the CAPE has been above 24.  See: https://www.researchaffiliates.com/en_us/publications/articles/645-cape-fear-why-cape-naysayers-are-wrong.html  

Here are some reasons why the average CAPE going forward could be 24 (or even higher) instead of 16.6.

  • Interest rates have gotten progressively lower over the past couple of decades, especially since 2009.  This may continue.  The longer interest rates stay low, the higher stock prices will be.
  • Perhaps the government has tamed the business cycle (at least to some extent).  Monetary and fiscal authorities may continue to be able to delay or avoid a recession.
  • Government deficits might not cause interest rates to rise, in part because the U.S. can print its own currency.
  • Government debt might not cause interest rates to rise.  (Again, the U.S. can print its own currency.)
  • Just because the rate of unemployment is low doesn’t mean that the rate of inflation will pick up.
  • Inflation may be structurally lower—and possibly also less volatile—than in the past.
  • Profit margins may be permanently higher than in the past.

Let’s consider each point in some detail.

 

LOWER INTEREST RATES

The longer rates stay low, the higher stock prices will be.

Warren Buffett pointed out recently that if 3% on 30-year bonds makes sense, then stocks are ridiculously cheap: https://www.cnbc.com/2019/05/06/warren-buffett-says-stocks-are-ridiculously-cheap-if-interest-rates-stay-at-these-levels.html

 

BUSINESS CYCLE TAMED

The current economic recovery is the longest recovery in U.S. history.  Does that imply that a recession is overdue?  Not necessarily.  GDP has been less volatile due in part to the actions of the government, including Fed policy.

Perhaps the government is finally learning how to tame the business cycle.  Perhaps a recession can be avoided for another 5-10 years or even longer.

 

GOVERNMENT DEFICITS MAY NOT CAUSE RATES TO RISE

Traditional economic theory says that perpetual government deficits will eventually cause interest rates to rise.  However, according to Modern Monetary Theory (MMT), a country that can print its own currency doesn’t need to worry about deficits.

Per MMT, the government first spends money and then later takes money back out in the form of taxes.  Importantly, every dollar the government spends ends up as a dollar of income for someone else.  So deficits are benign.  (Deficits can still be too big under MMT, particularly if they are not used to increase the nation’s productive capacity, or if there is a shortage of labor, raw materials, and factories.)

Interview with Stephanie Kelton, one of the most influential proponents of MMT: https://theglobepost.com/2019/03/28/stephanie-kelton-mmt/

 

MOUNTING GOVERNMENT DEBT MAY NOT CAUSE RATES TO RISE

Traditional economic theory says that government debt can get so high that people lose confidence in the country’s bonds and currency.  Stephanie Kelton:

The national debt is nothing more than a historical record of all of the dollars that were spent into the economy and not taxed back, and are currently being saved in the form of Treasury securities.

One key, again, is that the country in question must be able to print its own currency.

Kelton again:

MMT is advancing a different way of thinking about money and a different way of thinking about the role of taxes and deficits and debt in our economy.  I think it’s probably also safe to say that MMT has, I think, a superior understanding of monetary operations.  That means that we take banking and the Federal Reserve and Treasury operations and so forth very seriously, whereas more conventional approaches historically have rarely even found room in their models for things like money and finance and debt.

Let’s be clear.  MMT may be wrong, at least in part.  Many great economists—including Paul Krugman, Ken Rogoff, Larry Summers, and Janet Yellen—do not agree with MMT’s assertion that deficits and debt don’t matter for a country that can print its own currency.

 

UNEMPLOYMENT AND INFLATION

In traditional economic theory, the Phillips curve holds that there is an inverse relationship between the rate of unemployment and the rate of inflation.  As unemployment falls, wages increase which causes inflation.  But if you look at the non-employment rate (rather than the unemployment rate), the labor market isn’t really tight.  The labor force participation rate is at its lowest level in more than 40 years.  That explains in part why wages and inflation have not increased.

 

INFLATION STRUCTURALLY LOWER

As Howard Marks has noted, inflation may be structurally lower than in the past, due to automation, the shift of manufacturing to low-cost countries, and the abundace of free/cheap stuff in the digital age.

Link again: https://www.oaktreecapital.com/docs/default-source/memos/this-time-its-different.pdf

 

PROFIT MARGINS PERMANENTLY HIGHER

Proft margins on sales and corporate profits as a percentage of GDP have both been trending higher.  This is due partly to “increased monopoly, political, and brand power,” according to Jeremy Grantham.  Link again: https://www.barrons.com/articles/grantham-dont-expect-p-e-ratios-to-collapse-1493745553

Furthermore, lower interest rates and higher leverage (since 1997) have contributed to higher profit margins, asserts Grantham.

I would add that software and related technologies have become much more important in the U.S. and global economy.  Companies in these fields tend to have much higher profit margins—even after accounting for lower rates, higher leverage, and increased monopoly and political power.

 

IGNORE FORECASTS AND DON’T TRY TO TIME THE MARKET; INSTEAD FOCUS ON INDIVIDUAL BUSINESSES

The most important point is that it’s not possible to predict the stock market, but it is possible—if you’re patient—to find individual stocks that are undervalued.  This is especially true if your assets are small enough to invest in microcap stocks.  In 1999, when the overall U.S. stock market was close to its highest valuation in history, Warren Buffett said:

If I was running $1 million, or $10 million for that matter, I’d be fully invested.

No matter how high the S&P 500 Index gets, there are hundreds of microcap stocks that are almost completely ignored, with no analyst coverage and with no large investors paying attention.  That’s why Buffett said during the stock bubble in 1999 that he’d be fully invested if he were managing a small enough sum.

Microcap stocks offer the highest potential returns because there are thousands of them and they are largely ignored.  That’s not to say that there are no cheap small caps, mid caps, or large caps.  Even when the broad market is high, there are at least a few undervalued large caps.  But the number of undervalued micro caps is always much greater than the number of undervalued large caps.

So it’s best to focus on micro caps in order to maximize long-term returns.  But whether you invest in micro caps or in large caps, what matters is not the stock market or the economy, but the price of the individual business.

If and when you find a business selling at a cheap stock price, then it’s best to buy regardless of economic and market conditions—and regardless of economic and market forecasts.  As Seth Klarman puts it:

Investors must learn to assess value in order to know a bargain when they see one.  Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

For example, if you find a conservatively financed business whose stock is trading at 20 percent of liquidation value, it makes sense to buy it regardless of how high the overall stock market is and regardless of what’s happening—or what might happen—in the economy.  Seth Klarman again:

We don’t buy ‘the market’.  We invest in discrete situations, each individually compelling.

Ignore forecasts!

(Illustration by Maxim Popov)

Peter Lynch:

Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Now, every year there are “pundits” who make predictions about the stock market.  Therefore, as a matter of pure chance, there will always be people in any given year who are “right.”  But there’s zero evidence that any of those who were “right” at some point in the past have been correct with any sort of reliability.

Howard Marks has asked: of those who correctly predicted the bear market in 2008, how many of them predicted the recovery in 2009 and since then?  The answer: very few.  Marks points out that most of those who got 2008 right were already disposed to bearish views in general.  So when a bear market finally came, they were “right,” but the vast majority missed the recovery starting in 2009.

There are always naysayers making bearish predictions.  But anyone who owned an S&P 500 Index fund from 2007 to present (mid 2019) would have done dramatically better than most of those who listened to naysayers.  Buffett:

Ever-present naysayers may prosper by marketing their gloomy forecasts.  But heaven help them if they act on the nonsense they peddle.

Buffett himself made a 10-year wager against a group of talented hedge fund (and fund of hedge fund) managers.  Buffett’s investment in an S&P 500 Index fund trounced the super-smart hedge funds.  See: http://berkshirehathaway.com/letters/2017ltr.pdf

Some very able investors have stayed largely in cash since 2011.  Meanwhile, the S&P 500 Index has increased close to 140 percent.  Moreover, many smart investors have tried to short the U.S. stock market since 2011.  Not surprisingly, some of these short sellers are down 50 percent or more.

This group of short sellers includes the value investor John Hussman, whose Hussman Strategic Growth Fund (HSGFX) is down nearly 54 percent since the end of 2011.  Compare that to a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund Investor Shares (VFINX), which is up 140 percent since then end of 2011.

If you invested $10,000 in HSGFX at the end of 2011, you would have about $4,600 today.  If instead you invested $10,000 in VFINX at the end of 2011, you would have about $24,000 today.  In other words, if you invested with one of the “ever-present naysayers,” you would have 20 percent of the value you otherwise would have gotten from a simple index fund.   HSGFX will have to increase 400 percent more than VFINX just to get back to even.

Please don’t misunderstand.  John Hussman is a brilliant and patient investor.  (Also, I made a very similar mistake 2011-2013.)  But Hussman, along with many other highly intelligent value investors—including Rob Arnott, Frank Martin, Russell Napier, and Andrew Smithers—have missed the strong possibility that this time really may be different, i.e., the average CAPE (cyclically adjusted P/E) going forward may be 24 or higher instead of 16.6.

The truth—fair value—may be somewhere in-between a CAPE of 16.6 and a CAPE of 24.  But even in that case, HSGFX is unlikely to increase 400 percent relative to the S&P 500 Index.

Jeremy Grantham again:

[It] can be very dangerous indeed to assume that things are never different.

As John Maynard Keynes is (probably incorrectly) reported to have said:

When the information changes, I alter my conclusions.  What do you do, sir?

 

WARREN BUFFETT: U.S. STOCKS VS. GOLD

In his 2018 letter to Berkshire Hathaway shareholders, Warren Buffett writes about “The American Tailwind.”  See pages 13-14: http://www.berkshirehathaway.com/letters/2018ltr.pdf

Buffett begins this discussion by pointing out that he first invested in American business when he was 11 years old in 1942.  That was 77 years ago.  Buffett “went all in” and invested $114.75 in three shares of City Service preferred stock.

Buffett then asks the reader to travel back the two 77-year periods prior to his purchase.  The year is 1788.  George Washington had just been made the first president of the United States.

Buffett asks:

Could anyone then have imagined what their new country would accomplish in only three 77-year lifetimes?

Buffett continues:

During the two 77-year periods prior to 1942, the United States had grown from four million people – about 1⁄2 of 1% of the world’s population – into the most powerful country on earth.  In that spring of 1942, though, it faced a crisis: The U.S. and its allies were suffering heavy losses in a war that we had entered only three months earlier.  Bad news arrived daily.

Despite the alarming headlines, almost all Americans believed on that March 11th that the war would be won.  Nor was their optimism limited to that victory.  Leaving aside congenital pessimists, Americans believed that their children and generations beyond would live far better lives than they themselves had led.

The nation’s citizens understood, of course, that the road ahead would not be a smooth ride.  It never had been.  Early in its history our country was tested by a Civil War that killed 4% of all American males and led President Lincoln to openly ponder whether “a nation so conceived and so dedicated could long endure.”  In the 1930s, America suffered through the Great Depression, a punishing period of massive unemployment.

Nevertheless, in 1942, when I made my purchase, the nation expected post-war growth, a belief that proved to be well-founded.  In fact, the nation’s achievements can best be described as breathtaking.

Let’s put numbers to that claim: If my $114.75 had been invested in a no-fee S&P 500 index fund, and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019 (the latest data available before the printing of this letter).  That is a gain of 5,288 for 1.  Meanwhile, a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3 billion.

[…]

Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods.  That’s 40,000%!   Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency.  To “protect” yourself, you might have eschewed stocks and opted instead to buy 3 1⁄4 ounces of gold with your $114.75.

And what would that supposed protection have delivered?  You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business.  The magical metal was no match for the American mettle.

Our country’s almost unbelievable prosperity has been gained in a bipartisan manner.  Since 1942, we have had seven Republican presidents and seven Democrats.  In the years they served, the country contended at various times with a long period of viral inflation, a 21% prime rate, several controversial and costly wars, the resignation of a president, a pervasive collapse in home values, a paralyzing financial panic and a host of other problems.  All engendered scary headlines; all are now history.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

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