November 25, 2010
In October 2009, I highlighted 5 Signs of Irrational Exuberance. One year on and investors don't look any the wiser. It's not as if nothing has happened in between; the events of the past 13 months should have taught investors that the aftermath of the credit bubble will be felt for years to come and that the "path out of the woods" remains highly uncertain. Despite this, multiple classic tells of exuberance are once again on display (along with a couple of new ones):
- Stocks are overpriced. Overvaluation is the most telling observation of exuberance. At a cyclically adjusted price-to-earnings (CAPE) multiple of nearly 22, the S&P 500 provides damning evidence (the CAPE is based on average inflation-adjusted earnings over the prior 10 years). Professor Robert Shiller of Yale, who compiled the CAPE data series stretching back to 1881, found that stocks have declined on average roughly 2% per year during the decade that follows a year in which the multiple exceeds 20.
- Junk debt is at premium prices. "I don't see value in the high-yield market; you are not being paid to take risk," Mark Notkin told Bloomberg recently. Notkin manages the $12.8 billion Fidelity & Income Fund, the third-largest -- and the best-performing -- mutual fund focused on junk bonds. He isn't alone in thinking high-yield bonds are overpriced. The smart money has been exiting the market while yield-starved individual investors continue to pour money into high-yield mutual funds, pushing prices to three-year highs this month.
- The VIX is cheap. Labeled Wall Street's "fear gauge," the VIX is derived from the prices of options on the S&P 500 index. During periods of financial turmoil, investors are willing to pay up for protection against price declines, pushing the VIX up. Conversely, as investor fear recedes, option prices, and, hence, the VIX, tend to decline. At its current value of 18.95, the VIX remains slightly below its average going back to its 1990 inception. Is there any way in which one could label the current environment "below-average" in terms of uncertainty? "Extreme/exceptional" is a lot closer to the mark. Super-investor Seth Klarman says he is "more worried about the world, more broadly, than I have ever been in my career" (more on Klarman coming up). Even General Ben Bernanke told Congress in July that the economic outlook "remains unusually uncertain."
- "Lambs to the slaughter" bond offerings. I can offer no other description of Mexico's 100-year bond issue priced to yield 6.1% in October. It should be evident that investors are accepting an inadequate return to hold a long-dated promissory note from a country that spent almost 60% of the period 1825-1940 in default. The same goes for Goldman Sachs' (NYSE: GS ) 50-year issue, priced to yield 6.125%. This is an institution that ran a significant risk of failing twice in the last 40 years and three times in the last 80 years.
- A super-investor returns cash. In a letter dated Nov. 8, Klarman told his investors he would return 5% of their stake at the end of the year, explaining that "today, Baupost's opportunity set is smaller than it has been in some years." Klarman is a genuine investing legend with one of the best long-term investing track records out there (19% annualized returns since 1983 in his main fund). This isn't just a vote of no-confidence on stocks, either. Klarman is a nimble investor who is comfortable investing across asset classes, whether it be in bonds or real estate. If his opportunity set has shrunk, that suggests that risk assets are broadly expensive.
I'm not trying to sound like a curmudgeon in pointing all this out, but I firmly believe that investors need to adopt a highly defensive stance right now; not because I said so, but because the facts on the ground demand it. There is nothing wrong with holding more cash than usual at this juncture; as Klarman pointed out in a 1983 investor letter:
Cash is a way of safely doing nothing until compelling investment opportunity arises. It offers positive, albeit very limited yield, complete safety of principal, and full and instant liquidity. A low positive return ... is not a bad proposition in the absence of better alternatives.
If you are putting money into stocks now, I strongly recommend you look at the shares of high-quality, "franchise" businesses, which look reasonably valued as a group. I like General Electric (NYSE: GE ) at these prices, for example, and I also like the four top commercial banks as a basket: Bank of America (NYSE: BAC ) , Citigroup (NYSE: C ) , JPMorgan Chase (NYSE: JPM ) , and Wells Fargo (NYSE: WFC ) .
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