I used to work with a guy who was fond of saying that clichés exist for a reason. “Perception is greater than reality” is certainly one of those clichés. Coming to the end of this year I keep hearing the same thing, both from clients and some pundits: When is the market going to crash?
It is understandable. After all, most of us have witnessed first-hand two bubbles that burst. We have become programmed to believe that every time the market is up this much, it must be another bubble. However that is perception, not reality. This not to say that there will not be volatility or that we may not be due for a correction; markets certainly don’t continue to go up six or seven percent a month indefinitely as they have done in the fourth quarter. However, not every bull market is a bubble.
Bubbles occur when valuations get stretched beyond anything reasonable, or put more simply, when people pay far more for something than it could possibly be worth. I know what you are thinking: All the people on TV keep saying the market is at record highs. Doesn’t that mean it is expensive? No, it does not. The level of any market index, whether it is the Dow Jones or the S&P 500, is really just an arbitrary accounting measure based on the price for the stock. Inflation alone would cause this value to rise and making new highs is really the norm, it just hasn’t seemed like it for thirteen years as we have recovered from the technology bubble – a true bubble. What matters in determining the price of the stock market is the price relative to the earnings of the companies in the market, or what we refer to as the price-to-earnings (P/E) ratio.
Crashes occur when the price for dollar of earnings gets way too high. In the tech bubble that is exactly what happened, and why true investment professionals, like us, looked like complete geniuses when that bubble burst. It is easy to look at a high P/E and know that eventually it means trouble. The 2008 situation was a little more difficult to foresee. In 2008 the stated P/E didn’t look all that bad, but we were about to enter a massive recession and the E (earnings) part of the equation was about to drop dramatically.
Neither of those cases seems to be the situation today. U.S. stocks are valued in line with historic norms, neither cheap nor expensive, based on earnings. The economic data seems to be improving, not deteriorating. International valuations are reasonable and their situation, while not all that good, seems to be stable to improving slightly. Emerging market stocks are cheap; there are risks of course, but in the long run cheap is usually a good thing. Bonds and so-called alternatives continue to be the areas that look most expensive, although less so than a few months ago.
Of course things can always change quickly, but I was reminded the other day that part of our job is to give our clients peace of mind. In 2000, before I started Iron Capital, I went to my then-boss and told him that a fund our firm was running was about to blow up. Two months later the bubble burst. In January of 2008 I stated in our Quarterly Report that we were heading for recession and a bear market. As many of you know, the reason I am in this business is because as a student in the fall of 1987 I had the foresight – or sheer dumb luck – to short the market in my student mock portfolio.
Of course I also predicted a downturn in 2012, and that didn’t happen. The point is that I, and we for that matter, have been very good at seeing downturns, and we don’t see one right now. We are not perfect; I should have made the 2008 prediction in the fall of 2007. I could be making the same mistake today, but the data isn’t there. Perception rules in the short term, but eventually reality wins out. The reality today looks pretty good for equity investors.
There may be areas of concern – small-cap stocks, social media stocks, and banks come to mind. But, this is why prudent investors always start from the bottom-up. Prudent investors are absolute return-focused and do not invest in hot areas to try in compete with the market or our neighbors. Prudent investors are risk-averse, and if we are anything at Iron Capital, we are prudent.
I hope that helps provide some peace of mind. All of us at Iron Capital wish you have a very Merry Christmas and a Happy New Year.
Chuck Osborne, CFA