US equities are trading at a P/E ratio of 25x and a Shiller P/E (aka CAPE) of 27x. Since 1870, the mean P/E ratio had been 15.6x while the mean Shiller P/E is 16.7x. A somewhat naïve conclusion is that the market is overvalued as it trades above its mean and if financial markets have any chance of mean reversion equity holders will lose out big time. There are however several problems to this conclusion.
- It does not bring into consideration the extremely low interest rate environment. The current 10 year government bond is yielding 1.6% while the average since 1871 is 4.6%. Intuitively we can understand the inverse relationship between P/E multiples and interest rates. This article sheds some color on the topic. It is only natural that stock valuations will remain high in this environment.
- Selling stocks will mean the cash has to be deployed elsewhere. The problem is that the low interest rate environment has resulted in high prices for other asset classes including fixed income and real estate. This caused a few commentators to comment that staying in overvalued equities might be better than shifting to overvalued fixed income and other asset classes.
- A P/E higher than mean does not always lead to poor returns in later years. In fact on many occasions market has performed even from a high P/E level. However, when the P/E ratio goes way out of line it does indeed result in a poor 1 year or 3 year returns. Thus some investors prefer to remain fully invested at all times. Also, there have been periods when modest rises in interest rates have not caused stock under-performance as they coincided with an acceleration in economic activity.
- The mean P/E we calculate can be affected significantly by the time frame we choose. There is no scientific method of choosing the perfect time frame.
One thing is however clear. If interest rates start to mean revert (if it goes up a lot), value of all asset classes will suffer. This is why people are so concerned about interest rate decisions by the US Fed. Yesterday (22nd September), Fed kept interest rates steady but indicated that there could be a hike by the end of the year. Yet trying to predict the path Fed will take is a gargantuan task.
While reading books and listening to podcasts I came across a variety of different such methods people have employed to deal with such an environment. Each of these strategies have their own pros and cons. There are also limitations that might prevent portfolio managers from using some of these. For example, a pure equity fund manager might have limit on how much cash he can keep. Similarly someone mandated to invest in US equities cannot move to other geographies or other asset classes.
- Actively look for undervalued assets: The best strategy would be to look for companies which are trading far below their intrinsic value. This gives the margin of safety that could limit downside risks. The best example that I read was something Marathon Asset Management described in their book Capital Returns. In an environment when equities became expensive they choose companies with pricing power and strong economic moats. Their portfolio traded at a similar P/E ratio similar to the broader market with one major difference. The FCF/Net Profit ratio of their portfolio was 90% compared to 50% for the market. On a free cash flow metric the portfolio was actually cheaper than broader market. The strategy appealed to me because in an overvalued market all assets will typically look expensive and it will be extremely difficult to pick stocks which look cheap on traditional multiples. However the smart analyst can find companies which ‘appear’ to be expensive but in reality are not. In Marathon’s case they prioritized cash flow capabilities. Other examples could be companies which are making investments for the future but maybe the accounting treatment makes them ‘expense’ these investments instead of capitalizing.
- Move into cyclicals with better risk reward: This strategy is in one way almost the exact opposite of the first method. This is the strategy that Simon Hallet of Harding Loevnor explained in an interview with Consuelo Mack. In order to buy companies at reasonable valuations they moved into more cyclical companies which as they explained could have volatility in the near term (which they are willing to tolerate) but the underlying economics of these companies should allow them to perform in a longer time horizon. While Simon did not elaborate on which sectors they invested in one can guess that he would avoid cyclical sectors that are at high valuations and may have invested in those that have come off a lot. An example could be commodities which have been hurt by lower demand from China and in case of oil higher supply. The reason it is the opposite method to Marathon’s is because cyclicals are unlikely to have economic moats or pricing power. However, looking from another perspective Harding’s approach is actually similar to Marathon’s. At the end of the day both are trying to buy equities below their ‘intrinsic value’ (which is in its true sense value investing).
- Diversify abroad: For US investors one option that has been described by many experts has been to diversify to overseas equities. Emerging markets (EM) has been mentioned as EM equities had been under-performing US equities for a long period. It is true that many of the larger EM markets like Russia, China and Brazil have their own macro issues. Yet that should not prevent anyone from at least searching for ideas.
- Move into different asset class: Another strategy that I heard several times is owning some gold. This has less to do with higher interest rates and more to do with the possible aftermath of the massive and unprecedented monetary expansion done by central banks around the world. A few investors also have no problem holding cash even though they could underperform the broader indices with that approach.
- Form a market neutral portfolio: In layman terms if we are long on certain stocks and short on some others, the market direction might not matter that much as we should theoretically be able to eliminate the beta. A somewhat different and more advanced method is the one used by Bridgewater Associates even though they are more a macro fund than a bottom up stock picker. By studying long periods of macroeconomic data they have built internal models of how certain asset classes behave in certain environments. They use these conclusions to create a number of potential trades at any given time. These trades minimize correlations and hence the term ‘Pure Alpha’.
Finally, sometimes the world is such that we need to be prepared to have periods of low returns. The focus at such times should be to lower permanent capital losses. By protecting the portfolio one can set up a stage for decent returns in the future.