The mood is glum in Valueville these days. Conditions are so depressed that its inhabitants can be spotted packing up their Bloomberg terminals and heading off on extended vacations.
As other investors pile into stocks they must be wondering why value investors are leaving. After all, the market is well up from its lows of 2009 and it continued to move sharply higher last year. Even better, the economy seems to be on the road to recovery and there are signs that the good times are here again.
Problem is, every upward tick makes stocks less attractive as investments. They’ve climbed so high in recent times that price-sensitive value investors are starting to run for the exits.
As the Economist observes, Professor Robert Shiller’s favourite measure of the market, the cyclically-adjusted price-to-earnings ratio or CAPE, is now at historically lofty levels.
It represents a dark portent for the S&P500 according to calculations by Dr. Clifford Asness. He points out that after the market hit similar levels in the past it went on to provide real gains of less than 1 per cent annually over the subsequent decade, on average. If history is a good guide then investors should expect to receive relatively little for taking on a good deal of risk.
But Professor Shiller’s formulation has its critics. Some analysts believe the 2008 crash was a once in a lifetime event. As a result, the depressed earnings from the period paint an overly pessimistic picture.
A more substantial criticism comes from Professor Jeremy Siegel who notes that accounting standards have changed in recent years which tends to undermine the metric. It’s an interesting critique that is discussed in some detail at the Philosophical Economics blog.
However, Professor Shiller’s ratio hardly stands alone. Several other market measures suggest the market is pricey. For instance, the Q ratio follows a pattern very similar to that of Professor Shiller’s CAPE. (It tracks the market value of companies compared to their replacement cost.)
While these measures are far from perfect, they represent some of the best long-term indicators we have.
But that doesn’t mean the market is doomed. It could march higher over the next few years. It has been a lesson learned the hard way by many tardy real estate buyers in Toronto and Vancouver where expensive markets have become even more so – at least in the short term.
In addition, while the market is pricey, that doesn’t necessarily mean bargains are scarce. Just think back to the internet bubble of the late 1990s. Sure, high-tech stocks traded at outrageously high prices, but many less glamorous companies could be purchased for a song.
Alas, we aren’t quite in the same situation today according to money manager Lonnie Rush. He examined research that suggests stock valuations are unusually compressed. In other words, stocks are trading in a much tighter price-to-earnings range than they have in the past and there are relatively few stocks with very low ratios to be found.
It’s something I’ve noticed in my own business. One stock screen I follow spotted more than 40 candidates near the bottom in 2009. But the number of stocks that pass the test has dwindled over time and now only a handful remain.
These are some of the reasons why many value managers are holding more cash in their portfolios than usual. MoneySense’s Jonathan Chevreau talked to Vito Maida of Patient Capital Management, who thinks new accounts should keep 75 per cent in cash. Lonnie Rush is of a similar mind and has more 70 per cent in cash. Others are a little less extreme.
But if they’re right, investors might do well to take a little vacation until the next big crash.