A Review Of Stock Market Valuations - Part 2

<< Read Part 1: A Review Of Stock Market Valuations 

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

Charles Mackay - Extraordinary Popular Delusions and the Madness of Crowds (1841)

Money is a public good; as such, it lends itself to private exploitation.

Charles KindlebergerManias, Panics, and Crashes: A History of Financial Crises (1978)

Contributing to euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

JK Galbraith - A short history of financial euphoria (1990)

This is the second of a two-part letter reviewing the current valuation of stocks. The focus is US-centric and looks at both long-run valuation (Part 1) and shorter-term factors which may be warning signs of irrational exuberance (Part 2).

During the last year, we have seen stock markets around the world, decline rapidly and then rebound. Technically the longest bull market in history ended in March of 2020, but the recovery was so swift that many commentators are calling it merely a sharp correction, simply an aberration. Since March the US stock market, fuelled by aggressive monetary and fiscal easing, has shot to new all-time highs. 2020 ended with the approval of the first Covid-19 vaccines, sending markets higher still.

Equity markets are forward-looking, the economic woes of today are discounted, expectations of recovery, backed by further fiscal support, make the prospects for future earnings appear relatively rosy. In this, the second part of my letter, I want to examine some shorter-term indicators which may or may not be cause for concern that current valuations are a triumph of hope of reality.

I once gave a speech entitled The Trouble with Alpha the gist of which contained my observation that Alpha - that portion of an investment manager's returns which are not the result of the performance of the underlying assets was, was simply timing. To arrive at this conclusion I looked at 24 definitions of Alpha, finding that - once I had accounted for factors such as leverage, the ability to be long or short, and (of particular importance) the choice of the index which was supposed to represent Beta – all that remained was timing. Suffice to say the speech was not received with acclaim by the audience - who were primarily investment managers. I mention this because, for the majority of investors, the investment time-horizon is finite. It is all very well for me to write about the Long Run and for Warren Buffet to describe his favorite investment horizon being forever, but for most investors, volatility, liquidity, and mortality are key.

The economic historian Charles Kindleberger published Manias, Panics and Crashes: A History of Financial Crises in 1978, in which he observed patterns of fear and greed stretching back centuries, however, personally, I think Jesse Livermore sums-up the behavior of financial markets best in the opening pages of Reminiscences of a Stock Operator, published in 1923: -

There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.

In trading especially, but in investment too, timing is (almost) everything.

Show me the signs

There are times when making money from the stock market is hard, and times when it is easy, the latter periods are few and far between, but one of the tell-tale signs that a market has become excessively speculative is when retail investors pile in.

Stock market folk-lore tells of how Joseph Kennedy (although others attribute it to James Pierpont Morgan) decided to sell his stock portfolio ahead of the market crash of 1929. Kennedy figured that when he found himself in receipt of stock tips from his shoeshine boy, the market bubble was very well advanced. The table below shows the uptick in retail stockbroker accounts between Q1 2019 and Q1 2020: -

Source: Factset, CNBC

Robinhood is not on the list above, but more on that topic later.

In a recent post - A Visit from the Doom Squad - 10th Man, Jared Dillian quotes research from South Korea on the behavior of retail stock traders in the aftermath of a bursting stock bubble: -

The researchers observed the behavior of a few thousand of them. After six months, 90% of them had given up. After a year, the 1% who were left barely had enough money to cover their daily expenses.

Dillian believes the biggest risk is of the Federal Reserve becoming more hawkish as the pandemic is brought to heel by the process of mass-vaccination. He concludes: -

That is a real risk. In fact, it is really the only risk, because people correctly point out that the economy will recover strongly in the second half, once most of the vaccines have been distributed.

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