Valuations Matter

I’ve been writing for a couple years now that much of the appreciation in stock prices over the past six-plus years has been the result of central bank largesse, and that historically high corporate margins are bound to revert back closer to the long-term average. A defensive strategy made most sense in this environment. But the world may be changing. Following several years in which investors blindly bought stocks more in response to Federal Reserve action and rhetoric than anything else, the world is starting to make sense again. The laws of gravity have set in for many of the former market darlings. Positive reactions to earnings growth without corresponding revenue growth (and vice versa) are now much more subdued. Announcements of major stock buybacks using borrowed money are not being greeted as warmly as they had been. It is not quite as popular to initiate or raise dividends in lieu of investing in future growth. And companies aren’t being rewarded for making acquisitions without much regard to price. In short, it is no longer in vogue to neglect fundamentals and valuations when making investment decisions. Rather, investors are once again beginning to reward earnings quality and stability, cash flow, and balance sheet strength. Count us among the relieved.

I didn’t know how to invest in that artificial environment. I was unwilling to commit client money to stocks (and bonds for that matter) for which I could find little fundamental justification. Needless to say, it was gut-wrenching to watch the same few stocks drive the gains in the major market averages. Toward the end of 2015, we sent out a couple of Market Commentaries in which we tried to demonstrate how narrow the market leadership had become. The first of the two, entitled “When Quality Gets Cheap“, discussed the meteoric rise of a handful of stocks that had risen over 400% on average since the end of 2011. The combined market capitalization of those seven stocks had risen to an eye-popping $676 billion and traded at an average price/earnings multiple of 112x. As the following table shows, those same stocks are down an average of 22% from that September 16, 2015 Market Commentary.

6bef173b-8a6f-488d-bc7e-c37492696748Source: Bloomberg

The second Market Commentary, entitled “Market Leadership“, discussed how the average year-to-date return (through November 24, 2015) for the Top 20 performers in the S&P 500 was +59% compared to -3% for the bottom 480 performers. We also calculated that those top 20 performers increased the overall S&P 500 return by about 4%, taking the overall index performance to +1% for the period. We said that the analysis demonstrated the lack of breadth in the market, and that this kind of disparity in returns was not a good omen for stock prices. “As market leadership gets smaller and smaller, it could be a harbinger of broader market weakness.” Incidentally, I ran the same analysis for the year-to-date through today. The top 20 performers in the S&P 500 are up an average of 15% compared to an average of an 11% decline for the remaining 480. This spread seems much more reasonable.

As greed turns to fear, we maintain our defensive posture. It is very important to the long-term health of the economy that the capital markets transition to an environment in which the right things are driving securities prices. As we’ve said from the beginning, the Fed has no business targeting or opining on the level of stock prices. We are confident that the rocky environment we are enduring will result in the cream rising to the top. A clear investment discipline applied doggedly and dispassionately is the only reasonable approach.



PS Next week’s Economic Forecast at the University of Delaware on February 16th is almost sold out. There will be TV screens in the lobby, but if you want a seat, email us quickly. I will be honored to share the stage with Dr. Patrick Harker, President of the Federal Reserve Bank of Philadelphia, and my great friend P. J. O’Rourke the award winning author and scathing political satirist.