Prediction vs. Valuation

Two weeks ago we hosted a quarterly investor call, discussing our strategy and our viewpoint on the financial markets. Afterwards we took questions.

The first question we got was, “When will the Fed raise rates and what will happen when they do?”

Our answer was to quote Warren Buffett’s observation: as investors, we are better at valuation than prediction. We can’t know what will happen in the future, no matter how badly we wish to, but even if we could confidently predict a future event, we would still be unable to reliably forecast its effects.

This past week, events demonstrated Buffett’s acumen yet again, and our borrowed wisdom in aping his viewpoint. With many investors publicly worried that the Fed would raise rates, and that the end of free money would hurt the markets, instead the Fed chose to stand pat on rates.

So the market went up, right? No, the market went down, concerned that the Fed’s restraint proved the world economy was in worse shape than we thought. (We are not the first to observe that the Fed is trapped in a Catch-22 of its own making.)

There are two takeaways here. First, forget about predicting. Second, markets that want to go up will interpret most news as bullish, while markets biased toward decline will go down on a similarly broad span of news. Right now the markets see the glass half-empty. Which helps us not at all, since sentiment can swing from greed/bullishness to fear/bearishness with shocking speed and unpredictability.

This leaves us with valuation. U.S. stocks remain very expensive by the long-term measures we find most persuasive, though another week or two of declines would change “very expensive” to merely “quite expensive,” with some limited implications for asset allocation. Foreign stocks are, relatively speaking, unusually, even extraordinarily cheap. That we can act on, never mind the Fed.

Last Bear Standing?

Over the last few weeks, there has been a steady trickle of headlines about formerly-bearish money managers and commentators who have jumped (or slunk quietly) onto the bull-market bandwagon.

One such is Hugh Hendry, a hedge fund manager who shorted financial stocks in 2008, earning a 31% return in a year when most investors lost big. As is all too usual in the hedge fund space, this made him a rock star, got him lots of exposure, and attracted millions to his fund. Which, somewhat predictably, did nothing much for the next five years, as Hendry maintained his prediction that worse was yet to come. Referencing the possibility of a Greek default in 2010, Hendry commented, “I suggest you panic.”

Last month, Hendry announced that he has now become a trend-follower, and is going long stocks. This after a 160% advance in the markets since the March 2009 low, all of which he missed.

Another perma-bear has been Paul Farrell of MarketWatch, who I singled out as an especially worthless analyst in a prior post. After years of advising individual investors that the game is rigged against them, even predicting the collapse of the capitalist world system and suggesting buying a farm in the mountains and stocking it with canned goods, he suddenly turned bullish in late October. A recent headline tells the story of Farrell’s conversion: 12 get-rich sectors for a hot 2014 bull market.

Of course, Farrell is an idiot. But some of the others advertised as new bulls are not. Of particular interest is Jeremy Grantham of GMO, who we at TGS regard as one of the world’s smartest asset allocators.

Grantham has recently been advertised as a bear-turned-bull, with a Barrons headline pretty typical: Jeremy Grantham’s Bullish Two-Year Outlook. (The Barrons article is behind a paywall, but GMO’s quarterly newsletter, from which Barrons and others conclude Grantham is now a bull, is not.)

Given that Grantham is on our very short list of investors too savvy to ignore, this would be a huge change in viewpoint, and would certainly cause us to question our own cautious investment stance. Even a cursory reading of GMO’s recent newsletter, however, suggests Grantham’s opinion has hardly changed.

GMO’s newletter actually starts with Paul Inker’s analysis, titled Breaking News! U.S. Equity Market Overvalued! Hardly bullish. Grantham then discusses the reasons he believes the U. S. stock market is significantly over-valued, but suspects that irrational investors, emboldened by easy money, are likely to drive it higher before the bubble inevitably pops, finishing the three-time cycle of easy money leading to asset bubble leading to market bust (2000, 2008, and perhaps 2015).

We pretty much entirely agree. This is why we have increased our cash position, and tilted our sector choices so heavily toward managers running lower-volatility portfolios and owning higher-quality stocks.

As John Templeton pointed out, bull markets usually “die amidst euphoria.” We’re not there yet, but we are already past the point where further gains will be based primarily on economic fundamentals. As usual, we remain long stocks, but we are no longer over-weight, as we were from October of 2008 through summer of 2013.