“They say you never grow poor taking profits. No, you don’t. But neither do you grow rich taking a four-point profit in a bull market.”
-Jesse Livermore in Reminiscences of a Stock Operator
The dislocation between economic reality and the stock market is growing wider and wider everyday.
No matter where you turn there are pundits posting the Schiller CAPE ratio or the Buffett Indicator all of which are loudly screaming that THIS IS THE MOST RIDICULOUSLY OVERVALUED MARKET WE’VE EVER SEEN.
Investors have done away with P/E ratios because…well…they’re hard to calculate when E = 0. And instead they’ve started using P/Sales ratios and loudly proclaiming that anything under 1 is a bargain.
Then again, who even needs sales? QuantumScape ($QS) trades for a 16B valuation and the company doesn’t plan to have any sales until 2025!
Value investors are getting to ride along this time too
The Russell 2000 Index which represents mostly small cap stocks (the kind of stocks that usually fill independent investor portfolios) is up almost 18% already this year meaning that many of the investors who didn’t get to ride the ‘tech wave’ of 2020 are now seeing their stocks rocket too.
But how high is too high? Is it time to pull the plug?
At times like this when major investors are all sitting out the market and the word ‘mania’ is getting used on a regular basis it probably makes sense to ask, “is this the time to start pulling everything out?” It’s pretty tempting to say yes.
On the other hand, you could have said the same thing in December and if you had pulled the plug then you would have missed a roaring 6 week rally that has paid out more in investment returns than many multi-year stretches do.
Before we try to decide what to do it makes sense first to make the case FOR and AGAINST this roaring rally.
The case AGAINST the bull market
The case against is so obvious it’s barely worth mentioning. But for posterity sake…
The ratios are crazy
The Schiller PE measure the S+P 500 price over 10 year average earnings. It’s supposed to measure how expensive the stock market is over a whole boom/bust cycle. It usually averages about 16 (meaning normally the S+P 500 trades at 16x its own earnings).
Currently it’s trading at 35x, a level only exceeded once, right before the dotcom bubble burst in 2000.
The Buffett indicator tells an even darker story.
Warren Buffett’s favorite indicator takes the market cap of all publicly traded US stocks (about 41 Trillion right now) and divides by quarterly GDP (US GDP expected to be about 21 Trillion in Q4).
That makes the Buffett indicator 195%.
The Buffett indicator has never been anywhere near this level, even in 2000 before the dotcom bubble. Back then it was still less than 150% and now it traders at 195%. Ouch.
On top of that macro-economics are still in a pandemic
Despite these insane valuations, the macro-economic picture continues to be really ugly.
Unemployment is still way up. Many economies are still closed and government spending is at levels never before seen.
The market indicators may be at nosebleed levels but it sure doesn’t feel optimistic anywhere else right now.
The case FOR the bull market
The case for the bull market is really quite simple and it sounds something like this,
“Well WHAT ELSE could we possibly do right now except buy stocks???”
What I mean by that is that investment professionals really have no good options right now.
Normally when stocks trade at these insane valuations investment managers would move to ‘safer’ assets like bonds and cash to protect their principle in the case of a crash.
The problem is, both of those safe-haven assets look really risky right now
The problem with bonds
As we talked about in Bonds are dead so what do we buy? the real returns on most corporate bonds are barely above 0% and the real returns on any ‘safer’ government bonds are definitely negative.
Buying a bond with a negative return is like lending your money to someone and then paying them interest to hold it. Doesn’t sound like a good deal to me.
On top of that, interest rates have been falling pretty steadily for the past 40 years. And since bond prices move inversely to interest rates, it means that the bond market has actually been in a longer, more bubble-licious rally than the stock market!
Bonds sure don’t look better than stocks right now, even at nosebleed equity valuations.
Okay, so no bonds, but what about cash?
Normally this would be the answer.
If equities look insanely priced and bonds look worse, a cautious investor could usually just move to cash and wait for the tide to turn.
But wait…here come the central banks….
The problem with cash now is that governments everywhere have been creating money out of thin air at a faster rate than anytime in history.
To throw just one statistic at you, M2 money supply in the US (which basically measures how much cash/convertible cash/short-term deposits there are in the US) has gone up 30% from 15 Trillion to 20 Trillion since the start of the pandemic.
Let me say that again, the US government has basically printed 30% more money in the last year. And on top of that they have shown no signs of slowing down.
Here in Canada, the government is not far behind having increased M2 money supply by 24% since the start of the pandemic.
So far central banks are claiming this increase in money supply isn’t causing inflation
But no matter how many times I hear that, it’s really hard to believe that printing a whole bunch more money doesn’t make the money I have worth a lot less.
This whole story makes cash much less attractive than it used to be.
So what is Donkey Rocket Investments doing?
Taking a page out of Howard Marks’ book, I can’t claim to know what will happen but what I can do is start to play a little more defence rather than offence with the portfolio.
That means that while I’m trying to let some winners run (and let some others run way more than I normally would) I’m going to carry more cash than normal and whenever I sell something I’ll let the proceeds sit in cash rather than plowing it back into one of my other ideas.
I can’t see how any of this ends well for equity investors but for the time being I see no alternative but to run with the bulls until the party ends.
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