June 2006
It's certainly a weird sounding investment strategy, but having a reasonably bad case of myopia can be a real advantage. While being near-sighted runs directly counter to most other investment advice out there, when the cards being dealt are clearly against you from a probability standpoint, it pays to think more about the short haul than the long haul. It is safe to say that we don't know of many people who regret driving slowly on potentially slick roads in a dense fog. That's about how we see today's market climate.
I recently read a fascinating book, Fortune's Formula by William Poundstone, about a betting strategy for gambling. Contrary to what many financial professionals want to publicly admit, there are valid parallels between gambling and investing in the stock market.
Don't get me wrong, we wouldn't be in the investment business if we felt the market is the equivalent of a simple roll of the dice, pull of a lever or spin of a roulette wheel. The stock market is an entirely different animal in many respects, but it pays to acknowledge the similarities.
In both environments, participants (e.g. gamblers and investors) are operating in a world of uncertainty. They are both standing at a single point in time and looking out an unknown future that is highly dependent on their present actions. The blackjack player is looking at the cards they've been dealt and a good bettor is coolly assessing the odds of asking for yet another card.
They have to consider the still unseen cards left in the deck before placing their next bet. Smart ones certainly aren't committed to playing the same way as they played their last hand. They absolutely aren't trying to convince themselves into believing that over the long haul they should just say, "Hit me twice and then I'm done".
Is their intense focus on what's left in the current deck a myopic, or near-sighted, way of thinking? It certainly is and it makes a lot of sense. If you place bets without using this information, you may not be around long enough for the long haul to ever play out. Good gamblers bet based on the odds of the game from that point forward.And by forward, we mean, for just the next card to be dealt. Finally, really great gamblers only bet in proportion to their odds of winning. When the odds are stacked against them, the smart ones wisely recognize they simply don't like makeup of the deck and call it a game.
Circling back to the stock market, we see our actions as being quite parallel to that of a smart blackjack player. We look out at the investment landscape - the current US economy and the state of the larger global economy, the US consumer's health and the things that will likely affect them in the future, the price of stocks and bonds today and the past levels of key statistics that directly or indirectly drive future market returns. This is our unseen deck of cards. Some investors really like this deck.
We think we understand the bullish case for stocks. Bulls point out that corporate profit growth has been strong for some time now. In fact, over each of the past 12 quarters (that is a long time) corporate earnings have grown by double digit percentages. Corporate profits as a percent of total economic output in the US now stands at record levels or about 9% of GDP. During the 90s, we saw this same figure in the 5% to 6% range. Clearly a profit recovery has been a big driver for the market since early 2003.
Further, bullish investors look to the robust growth in Asia as a positive to global growth. This world-wide growth is an important consideration for optimists who acknowledge that the US consumer cannot go it alone anymore.
The long term story is that India and China - the two biggest nations measured in potential future consumers - will continue to grow without major hiccups and the world economy will gently lessen its dependence on the over-spending and under-saving U.S. consumer.
Additionally, bulls tend to look at our markets as being cheap based on a price-earnings standpoint. After three years of double digit earnings growth, the S&P 500 companies reported earnings of $70 to $75 per share last year. Frankly, it depends on what you count as the true earnings. Should we all just forget about the real expense of stock option grants? Do non-recurring write-offs really not recur over time? Nonetheless, we won't try to argue that these aren't record earnings built on the back of record corporate profit margins.
We've seen quotes from many investors that, using 2007 projected earnings, this market is priced at around 14 times earnings. In the same breath, they mention that the average price-to-earnings ratio has been about 14 over many decades of market history. In their view, this supports stocks at today's prices.
Finally, the last piece of the bullish thesis for the stock market is that the Fed is almost done raising interest rates. Many commentators and investors are stating that this is a predictable precursor of good things to come for the stock market.
Summing it all up, these four things make up the bull's case for owning stocks; (a) corporate profits are at record levels and will keep growing at a good clip, (b) we are transitioning into a more balanced worldwide expansion led by hyper-growth economies in the Asia-Pacific region, (c) they see low valuation of stocks based on future earnings projections and finally, (d) the markets will get a pop when the Fed finally ends its tightening phase.
Well, we look at the deck's composition slightly differently. We worry about the strength of the pillars of the bulls' case and are adjusting our bets accordingly. We don't really like this deck. Here is our myopic view in a nutshell.
Corporate profits a percent of GDP looks to have spiked 50% from only 5 years ago. If that level reverts back to recent historical ranges, the banked on earnings growth will not materialize. We feel the gains in productivity and other efficiency enhancing techniques will diminish. It is actually an economic law. And labor will eventually want a bigger slice of the pie to boot.
We still feel very strongly that the world economy is still very much dependent on the US consumer and will be for quite some time. China and India are a great long term trend, but long term trends typically happen over the long term - this one will probably be no different. In the meantime, China's growth is actually causing us some pain right now in the form of higher commodity prices. Frankly, we would rather worry about the problems of inflation looming today rather than faithfully hang our hat on the futuristic opportunities coming during the next 20 years.
Also, a pause by the Federal Reserve is no guarantee with these inflation worries growing. Market history isn't as clear as people think after a pause by the Fed. It did in 1995, but check out the many times the Fed paused in the 50s, 60s and 70s to see that this isn't a rule investors can just take to the bank.
Lastly, let's talk about stock prices relative to earnings (the PE ratio). We don't argue that based on next year's estimates the S&P 500 companies are selling at about 14 times no-so-true earnings. But it turns out that this is above the average valuation level from 1960 to 1995 (we've purposely excluded the bubble years in this average). It strikes us as interesting that many use today's PE ratio as a bullish factor. We currently have slightly above average stock market valuations based on record profits hinged on continued strong growth for next year! That doesn't comfort us.
Further, just looking back in time, if you instead look at the market's price-to-earnings ratio using say, past 3-year and 5-year average earnings numbers, the comparison to today's market and history isn't so comforting. Price to earnings ratios are about 20% to 30% higher than the 1960 to 1995 market averages. Today's stock market is arguably more expensive than in most periods in recent history. We aren't talking bubble levels, but we wouldn't justify a continued bull market based on prices today.
The great thing about the investment markets is that time will eventually tell the full story. A non-analytical gambler often feels deep regret by choosing not to draw another card and end up losing because of it. Part of the excitement of gambling is taking the chance to win. And that actually may be one of the huge differences between a poor gambler and a good investor. Intelligent investors and gamblers use the information they have today to make choices about when to bet and when to walk away. We wouldn't be at all surprised to learn that the best ones have a mild case of myopia.
Jason P. Tank, CFA
jason@frontstreet.com