The end is near, oh no! According to Wells Fargo, the stock market rally as we know it could be all but done. This really shouldn’t be much of a surprise to anyone that has been paying just the slightest bit of attention as the market has been hitting record highs rather consistently since Trump took office. If you look at the longer term, we have seen very few hiccups since the Great Recession which ended on March 9, 2009 as you can see in the S&P 500 Chart below. A typical Bull Market lasts 4-5 years before we see a change is the cycle, so this rally is definitely out of the ordinary. It’s no surprise that the best of this rally is behind us.
If you still don’t believe that the market is high, just look at the average historical PE ratio for the S&P 500: The average PE going back to the 1800’s is 15.67. Today we are at 24.91. (Source: www.multpl.com) That means we are 58.9% HIGHER (or overvalued) compared to what the average market valuation has been based on this metric.
Let’s check out another metric to see where the market is now compared to historical levels. The Buffett Indicator, or Market Cap to GDC Ratio. A fairly priced market is when this indicator is between 75-90 based on historical valuations dating back to 1950. A “significantly” overvalued market is when this ratio gets to 115 or above. Today it is at 131.6. Yikes.
I have been saying this all year, but the market keeps going up. How does this affect us as Value Investors? According to Wells Fargo (how did I get 100 checking accounts there?), they say that we can still be in the markets, but we should start moving up the quality ladder. Wow, that is sage advice. I was just getting ready to invest in Bear Stearns and Enron. I should ask them if the new machete I bought my five-year-old should be an inside toy or an outside toy.
As value investors, we don’t need third grade common sense to tell us to invest in good companies, not crappy companies. Our investment philosophy is investing in well run companies that have a durable competitive advantage, aka “quality” companies. I am still holding on to a few of my value stocks, and I probably will for quite some time unless I am really convinced, based on the numbers or the reason why I bought in the first place changes. However, I am having problems finding new companies to invest in. I am certainly not going to buy and index ETF when the market is 58% overvalued. So what do we do?
There are two things we should do. First, if the market is obviously telling us that there are no quality companies that are also trading at a discount, then that is a clear sign to be in cash or other short-term alternatives. If the market is so overheated, it’s only a matter of time until we see some sort of correction. Think back to 2008. Those who were fully invested lost nearly half of their portfolio value. However, those who were paying attention to market valuations, were prepared and were able to buy shares of just about anything at once in a lifetime prices.
Secondly, if you want to allocate some of your money into equities, but not at these current levels, then we can artificially create that margin of safety, aka Discount Price or Sale Price. Let’s say you like a company such as Amazon, but there is no way in a million years that you are going to pay $994 for their shares, which is their current quote on September 14, 2017. Let’s say you are ok buying those shares 15% lower than its current price.
We can sell a Put Option. That means that we are obligated to buy Amazon anytime between today and a future expiration date. Let’s use the January 2018 date as an example. If we sell the $850 Puts expiring in Jan. 2018, as of right now, we can collect $12.37 per share. What does this mean? If Amazon does not fall below $850 in the next four months, then we do not have to buy AMZN. However, the $12.37 is all ours. We get to keep that. If AMZN does fall below $850, we are forced to buy the shares. Since we collected $12.37 for this obligation, our cost basis is not $850, it is $850 minus $12.37. Our cost basis is $837.63. So we would be buying AMZN at a slightly better discount. Are we ok with either scenario? I am. If I don’t have to buy the shares, I am all good keeping $12.37 per share for not doing anything. I would actually rather buy the shares at a total cost of $837.63. In my opinion, there is much more long term upside owning Amazon at that price than there is collecting just a $12.37 premium. Either scenario is a win for me. The risk is if AMZN tanks well below $850, say $790. We still have to buy it at $850. The risk is definitely there, but I think it’s a lesser risk when we are talking about doing this strategy with high quality, fundamentally sound companies. Amazon is taking over the world. They may get kicked in the butt if the entire market comes down, but if that happens, they won’t stay down for long.
Value investors welcome bear markets, we are not afraid of them. Remember what Buffett says, “BUY when others are fearful”. A correction will finally give us an opportunity to buy great companies at great prices. Money is made when you buy, not when you sell.