I've been hearing a lot of people argue that "stocks are cheap" as we continue to see bourses around the world plummet. As an investor, I'm acutely aware of valuation and its role in investment selection and subsequent performance. But I'm also mindful of how valuation loses significance at times of great velocity.
Are stocks cheap? By some measures, they certainly appear to be; at least relative to where they've traded over the last decade. But here's the rub...the de-leveraging we're seeing and the financial crisis we're dealing with is unlike anything this world has seen in generations, much less the last ten years. The daily moves we're seeing are comparable to what we saw in the 20s and 30s folks. So whether our equity markets are cheap compared to the last ten years hardly seems relevant.
But at the end of the day, if you're a fundamental investor [as I and my partners are], you have to remember that valuation doesn't supersede fundamentals. It can be tempting to look at a stock and see that it's trading at valuations we've not seen in our careers, but that can be a painful crutch. It gets back to my assertion last week that stocks aren't as effective at "pricing in" downward estimate revisions as we would like to think.
Remember the Nasdaq Bubble...the inverse can be true, too
At the peak of the Nasdaq bubble, very few investors could make a credible argument that stocks weren't obscenely valued. Blue chips were trading at 10x-20x-30x REVENUES. Triple digit P/Es were the norm. Companies with almost no revenues were coming public and trading at 100x projected sales, or higher. The idea of valuing companies on their future cash flows was resoundingly discredited as "out of date." Sell-side analysts turned to the "relative valuation" game, i.e., "ABC Corp trades at 80x revenue and XYZ is growing faster, so it should trade AT LEAST 80x revenues or more." And buy-siders played the game because you would've been slaughtered on an absolute basis if you didn't.
There were plenty of fund managers waiting for the inevitable crash to happen at the start of this decade. And yet I can tell you that many of them went out of business waiting for that crash to happen. Stocks were expensive, insanely so. And they continued to get more expensive.
The Nasdaq Bubble didn't burst because of valuation. It was only after the fundamental problems became unmistakable that investors began a rampant and unapologetic DE-LEVERAGING of their equity investments. And stocks went from insanely expensive to, in many cases, inordinately inexpensive. How many optical networking stocks went from 80x sales to trading a below net cash? More than you and I care to remember.
So again I'll say...the inverse can be true
Stocks can also become INSANELY cheap. And they can stay that way for years IF the underlying fundamentals that drive the market remain weak. I sure hope that doesn't happen. And I've seen a lot of aggressive action by the world's governments to prevent that from happening. There's a truism that says, "Don't Fight the Fed." Well right now the stock markets are "Fighting the FedS." And we're all not going to magically wake up one day and say, "OK, that's it...stocks are TOO CHEAP and I'm buying." Nope.
Valuations aren't an impediment to a new bull market, and that's a good thing. But for stocks to turn, and sustain an upward trajectory, it's got to come from improvements [or anticipation of said improvements] in the fundamentals. And right now that's as much about watching the TED spread, the Baltic Dry Shipping Index, and what specific investments (and when) TARP will be undertake.
As my friend Howard Lindzon has been saying, this is dangerous market. Guys like Steve Cohen, Israel Englander and John Paulson aren't sitting on billions in cash right now at market lows because they're scared. They are some of the most aggressive, accomplished investors on the planet and yet see too much uncertainty to put the majority of their partners' capital to work. Take note, I certainly am.
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