Valuation isn't a catalyst to move markets

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.

Link provided by CNNMoney.com

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 The idea of valuing companies on their future cash flows was resoundingly discredited as "out of date."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.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Comments

[Kris]

True valuation is only part of the puzzle but it's also a crucial part of kicking off the greed impulse that gets people to move cash into individual stocks. For many professional managers the prospects for 2009 and 2010 are looking pretty juicy. It always amazes me how fast things turn around. Hundreds of the "failed funds" of 2008 will probably set up shop in January with a nice new low bar to measure performance against and have valuations that will let them make tons of money.

There's no telling at what price the "bottom" will be put in but I know that when some names start trading close to cash *and* they are generating substantial free cash the greed light glows bright.

EMC hit this point in October of 2002.

[market folly]

good thoughts and for the most part, my sentiments exactly. i'd also add that what is clear to me is that a massive deleveraging, unwinding, and liquidation will continue to take place until the hedge fund (and even to some extent possibly mutual fund) spaces are condensed.

redemptions and liquidations force the cycle to be repeated as sellers continue to sell down assets. everybody knows this already. but, i think to some extent its underestimated how much of a domino effect there will be. this round of redemptions is over, but what about the next round? the market can't stop going down until the sellers have nothing left to sell. (though you could add in the whole "funds front-running each other" bit into the mix)

i'll liken it to someone standing on the roof and pouring a gigantic bucket of water on your head like a waterfall while you're pinned down. you can't see how big the bucket is so you don't know how long the waterfall will last, but you do know it will run out of water at some point. you bringing up the nasdaq bubble is excellent because the cheap can always get cheaper.

this market makes me want to throw around all kinds of cliches just haphazardly haha. "market can remain irrational longer than you can remain solvent"

[Jason Wood]

Gregor...I'm talking more about changing the market direction. Once the bubble started rolling over, valuation was an ENORMOUS reason for rampant selling. When estimates were coming down, it didn't matter that stocks were down 50%-60%-70%, they were still expensive. But no one woke up one day and caused the Nazzy to correct because of a certain valuation level.

Same with where we are now. Valuation isn't a detriment to a rally or recovery now certainly. But there's also no reason why it will signal or create the bottom. We need people to discount the weakening of fundamentals [second derivative stuff if you will] and given the duration of this downturn [or at least the likely duration as I see it], that COULD be a ways off.

[Gregor]

True enough. And a very good post.

That said, is it not usually valuations--in the midst of horrid fundamentals--that attracts buyers in periods like these? Equally, is it not usually the most dire, most foreboding outlook on the fundamentals (or macro conditions) that creates the values? It seems to me that the best values are captured when fundamentals are terrible. Or, when valuation is seriously misunderstood, during a time of healthy fundamentals.

At our current juncture, I think some yield hunting in resource equities presents risk, but, a decent risk as I look forward to a time when the Cash is King Mantra crashes. Cash and T-Bills and Treasuries are the the most at risk, imo. But, that risk will likely not present itself anytime in the next 2 months. Will take longer.

Best, Gregor