Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog. If you are interested in receiving this letter monthly by email, sign up here.
At the beginning of this year I wrote that a combination of negative sentiment, reasonable valuation and monetary stimulus could prove a “potent cocktail” for equity markets. Now seven months into the year, that forecast has borne itself out. The S&P 500 is up nearly 20% for the year and has crossed the 1700 level for the first time in its history.
As the index has risen, sentiment has turned from negative to positive, valuation has turned from reasonable to expensive and monetary stimulus may soon be changing from aggressive to incrementally more restrictive. Simply put, the three factors that I highlighted as tailwinds for the market in 2013 are slowly turning to become headwinds. As a result, increased caution is warranted in the back half of 2013.
It’s almost difficult to remember how negative the mood was to start this year. Fears over the potential effects of sequestration were at the forefront of market psychology, Europe remained a cause of great concern, and positivity was broadly met with skepticism. Today, the opposite is true. Investors seem willing to forgive long term risks and embrace the market rise with hope that the future will be better than the recent past. Despite mixed economic data, the market has continued higher.
The optimism is extremely refreshing. We have collectively endured a terrible economic period and deserve to enjoy a positive break. For this reason alone I wish that I could write a supportive outlook, but the unfortunate reality of markets is that pessimism marks bottoms and optimism marks tops. This is because optimistic buyers offer to pay higher than reasonable prices, and when they do, we must be prepared to take them up on their offer. As I have written before, markets will swing from despair to euphoria and back again. We want to be buyers when others are in despair and sellers when others are euphoric.
Looking at valuations, investors are showing signs of euphoria. Earnings multiples have ballooned as prices have increased faster than earnings, and depending on the metric you use, the market is currently trading for a similar multiple to already inflated levels seen in 1996/1997. Based on this analysis, in order to expect strong returns from equities today, investors effectively need to believe that valuations will return to the bubble levels of the late 90s.
I don’t believe that this is a realistic outlook for several reasons. I believe that the 90s were most likely an anomaly fueled by 1) rapid adoption of information technology that drove huge productivity gains 2) the rise of securities as a primary savings mechanism for American households and 3) the demographic wave of the Baby Boomers in their prime years of wealth accumulation. These three factors combined to mean that money was pouring into equity markets at precisely the time that company earnings were growing at an accelerating pace. If the circumstances of 2013 were a potent cocktail, the 90s were a 100 year flood.
In contrast to the 90s, today Boomers are on the cusp of retirement and will soon begin drawing down on pension funds including social security. They are going from net savers to net liquidators of wealth, which is likely to create a headwind for prices at the very least. Their children are still at least ten years away from a wealth accumulation phase of their own. Furthermore, for the moment we seem to be mired in a technological malaise as indicated by the fact that technology companies uncharacteristically trade at a discount to the market multiple. Couple this with the fact that the S&P 500 is already at a similar multiple to where it was in 1996 and the prospects for a multi decade bull market like we saw in the 80s and 90s seem limited.
For these reasons, as the bull market party has started to rage, we’ve spent most of the year with one foot on the dance floor and our eyes studying the exits. Our intention has been to soak up as much fun as we could before the lights come on. Now that it’s four years into an economic expansion that historically lasts four to five years, I think it’s time to start thanking our hosts (the Fed) for a wonderful evening, casually grab our coats and make our way to the door. Ideally we’ll be able to hear the last dance from the valet stand as we get into our car and drive away.
In an average account, we came into the year ~70% invested, and as our companies have reached our price targets (factoring in what I believe to be optimistic assumptions) we have sold several holdings and are now ~55% invested. I hope that the market will continue to give us opportunities to sell; I would like to be as little as 30% invested at higher price levels. For the first time I am also thoughtfully preparing to put a small short on the index in order to further hedge our risk of participating in a broad market decline. As I’ve frequently said, my primary job is to protect our invested capital and second to grow it. With this order of priorities, there is certainly the chance that we could miss out on further gains, but hopefully we’ll be effective in mitigating potential losses. The plan is to preserve our capital so that we can reinvest at more favorable prices.
Scott Krisiloff, CFA