Secret NIH-funded research at the Wharton School of Finance in Philadelphia has demonstrated that prolonged exposure to the stock market permanently impairs the prosencephalon diecephaion subthalamus, the part of the human brain that governs good sense and logical thinking. I’m just kidding. But it would not surprise me. Consider four egregious equity errors (and then take a look at my next post, Three Stock Picking Themes that can make you money).
Don’t be Shilled by CAPE
For some reason financial media treat bearish pundits far more gently than bulls. Robert Shiller’s CAPE (Cyclically Adjusted Price Earnings Ratio) is regularly cited in the Financial Times and Wall Street Journal even though he has been wrong on the stock market for the past three years. In January 2011 Shiller told CNBC, “I would say the market is overpriced on fundamentals.” It is up 36% since then. And it’s not just the media that dons the CAPE. Asset allocation committees overseeing huge pension funds use CAPE to gauge whether stocks are “expensive.” Shiller’s CAPE is simply
Current price of S&P 500 / (average inflation-adjusted GAAP EPS over the past 10 years).
Shiller thinks stocks are “overpriced” if the current CAPE exceeds the historical average CAPE. Here is all you need to know to see that this is a profoundly misleading metric. The average CAPE since 1896 (which marks the inception of the DJIA and a modern stock market with numerous industrial issues) is 16.53x. Now, if you look at the level of the CAPE each month since the start of 1990, there are only 16 months, or 5.6% of the time, when CAPE was below 16.53x and stocks looked “inexpensive”! In other words, according to CAPE stocks were “overpriced” more than 94% of the time, even though the S&P 500 has quintupled since 1990. CAPE does not work for a few reasons:
- Much of the time since 1871 the S&P 500 PE ratio was depressed by lengthy crises such as the post-1873 depression, World War I, World War II, the Great Depression, and 1970s inflation. None of those conditions exist now, though we do have Barack Obama to contend with.
- GAAP EPS can be misleading—which is why no analysts use GAAP to value individual stocks. For the last 15 years GAAP EPS has been depressed by new accounting rules (FAS 142) requiring companies to write-down goodwill from mergers if the goodwill seems impaired. Often investors ignore these write-downs, but they reduce S&P 500 GAAP EPS and thus magnify CAPE. The write-downs tend to be concentrated in a handful of failed companies (such as the tech companies that blew up in 2001-2002) that cautious investors can largely avoid.
- It is wrong to compare the current PE with the average PE going back to 1871; the stock market has changed a lot since then. Specifically, it has become much cheaper and safer to invest in stocks, thanks to lower commissions, tighter spreads, ETFs, lower mutual fund fees, and better regulation. Don’t forget the fraud factor—average investors used to be regularly fleeced by corporate insiders and Wall Street operators. The minor classic Frenzied Finance describes how in 1904 the “Standard Oil Crowd“ manipulated the flotation of a copper trust, Amalgamated Copper, in order to cheat the public. In the 1920s “pools” of big-shot speculators pumped up stocks (usually glamour issues such as RCA), drew in the public, and the sold at an elevated price.
Buy SBUX? What About Bean Prices?
In the mid 1990s I travelled to the Midwest and met with the portfolio managers for a large state pension fund. I mentioned that Starbucks looked attractive. My clients demurred; they didn’t like the stock because profit margins might be squeezed by rising coffee bean prices. At the time, SBUX was trading at $2.00-3.00; now it is at $75. If these folks did not buy SBUX because of potential transitory margin pressure from bean prices, it was a very costly mistake.
Investors, especially Wall Street professionals worried about quarterly performance, can be more myopic than Mr. McGoo. They get cute about minor near-term risks while ignoring the Big Picture of a company’s long term growth prospects. “It’s a great company that could grow 20% per year for a decade, but it’s expensive. Let’s wait for a pull-back.” Frequently, the pull-back never comes and they miss the stock. They end up trying to scalp nickels and dimes on mis-pricings of mediocre companies while leaving $1000 bills on the table. Remember, if a company really can grow 20% per year for a decade, earnings rise by a factor of six.
The CNBC dEffect
Many (not all) of the people on CNBC and Bloomberg are intelligent and knowledgeable, and I do glean useful information. But for the individual trying to learn how to invest, their programming is systematic disinformation—a catalogue of what not to do to make money in stocks, including.
- Obsessive scrutiny of the economy and Fed policy (Will they taper? How much? All T-bonds or some MBS?). Unless you run a bond desk on Wall Street, it doesn’t matter much. Famed investor Peter Lynch was not all wrong when he quipped, “If you spend 10 minutes a year worrying about macro issues, you wasted ten minutes.”
- Analyzing every twist and turn of the stock market, which boils down to gauging investor “sentiment” rather than substantive matters.
- A focus on “trading” not investing.
- A fixation on problematic stocks that individuals should avoid. Unless it is a super-expensive high flyer (TSLA, LNKD) or operates in an exotic and risky new industry (FB, TWTR, ZYNG, DDD, GRPN) or is the dumb idea of a famous hedge fund manager (JCP, HLF, SHLD) CNBC is not interested. The honorable exception is AAPL, but it gets way too much attention.
Harvard Hates America (or at least its Equities)
Jane Mendillo, the head of Harvard’s $38 billion endowment, was interviewed in the latest Barron’s. For many years Harvard and other Ivy endowments have been underweight U.S. stocks even though they were, until recently, trading at or below the levels reached in 2000 (when they were overpriced) and 2007. Today, Mendillo told Barron’s, Harvard has 49% of its assets in equities, broken down as follows: U.S. Stocks 11%, Foreign Developed Nation Stocks 11%, Emerging Market Stocks 11%, Private Equity 16%.
The allocation to U.S. equities looks way too low. For one thing, Mendillo admits the Private Equity space has become too crowded, which will lower returns. Harvard significantly underweights U.S. stocks even though A) they are more liquid than emerging market equities, B) they don’t carry the same underlying financial and political risk inherent in emerging markets, C) their corporate governance is better, D) U.S. firms have material exposure to emerging market GDP growth via exports and foreign subsidiaries, E) In many areas such as electronics, aerospace, biotechnology, consumer products, finance, etc. the world’s leading companies—those with the best technology, brands and global franchises—tend to be U.S. or European firms. (On the last point, I will freely grant there are many important exceptions such as Samsung, TSMC, and Alibaba.)
Harvard is guilty of “anchoring”—of adhering to a prior view that has lost validity. It became fashionable for college endowments to follow Yale’s lead and overweight private equity and hedge funds while deemphasizing domestic stocks. This bias was smart for a while but not now. Back in 1995 Harvard’s exposure to U.S. public equities was 38%, more than three times what it is today. Look for it to rise back toward (but probably not all the way to) 38% over the next decade.
Coming Soon: Three Stock-Picking Themes
Having dissected with unbecoming elan these four equity errors, in my next post I will strike a more constructive tone by discussing three stock-picking themes, all of which tend to be positive for industrial stocks, broadly defined.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
