There is a lot of collective wisdom in old Wall Street adages. Most are quite simple. but reflect generations of hard learned lessons. Unfortunately, they also usually demand a kind of discipline that runs counter to emotions---which are always what get investors in trouble. One such adage is buy low, sell high; and it deals with the two dominant investor emotions: fear and greed. Today, I believe that we should be focused on the latter of this adage---the 'sell high' part.
Let me start with a question, when stocks are hitting their all time highs, isn't that by definition, the 'high' in 'sell high'? CNBC is visited daily by multiple pundits who answer that question---no. They put forth numerous arguments (rationalizations?), the most prominent of which are:
(1) the economy is improving and will soon accelerate. Yes, the economy is improving. With that I would agree. However, if you haven't read Rogoff and Reinhart's definitive study on government debt and economic growth, you might want to check it out. The bottom line to that study is that countries whose government's incur a national debt in excess of 90% of GDP can't and won't grow at historical rates due to the interest burdens of servicing that debt along with the larger [inefficient] regulatory environment implied by higher government spending/debt. Don't look now, but that ratio for the US is over 100%. To be sure, this number has declined of late and our ruling class is making noises that they will implement policies to bring it down further. That is great; and if it happens, I will be the happiest kid on the block. However, 'if' is the operative word in that statement. So until it does occur, we are stuck in Rogoff and Reinhart's sub par growth paradigm.
(2) corporate profits are strong and will continue to improve. Corporate profits are strong. Indeed they are so strong that one has to question their sustainability. In a study by John Hussman, he points out that corporate profits are now represent about 10.2% of GDP whereas historically, [a] they have averaged 6% of GDP and [b] they have a strong tendency toward mean reversion---which could clearly happen. Certainly corporate managements deserve kudos for growing profits in an otherwise ho hum economic environment. They did so by slashing expenses and outsourcing to low wage countries---neither of which do I have a problem. But that is a finite amount of expenses that can be cut. Furthermore, the majority of our trading partners are sliding into recession. No matter how well the US is doing, if corporations start losing top line growth overseas that will impact margins and profits. Did anyone say higher taxes?
(3) stocks are undervalued. Actually, Doug Short points out that they are roughly fairly valued if you look at trailing 12 months earnings. He also observes that the record of this measure in anticipating directional moves in stocks is mediocre at best. Is there a better measure? Well, years ago Graham and Dodd started experimenting with correlating value with average earnings over various time periods. Robert Shiller [of Case Shiller] continued those studies and found that Fair Value had a much closer correlation with the average of the prior ten years in earnings than it did the trailing twelve month earnings. In Shiller's study, the average adjusted P/E on ten year trailing earnings is 16.5. Today it is 22.2 according to Chris Kimble.
Now let's think about what would Warren do? In his annual report to shareholders, he opines that his favorite Market valuation metric is the Q ratio---which is the ratio of the total market value of stocks as a percent of the replacement cost of their assets [roughly Market book value]. In a study by Lance Roberts, the historic average of this ratio [which I interpret as Fair Value] is .7. Today that number is .93 [again, according to Lance Roberts].
(4) the Fed will print money into infinity and as long as it does, stocks are going up. This argument is simply an updated version of another Wall Street axiom: the greater fool theory. Anybody buying stocks because he wants in as long as the party is going on should check how Chuck Prince (former Citi chairman) made out using that strategy. I listen all day long to Wall Street pundits parading in front of CNBC cameras telling me that while, yes, the Fed is quite easy, all will work out fine, Mr. Bernanke is a rocket scientist, he will be able to guide the Fed through a transition to tighter money with only a mere hiccup; and even if he doesn't, they [i.e. the pundits] are also rocket scientists, and they will know when to get out with little to no damage.
If you believe that, I have a bridge in Brooklyn that I will sell you cheap. I know Bernanke is smart. He was just as smart back in 2007 when he didn't see a housing/financial crisis coming. How did that work out? Greenspan was also believed to be a rocket scientist; and he said that he could pump up the volume with no adverse consequences. The only problem was he missed in the 2000 dot.com bubble burst. Today, Bernanke's liquidity expansion dwarfs both those of 2000 and 2007. Why will it be different this time?
As for those geniuses that think that they will be the first out the door, here's a news flash: there is only one first out the door. When this Market turns, I believe that it will be every bit as vicious as 2008-2009. Back then, there were no seconds out the door, just a lot of dead soldiers.
For the moment, let me play devil's advocate to myself and assume that the current uptrend will continue. How far up can it go? Below is an eighty-five year S&P chart. Note the 80 year uptrend. The upper boundary of that uptrend intersects at roughly 1750. So that gives us upside---technically speaking---of about 12%. If you want to argue that the 1750 can be achieved and that stocks will hug that boundary to infinity, then 12% looks like an attractive reward.
But what is the downside from here? A partial answer is approximately 1410, which where our Valuation Model places Fair Value. That is 10% downside. So on my calculation, the risk/reward equation right now is approximately 12% up/10% down, not overwhelming, given the S&P's proximity to an 80 year resistance level. Now you may have a different Fair Value which would alter your risk/reward. You could also observe that in 2000 and 2007, stocks managed to temporarily bust out of this long term trading range. I would simply point to what happened afterwards. You could also argue that you are one of those rocket scientists that will 'know' when to get out. I respect that. But I am not that smart; and I am an investor, not a trader and therefore, I need to be preparing for the risk side today.
Oh, I forgot the other part of my answer---in the above example, I used our Valuation Model's Fair Value and failed to mention the lower boundary of that long term uptrend which intersects at 688. In other words, the S&P could go to 688 and not break below its long term uptrend. Now run your risk/reward.
To be clear, I am not a bear on the economy. It is improving; and I am not a recessionista. I am in awe of corporate management's ability to have grown profits through an extremely difficult period. The question that I am raising in this article is, what do we pay for that? And my answer is less than what stocks are selling for today. Furthermore, I would add that currently, there is almost no accounting for the tail risks associated with a far too easy Fed that has sailed into historically uncharted waters and a continent (Europe) in crisis in which most countries have debt to GDP ratios that make the US look like Scrooge McDuck and a financial system that is not only overleveraged but overleveraged with the sovereign debt of their host countries.
Nor are our Portfolios all in cash. To be sure, today they are 40% in cash. But that is up from 15% in early 2012; and it has grown as a direct function of stocks selling at or above historical valuations. And again to be clear, when sales were made, we didn't even sell the entire position. Our discipline is to Sell Half when a stock reaches historically high valuation territory. So our Portfolios equity exposure remains broad and diversified---but it is less than normal for all the reasons cited above.
Bottom line: this is not a time to be chasing stock prices up; it is a time to be building a cushion for a period when the euphoria is a bit more muted.
We own all of the following stocks. As long as they continue to meet our fundamental criteria, we will continue to own them. But we believe that they are mispriced and therefore, the size of our position should be reduced.
Here are the stocks in which our Portfolios have taken profits (i.e. sold half but still own) and would still take profits:
Colgate Palmolive (CL)
VF Corp (VFC)
Brown Forman (BF.B)
General Mills (GIS)
Johnson & Johnson (JNJ)
Sherwin Williams (SHW)
WW Grainger (GWW)
Kimberly Clark (KMB)
Sanofi Aventis (SNY)
Here are stocks in which our Portfolios have taken profits (i.e. sold half but still own) but because they have backed off in price would not do so today:
NuSkin Enterprises (NUS)