Valuing the U.S. Market: Forget Stocks, Buy Stuff

by: Hedgephone

Labor Day gave me an opportunity to sit back and think long and hard about investment risk versus investment reward. I have traded and invested several accounts for individual investors over the past eight years and have had many successes and many failures.

To be sure, those investors with a long term horizon always fare much better over the long run. Furthermore, I must recognize that after a large and significant drawdown in 2008, and a strong recovery in 2009 and 2010, market risk today is much greater than it was in March of 2009 after a 100% move or so to the upside in SPY and IWM.

Therefore, I must stay nimble and guard against what I see as a potential liquidity trap; I am much better off than I was in 2008 and I want to keep it that way. Unlike many pundits and advisors who focus on "getting back to even" as quickly as possible, I am ultra focused on managing my fund in the most risk averse manner after my small hedge fund racked up a 100% gain in 2009 and a 35% gain so far this year. Granted my losses on paper in 2008 and a small margin call that year mean that I am still tracking around a S&P 500 like return over that period (tough sledding). Lesson learned: If you have money to invest and want to invest with a deep value manager, put that money to work in a large drawdown, if possible. I have one investor on board whose account is up 300% as he was astute and bought into the fund in October 2008.

When stocks start to sell off in today's whipsaw markets, they ALL sell off -- it doesn't matter what they have earned, what product they sell, or what they have in the bank when a debt or banking panic hits Wall Street. With the increase of indexing, trend following, momentum trading, and structured products, the market does not care as much about earnings and cash flows as it does about the chart and investment psychology.

Take the IBD 100 strategy or the Barchart top 10 picks for example. Many investors have made 200-300% from buying into these strategies, and they are all espousing a trend based approach to stock market investing. This tends to bid up stocks that are not intrinsically worth what investors are willing to pay for their shares -- they are "buying the chart." While a breakout or trend following approach really does work, the internals and market forces at work can lead to huge asset bubbles in names that are just not worth what people "hope" they are.

Some great examples of this are the boom and bust charts of ENER, which topped out at $80 per share but had lost money every year since the 1970's and now can be purchased for a mere $4 and change. Or, one can look at CROX, which hit a high in the $60's in 2008 only to drop to $5 or so in the crash and panic of 2008. Were these companies really worth 1000% more just a year or two ago than they are today? No, what happens is that investors love to "buy the chart" on the hot new stock that Wall Street is touting.

This trend following approach is probably the best approach for an aggressive investor trying to amass a fortune in a short time in the market. If you bought ENER at $20 and sold it at $80 and then shorted it, you could be the weatlhiest person around. A simple 200 day moving average strategy could help you become the next Richard Dennis, who only bought breakouts. Today, these principles are more main stream than many want to admit. It is my argument that these principles have already or are about to create a large bubble in stocks that is not attractive to the conservative value investor.

The other problem with momentum on Wall Street is that the government wants the market to go up. In order for this to happen they have to create an environment of speculation -- a bubble, if you will. When all the money is already invested in the market and the government prints more money, it is next to impossible for the value investor to be in the market with a strong long term stock portfolio -- when there are no bargains, the smart value investors are in cash; note the 60% market weight of Fairholme currently for example, or Sequioa's large cash position over the past few years (a very wise decision of course).

So, what happens when the government eases is that profit margins expand artificially, investors begin to speculate on charts that rise 45 degrees to the right, earnings and book values become unimportant, and investors become complacent. They take out margin thinking the good times will last forever. This has been the cycle over the past one hundred years or so -- boom and bust. Today, it is hard to argue that we are in a bust after the large gains in stocks recently, the record corporate profit margins, and interest rates that have never been lower. The cracks in the foundation are starting to show.

The government knows this and is printing like mad. Yes, overvalued equities can benefit and go higher because of this, but ultimately it's the path to sovereign default and therefore is much better for hard asset investors.

Currently I am 10% weighted on a notional basis in SLV and AGQ calls -- If I am correct, this position can protect the account from "Stealth Stagflation", as termed by Old Trader, whose many insights into our current printing regime are worth reading. I have another 10% allocation to Agricultural commodities, which must go up 100% or more to reach their 2008 highs (meanwhile the money supply has likely gone up 50% or so).

Why do I feel an investment in "stuff" is a better deep value investment than stock? Because stuff can't commit accounting fraud, charge exorbitant salaries, mark up the books, take on too much debt, or commit an error that leads to a large lawsuit.

I have been bullish on oil for example since the start of 2009. I made a mistake by selling put options on RIG and NE too early as my logic told me that the stocks were cheap at 7-8X cash flow with the backdrop of higher oil prices. Although I was able to sell call options against my now deep-in-the-money short puts for a "strangle" position when the oil spill gushed into the fund account; this play cost the fund 3% overall for the year. As I am still in a rough drawdown, this is a very painful development for me. Luckily, I have learned that concentration is the cousin of financial ruin and I have a much more diversified approach than I did a few years ago -- accounting fraud and lax oversight has made financial statements much less reliable.

Meanwhile, oil prices over the same period are up over 100%. So clearly there is merit for a deep value investor to look into commodity ETFs if he believes, as I do, that debasement of the currency must lead to higher raw materials pricing down the can kicking road. Many investors believe the economy is really on the Yellow Brick road and complain that commodity ETFs are in contango and that investing in these funds are too "risky." Personally, I feel not gaining meaningful exposure to raw materials is the greater risk as the unprecedented bubbles in housing and stocks are being propped up artificially by the Fed's massive printing.

The problem with this approach is that the government regulatory bodies are asleep at the wheel when enforcing CEO pay and accounting fraud provisions. This just leads to rich executives stealing this printed money from their shareholders and moving this money offshore -- if you are "smart" enough to loot a public company, I would argue that you are smart enough to put the booty into gold, silver, or a Swiss bank account. There is no shortage of greed or immorality these days.

These moral hazards have not changed under Obama yet the printing presses are running at higher speeds than ever before. Therefore, stocks look much less attractive than things to me going forward -- its hard to get a 200% gain out of stocks from simply dumping money out of helicopters -- sure, consumption will rise, but so will inflation and moral hazard, which will erode profit margins. The more Enrons that get away with fraud, the more executives at public companies who are already grossly overpaid will be tempted to steal that tangible book value that us value investors covet so dearly.

There are many other factors that lead me to overweight stuff over stock right now: For one, the price of sugar, soybeans, and oil would all have to rise over 50% and some commodities must rise 100% to reach their 2008 highs. Stocks, meanwhile, have really only 400 points or 36.6% more to go to reach their highs from 2007-2008...

Furthermore, commodities lagged stocks in 2007-2008, showing their biggest gains in the summer of 2008, which was a full seven months after equities peaked. This suggests to me that investors may move out of stocks and bonds and into raw materials as the fiat currencies are continually debased.

Next, there are several deep value reasons to be lightening up on stocks. First, the Tobins Q Ratio is 1 versus a mean of .73 or so. Much of this replacement cost value is due to lax accounting rules and an economy flush with printed cash -- remember that no country can print forever. Eventually inflation will send the country back into recession or depression, and this time it will be much worse. A good resource for researching the Tobin's Q is Adam Smither's website (a discussion on this can be found at or Furthermore, the CAPE or PE 10 of the market is around the same value as it was before the 1987 crash. So when pundits say that stocks are cheap, remember that they are paid if people buy stocks and are not long and short.

Another interesting market valuation metric is NYSE cumulative margin debt. This figure stands at $235 billion. What worries me is that the banks are much quicker now to execute a nasty margin call onto an account than they were in 2006. Remember that margin debt was only $280 bllion or so before the dot com crash, and this was a time when the Nasdaq was more than 150% or so higher than it is today. So if you think about it, the margin debt as a percentage of market capitalization is far higher today than it was in 1999. That is pretty scary to think about.

Next, the bank reserve requirements have actually loosened. Companies are more highly leveraged than ever before. One bankruptcy and asset fire-sale can lead to the whole system collapsing -- all we have done is propped up this fraudulent architecture. Glass Steagall and the shortsale uptick rule were inventions that came out of utter necessity and the repeal of these vital safety measures creates risks that are not quanitfiable. Credit derivatives are another example of unchecked risk and leverage in the system -- if something goes wrong in Malaysia or Vietnam, the whole global financial system can collapse -- thanks to the repeal of Glass Steagall and TBTF banking. What needs to happen is TBTF firms should have greatly increased reserve requirements. This would force these institutions to break up and get smaller.

According to the iShares website, the Russell 2000 is trading at 25X earnings and over 2X a very questionable book value. Other sites list the Russell trading at much cheaper valuations, but these sites do not include companies with negative earnings -- how convenient. That's akin to an investment manager only counting his winning trades, or the government stating that food and energy prices are just too volatile to be counted in the inflation data.

Overall, I see many undervalued names and am long many listed on my portfolio section on Seeking Alpha, but the risks have led me to hedge these names versus the Russell and against the QQQQ, as well as some REITs and high flyer tech stocks. Yes, the trend is your friend, but one must ask whether the trend is a bear market rally or new bull market. I will be staying hedged until the market makes up its mind either way, and if we do embark on a new bull I view it as a sign of hyperinflation, and not for sound investment reasons. Good luck to all.

Disclosure: Author holds long positions in SLV, SGG, DBA, RJI, RJA, GCC and is short IWM, QQQQ