|Editor’s Note: I hope you enjoy today’s guest issue from Tim Melvin! Tim and I don’t always see eye to eye, but he is a contrarian par excellence, and right now, he agrees with me that the warning signs in the market look suspiciously similar to ones we saw back in 2007. Tim and I are both pretty “fed up with stocks” right now – and with good reason. If you hate stocks, you have to read this now. – Lee Adler
I have had my moments of stupidity over the years. (The 1970s stand out as a period where I excelled at really dumb stuff.) Taking the Patriots over the Giants and giving points in the 2008 Super Bowl was dumb. My early spring wager on the Orioles making the wild card doesn’t look so smart as we sit here in August either.
Sometimes, my stupidity is just stupid, like the time when I fell asleep on the beach at noon on a cloudless day after staying up too late the night before.
But at other times, it rises to the level of genius.
During the late years of an extended bull market, for instance, I’m the dumbest guy in the office.
I’m a valuation sensitive, stubborn investor and I do the exact opposite of what the “smart money” thinks I should.
Now that kind of dumb really pays off.
My pigheadedness kept me from losing a dime in 1998 and 2008, when everyone else was hyperventilating into giant paper bags — and made sure I had enough cash to plow in near the bottom and reap triple digit returns both times.
And it’s about to make me another nice stash of cash – as this strangely familiar 2018 bull market creaks to a top…
I Was A Moron During The Last Two Bull Markets…Until I Wasn’t
Urgent: Another 2008-style market crash is “certain” (Are you prepared?)
Take a look at what happened back in 1997, when I was a broker at a small regional firm in Annapolis Maryland by the name of Ferris Baker Watts.
For awhile there, I looked like the One Stooge.
Clients called up demanding that I buy them Netscape, AOL, Cisco, Pets.com or some other internet superstar stock. Even conservative accounts thought we should at least have some safe stuff like Microsoft (MSFT) and Intel (INTC) in our accounts. I refused to bend and had a bunch of clients leave. I also fired more than a handful of the more obnoxious would-be new paradigm investing superstars. The exodus was so steady that the brokers in the Merrill Lynch office down the street would buy me drinks when they saw me out and about.
The pattern repeated in 2007. I was a moron for not owning banks and mortgage lenders. There was no such thing as too much leverage. Banks were worth three times book and only an idiot would sell them for just two times. Bundles of garbage helped spread the risk, so garbage collections were triple-A credits. Everyone deserved a piece of the American dream in the form of home ownership, and it was society’s and Wall Street’s job to make that happen. Valuations didn’t matter because money was plentiful so not owning stocks, preferably on margin was stupid.
In both instances, I just nodded and politely pointed out that they were welcome to find another broker… but business had a value and paying more than that value was the true act of stupidity. 1997 was easier because REITs were ignored and undervalued and we had a lot of liquidation arbitrage situation to buy. In 2007 we had nothing but cash and some unique arbitrage situation to keep me busy. In both cases, I avoided any temptation to buy the flavor of the day regardless of price. Clients were furious as I refused to buy internet stocks or mortgage funds when they were apparently the smart money choice.
Both times over the next few years I got a lot richer very quickly as a slavish devotion to buying companies at unreasonably good prices helped me avoid the meltdown and have tons of cash to deploy when the markets collapsed.
In both cases, I fought the urge to say, “Who’s the idiot now?”
Right now, I see some comparisons to 1997 and 2007 conditions. We are almost 10 years into a bull market, and I see some real signs of concern. Seven, to be precise.
Why We May Be Looking At A Repeat of 2007 – And What to Do
1. We are running out of cheap stocks to buy. When I run my core valuation screens, I am getting fewer and fewer names each and every week. My core screen for good companies at unreasonably good prices turned up just 8 companies yesterday. Over the last decade, that number has been around 30. My Private Equity Replication Strategy screen has produced on average about 18 names every week for the past decade. Today there are four companies that pass the filters. We are running out of cheap stocks with the potential for extraordinary returns.
2. There is a Wall Street favorite that has made its way to Main Street as investing gospel. Index and sector-specific ETFs are all the rage, and anyone Private Equity Replication model has on average about isn’t using them in a moron and idiot. Value is dead, and you have to own the index to make any money. Every time I hear that song I immediately think of another one from Bob Dylan: “The Times, They are a-Changing.”
3. There are no banks that fit my criteria for purchase right now, and many of the larger ones trade at more than 2 times book value. In 2007 it wasn’t that I was some kind of super banking genius who foresaw all though some magic crystal ball. I could see that bank price to book multiples were well above the point that represented an excellent buying opportunity and much closer to previous peak levels. Further nonperforming assets ratios were starting to rise pretty much across the board. Declaring a buyers strike was more a matter of common sense and experience than a product of my soothsaying abilities.
4. Warren Buffett is sitting with lots of cash and not doing or saying much. Like me, Warren is often seen as irrelevant as markets mature. In the 2006 shareholder letter published in early 2007 Warren warned us that “In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby2% of your principal is paid each year to the manager even if he accomplishes nothing or, for that matter, loses you a bundle and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. In the most recent letter for 2017, he noted that “The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed.” He added “Despite our recent drought of acquisitions, Charlie and I believe that from time to time Berkshire will have opportunities to make very large purchases. In the meantime, we will stick with our simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” There is a time to buy and a time when even if you don’t want to be a seller, it is not the time to buy.
5. Interest rates are rising. The Fed has been raising rates since the end of 2016, and many think we will see a steady string of hikes over the next few years. In 2007 the Fed had been raising rates for almost 4 years, and it finally reached a point where it pressured corporate balance sheets and eventually stock prices. Scott Minerd of Guggenheim Partners thinks that Fed Funds rates over 3% will cause levered corporations to start to feel the pain. That’s interesting since Jamie Dimon rates should be at 4 right now and 5% is on the way.
6. The 10 year CAPE Ratio is over 30 at the moment. Historically that has been a danger zone for stocks as the returns from this level are low to negative for the next decade. In 2007 this valuation measure topped out just shy of 30, so we are even more overvalued at the moment than we were just before the credit crisis hit and the market imploded.
7. The Market Cap to Gross Domestic Product ratio shows stocks are not cheap. This metric is one that Warren Buffett has suggested is a reasonable measure of market valuation levels. The current reading of 144.9 is well above the pre-crisis levels of 137 and approaching 1999 peak levels above 145. You can talk all you want about overvalued or maybe the market is actually fairly valued because interest rates are so low, but you cannot say stocks are cheap here.
Taken all together – I wouldn’t call it a red light for the markets yet, but it’s definitely flashing yellow.
That means it’s time to get obstinately, stubbornly, pigheadedly dumb.
It’s time to do what I did the last time this happened – move more to cash, and buy exclusively value stocks.
Should we all run and sell our stocks right now? Probably not. Should we be cautious about buying shares that are not bargain priced or should we limit ourselves those that trade at true bargain levels? Not just careful. That’s all you should be buying, and there are not many of them.
It is also a good time to weed out any limited companies that you hold as they will be leading the race to the bottom when stocks do finally sell off.
And when that happens, you, like me, will suddenly look very, very smart.