Buy Low, Sell High Or Buy High, Sell Higher?
Fund managers have different strategies for navigating the ebbs and flows of investing. For Value style investors, it all boils down to one main rule; “buy low, sell high.” The phrase is often quoted, but often abandoned by Growth style investors in favor of another notable phrase: “buy high, sell higher.” While both styles can deliver gains, sometimes investors get swept up with the short term trends and forget the big picture. Over long periods of time, investments tend to reflect the characteristics of each asset class. Over short periods of time, the picture can be skewed or distorted by many factors, including market swings, investor sentiment, government intervention, recessions, wars, etc. Within these swings lies pitfalls and opportunity.
“The dumbest reason in the world to buy a stock is because it is going up.”
The following graph shows the year to year swings of various asset classes along with the 20 year long term average of each asset class (on the right). The long term averages reveal the range of the investment returns, along with the average of that range. Where the market lies within the range has a very dramatic impact on the experience you have as an investor.
Another rule of investing is called “gravitation to the mean” which means that all investments will eventually gravitate back to the characteristic average, often referred to as the “fundamentals” of that investment. The problem with this rule is that there are no market signals to tell you when the timing of this “mean reversion” will happen. This brings up a corollary to this rule, “the market can be irrational longer than you can be solvent.” This is the rule that drove hedge fund manager Julian Robertson out of business in 2000, four months before he would have been proven right.
This was never truer than the high tech boom of the late 1990s. Irrational exuberance over tech stocks sent valuations exponentially higher than their fundamentals warranted. The trend lasted for years before crashing back to earth. The NASDAQ still has not recovered. For the following few years, the trend reversed and the low tech stocks rallied. The previous graph shows four years of international stock outperformance in a row from 2004 to 2007. This momentum continued for four years before going to the bottom of the barrel in 2008.
To get a vision of where an investment category is in the cycle, one can look at the fundamentals of the category. Although dividends are the most visible form of income to the investor, we can go one step further to view the driver of dividends: earnings. Earnings are used as a signal of value in growing companies that do not yet pay a dividend, and earnings are strongly correlated to dividends in dividend paying companies. Based on these fundamentals, the price that one pays for the value of a stock in terms of its earnings can be expressed as a ratio, the P/E ratio. At the time of that KnowRisk commentary, the forward P/E ratio of the equity market was 12 with earnings rising. Since the third quarter of 2012 to present day, the Dow Jones Dividend index is up over 35% to a PE ratio of 17. To get a sense of what lies ahead for US stocks, we can look at future expectations for earnings. As you can see from the below chart, guidance is proving to be less optimistic. The domestic market has all the momentum from 2013 but may need to take a breather which is what has been happening so far in 2014.
With equity markets taking a bit of breather our first look is to bonds. As we’ve also discussed in a previous KnowRisk entitled Rising Rates, bonds with exposure to US interest rate risk do not have a rosy future for the next few years in this flat to rising interest rate environment. The latest estimates from the Federal Open Market Committee continue to show rate increases beginning in late 2015 and accelerating into the long run. What options, then, are left to the intelligent investor?
A more diversified chart including international stock, commodities, REITs, and splitting stock into the Growth and Value components, produces a graph that looks like the one below. Note that the growth and value styles are both successful, but can have wide performance differentials like the 10 point spreads in 2006 and 2007. Without steady growth and momentum producing a category consistently at the top for the last market cycle we find ourselves in a much different market position than in the 2004 to 2007 run of Foreign Stocks.
With the understanding that market cycles and long term trends shift we would perhaps be best served by looking for value in the investment categories that are at the bottom of return charts. The risk of owing them is often lower the longer they have been the worst performers and historical mean reversion should mean they are perhaps due for a period of stronger returns.
In particular Commodities and Emerging Markets seem to be undervalued. A glance at the Price/Earnings ratios of domestic stocks vs the Emerging Market stocks [below] reveals a differential of 17 vs 12 suggesting that after the big run up in US stocks, the EM companies can be bought cheaper than domestic. The spread in valuations between the two indexes is larger than it has been at any time in the past five years. The “buy low, sell high” investor, will look to these underperforming assets which can be purchased at a better price.
A look at Commodities in the previous asset class chart shows that they have produced the best returns during the 1st Quarter of 2014. This is after being the worst performing asset class for the three previous years. Perhaps it is the beginning of a period of mean reverting outperformance for Commodities? Perhaps it a short term positive move in a longer term bear market for the category? Only time will tell, but history has shown that eventually the categories at the bottom of the return charts will rotate to the top. The question for investors is where it makes more sense to buy these categories. At the bottom when they are cheap, or at the top when they have momentum?
Looking into the future will always be an inexact science. It is hard enough to look into the present and understand what you see. We leave you with a final quote from another notable philosopher.
“Predictions are hard to make, especially about the future.”