You may not be familiar with the Greek word pareidolia, but you’ve probably experienced it. Derived from the Greek for ‘faulty image’, pareidolia refers to the psychological phenomenon of seeing meaningful shapes where none actually exist. That’s why a chicken nugget shaped like US president George Washington sold for more than $8,100 on eBay in 2012, or why a grilled cheese sandwich that apparently resembled the Virgin Mary drew 1.7 million hits (eventually selling for about $28,000).
The Rorschach inkblot tests are another good example: the inkblot shapes themselves have been specifically designed to resemble nothing in particular; we make of them what we will, projecting subjective feelings about what is essentially random data.
I wrote recently about Seth Klarman’s warning to his clients. Klarman is a billionaire investor who has returned $4bn of capital to those same clients. He reportedly now has 40% of his portfolio in cash. Why?
Because the stock market in 2014, in his view, resembles a Rorschach test: “what investors see in the inkblots says considerably more about them than it does about the market”.
Easy money doesn’t last
Personally, I’m worried by what I see. Stocks in the US and the UK just look way too overvalued. Take a look at the chart below. It shows the cyclically adjusted price/earnings (Cape) ratio of the US S&P 500 index, calculated by Yale economist Robert Shiller.
Shiller uses a smoothed average of the prior ten years’ market prices in order to screen out short-term ‘noise’. As you can see, with a Cape ratio of over 25 times, the US market is trading well above its long-term average. It’s currently trading at the same level as in 1901 or 1966 – periods when the US stock market subsequently endured significant corrections.
Only two periods saw higher CAPE ratios than today, and they are 1929 and 2000.
Suffice to say I don’t find too many investment opportunities in the US at present. The recent IPOs of some very speculative social media companies point, in my mind, to a culture of easy money and effortless profits. Just as in the first wave of dotcom mania, because these businesses can’t be assessed on conventional metrics (because they’re growing so fast, though not necessarily with any attendant profits), the sky’s the limit when it comes to their potential valuation. Investors are willing to pay up for ‘growth at any price’.
But in a world in which central banks are casually printing trillions of dollars and pounds, how can we trust these prices anyway?
More to the point, the US Federal Reserve, which last year created $1trn out of thin air and used it to buy bonds, has said that it intends to “taper” bond purchases this year, at a rate which implies it will be completely out of the market by the end of 2014.
But last year, the Fed bought over $500bn of US Treasury bonds – and the bond market still went down. So what impact do we think the Fed will have if the largest buyer in the market steps aside?
Do we expect securities prices (both bonds and stocks) simply to brush off the presumed disappearance of the largest player in the market? I don’t. That’s why I question whether the Fed can ever truly abandon its market intervention.
But I am also acutely aware of how artificial this market is, and assuming that the Fed is able to step away, I don’t expect either the stock or bond markets to take the development in stride.
How to find value in a rigged market
There are essentially only two ways of engaging with this market. One is as a trader; the other is as an investor. In their 1934 classic Security Analysis, Ben Graham and David Dodd gave us a handy definition of the investor mindset:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Sadly for all of us, six years of extraordinary monetary stimulus have blurred the lines between these two disparate approaches. Interest rates at 300-year lows have caused countless thousands of ‘investors to flood into the equity markets and become transformed into reluctant ‘speculators’.
The trader is driven by price momentum: if prices are rising, he’ll buy. If prices are falling, he’ll sell, and quite possibly sell short. I’m not making any value judgments here. In fact, I find trend-following (ie momentum) strategies have a role to play in a diversified portfolio.
Another way of looking at it is to call momentum strategies ‘growth’ strategies. Seen from this perspective, the market comprises essentially just two types of stocks: ‘growth’ and ‘value’.
Growth stocks typically display strong upwards price momentum, but when the momentum ebbs (say, when earnings disappoint), they fall, and they tend to fall hard.
Value stocks, on the other hand, often look terrible from a technical analyst’s or chartist’s perspective, but offer a margin of safety plus the potential for dramatic positive returns.
That’s why I think deep value stocks are the only stocks worth buying right now.
I find myself increasingly returning to Ben Graham’s classic, The Intelligent Investor, because it contains so much timeless wisdom about the markets.
This quote sums up his most fundamental advice:
“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.”
In short: Don’t buy rubbish. Don’t overpay for quality.
Tobias Carlisle, who also happens to be a Ben Graham-style deep value contrarian investor, points to the current lack of dispersion in stock valuations in North America. Price/earnings (P/E) multiples for stocks in the S&P 500 index are now clustered together very tightly, irrespective of whether they are strictly ‘growth’ or ‘value’ businesses. I suspect this has happened as desperate investors, unwilling to sit in cash given zero interest rates, have chased the valuations of even relatively conservative businesses significantly higher. In other words, ‘value’ has become increasingly expensive of late, and ‘deep value’ is now either very difficult or impossible to find, from within the major US stock indices, at least. As Carlisle has it: “There are now fewer stocks with low P/Es than at any time in the last 25 years”.
I’m more convinced than ever that ‘deep value’ equity is now by far the best way to participate in equity markets, because of the ‘margin of safety’ that Ben Graham has always advised investors to seek. Stocks offering a ‘margin of safety’ are surely the antidote to markets that are murkier and more uncertain than anyone has ever seen before.