Valuations Matter

05/01/2016 1:02 pm EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

The trick for the market observer is to understand that Mr. Market is as wily as they come and that he will use all means necessary, both fair and unfair, to make you look as foolish as possible.

My late grandfather told me on many an occasion, “Life is the best teacher, boy." I took this as his colloquial way of saying that learning is experiential.

One of the many things I have learned experientially, hopefully, is the art of discernment, particularly as it applies as to what I write and when I write it.

You know, when you have been at this game as long as I have there are things you observe that tend to repeat, not always in the exact same manner but close enough that you have a sense they will happen again to one degree or another.

There are also things you learn academically that you may not have experienced directly, but they have occurred in a sufficient number of times that in similar circumstances you know the probabilities exist for them to occur again.

By example, for all intents and purposes the framework of the modern financial markets can be traced back to the 1700’s. Since that time there have been six credit dislocations, or asset bubble busts as they are more commonly known, with the most recent occurring in ‘08/’09.

In the five previous occasions, each was followed by a sustained period of deflation/disinflation, which included equity price declines and credit destruction. This makes perfect sense if you understand that a bubble by definition is produced by an extended period of excess, which must be eradicated before equilibrium is reached and a new cycle can commence.

Having learned the above academically, I was absolutely positive that the identical scenario would repeat after ‘08/’09. Accordingly, I became extremely defensive and held an exceptional amount of cash for an extended period of time with the firmly held belief that prices would work lower until the excess were wiped out.

As well all know now, however, the Fed and other central banks deployed a scheme of extraordinary measures that were designed to avoid the horror of the deflation/disinflation cycle that followed the five previous instances.

Although the central banks were not successful in achieving all their aims, they were successful in preventing a meltdown of the financial system, for which the markets in general and investors in particular should be grateful for.

That being said, as I watched asset prices recover and climb to new highs, all along I was thinking how is this possible? How do you cure too much debt and excess with more debt and excess? Well friends, I guess we’ll have to chalk this one up to the old axiom that, “History may not repeat, but it does rhyme.”

Like the classic Greek metaphor, “You can’t step into the same river twice,” time, like water, flows and while something can be similarly repeated it never repeats the same.

Where the rhyme comes into play is that there has been some deflation/disinflation in gold, crude oil and other commodity prices as well as deflation in global interest rates.

The only place there hasn’t been deflation is in equity prices, primarily because without sufficient returns in assets that investors have turned to historically for income, investors have been forced into equities, especially those that pay dividends.

Now that I’ve taken you over the hills and through the woods to grandma’s house, I get to the point of this missive: I am concerned about some of the valuations in some dividend paying stocks, and I have been for some time.

How this ties into my earlier mention of discernment at the top of this piece is that I have held my tongue, having been properly chastened by Mr. Market for exhibiting the type of hubris I have chided my peers for in the past.

The simple fact is there are some high-quality dividend-paying stocks that are overvalued on an economic earnings and fundamental basis, and have been for some years.

With a zero-interest rate policy combined with CEO’s zeal to boost dividends and buy back stock, prices have continued to rise, which of course attracts more investors.

Consumer staples stocks don’t historically support P/E ratios in the mid to upper 20’s. Some Consumer Discretionary stocks, especially if they’re market darlings, okay, so those valuations can be pushed fairly high for an extended period, of course until the market falls out of love with them and they come crashing back to earth.

My broader point is this: There is a reason we focus on valuations; at the end of the day your return is dependent on what you pay for a stock. If you pay too much for a stock, even a high-quality one, you are reducing the maximum potential return and increasing your downside risk.

Look, if you have a well-diversified portfolio with no glaring holes to fill, why push the risk envelope? Okay, so cash is trash, I get that. It sure beats the heck out of taking a loss though.

Don’t always feel like you have to be doing something. Sometimes it’s best to sit back and relax a while. Like Geraldine Weiss — the founder of Investment Quality Trends — always says, “Stocks and opportunities are like street cars, another one will come around soon.”

Related Articles on MARKETS