The reason valuations are important is because they provide reasonable projections about long-term investment returns, which I would define as over a ten-to-twelve-year period, or market cycle, and the potential for market losses within that market cycle, explains Kelley Wright, editor of Investment Quality Trends.
Within a full market cycle, however, there are periods, typically shorter-term, where valuations are seemingly divorced from the market action. That was a polite way of saying they simply made no sense.
Human nature being what it is, when an environment persists for a significant amount of time, investors can be lulled into thinking this is the way it is going to be forever. This is to say that a bull market will never go down and a bear market will never go back up. Those extremes typically indicate a bubble top or a secular low, and many investors invariably decide to go all in at the top or exit at the bottom.
My thought is after twelve years or so of QE (quantitative easing), which encouraged investors to speculate indiscriminately, that investor sentiment is solidly in the camp of this time is different and that valuations — we don’t need no stinking valuations — are a useless relic of the past. My further thought is this will end like it always has, with tears.
What will take the hardest hit will be what has been most popular, passive investing through indexes and ETF’s. Oh, I know, the trailing returns have been spectacular, they always are at the end of a cycle, which is exactly why so many get sucked into them. Because, you know, past performance is always indicative of the future.
A subscriber recently shared with me the frustration of having more cash than good buying opportunities and asked how we could remain patient for so long. I explained that “slow and steady wins the race” isn’t a slogan at IQ Trends, it is a culture nurtured from experience.
In our roughly fifty-six years of publishing, we have proven that wealth can be created by investing in high-quality companies that offer historically good value based on a repetitive area of high dividend yield and holding them until that value has been fully expressed at their repetitive area of low dividend yield.
The variable for realizing long-term value is out of our control, however, because that variable is time. In our experience though, if you remain focused on your goal and consistent in your approach you will be rewarded handsomely. Of all the things my grandfather taught me one piece of advice stands out, “Know something, know it well and be known for it.” Amen to that.
The above being said though, with short-term interest rates still close to historic lows, how does one justify giving up the opportunity to earn potentially higher returns? What a great question.
In short, barring a windfall of new, Undervalued stocks to choose from, I would suggest that the risk of initiating new, or adding to existing positions in Rising Trends stocks beyond their halfway mark to Overvalue, or in stocks that are already historically Overvalued in an environment where the broad market is clearly overvalued, and an interest rate environment that could possibly experience significant change is too great.
Yes, the yield on short-term instruments is painfully low, but a painfully low yield is more attractive than a capital loss. Although it is current apostasy to write this, one must remember that cash and short term cash equivalents are a primary asset class along with debt and equity.
While cash and equivalents are typically the least attractive asset class in terms of return, it nonetheless plays an important role in risk management. This is to say that the amount of cash one should hold should be based upon the assessment of the current risk/reward probabilities.
The current environment offers little in the way of new value, however. Accordingly, throwing caution to the wind does not, in my opinion, offer a high return probability. If your long-term goal is to minimize risk and maximize long-term total returns it sometimes requires a short-term strategy to protect the long-term return of a portfolio.