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Valuation Is Not an Investment Strategy
02/13/2020 10:40 am EST
While we recently warned of the possibility of market weakness, it all based on relevant data, stresses Landon Whaley.
The S&P 500’s massive decade-long rally since the crisis has provoked all manner of gurus, bloggers, and media types to call for a world-ending crash in U.S. equities constantly. While we have shared our concerns regarding the Market’s Fundamental Gravity, all our analysis is based on relevant data. One of the go-to catalysts these doomsayers cite for the anticipated downdraft is valuation.
Some analysts love to look at stock market valuation, there has been no shortage of bandwidth used to tout how overvalued U.S. stocks have currently become.
We aren’t one of the many perma-bull U.S. equity cheerleaders who believe it’s always a good time to invest in the S&P 500 or perma-bears who are always screaming that a market crash is lying just around the next bend. Instead, we are always data dependent, allowing the data and our Gravitational Framework to tell us when it’s time to be bullish, bearish, or entirely out of a given market.
The problem with the valuation argument is that equity markets don’t correct or experience significant drawdowns because of valuation. People don’t wake up one morning and suddenly decide that 26x earnings is too much to pay for the S&P 500.
Here, we pause to make a request of Buffett disciples who make the annual pilgrimage to Omaha to kiss the ring, and spend their weekends sifting through company balance sheets looking for the diamond in the rough: please keep nasty emails and passive-aggressive tweets to yourself.
We are not implying that valuation, as a metric, isn’t useful as part of certain investment strategies. What we are saying is that using valuation to decide when the stock market is ready for a correction is like using the Super Bowl to determine the stock market’s future direction.
Super Bowl Indicator
Back in the 1970s, Leonard Koppett figured out that the Super Bowl winner could accurately predict the future direction of the S&P 500. If the AFC won, the S&P would lose ground over the next 12 months. If the NFC (actually an original NFL franchise, for those Pittsburgh Steeler fans who want to take issue with the indicator) won, the S&P would gain in the following year.
At the time Koppett discovered this supposed connection,” the Super Bowl had accurately predicted the S&P 500 direction 100% of the time. As of last year, this predictor of S&P 500 returns has been right 40 out of 50 years—an 80% success rate!
Clearly, the Super Bowl has no real connection to the S&P 500, and this is just a coincidence. Similarly, stock market valuation has no real connection to causing corrections—it can simply act as a downside accelerant once the correction begins for Fundamental Gravity reasons.
Paging Mr. Hussman
Enter John Hussman, aka “Captain Valuation,” who holds a Ph.D. and manages hundreds of millions in assets. For years, Hussman has been calling for the next stock market calamity, and in each of these discussions, he points to “valuation” as we have noted here before.
The problem for Hussman is that the market has been getting more overvalued with each bear market commentary he produces. He’s written a “bear market is coming” commentary every two-to-three months for the last eightyears with valuation as his primary catalyst!
You may be saying to yourself, “But he has a Ph.D. and manages over $500 million, he must know what he’s talking about.” Well, keep reading.
The Proof is in the Pudding
Hussman’s flagship fund, “Hussman Strategic Growth,” has lost money over the last one, three, five, 10, and 15 years. Even during last year’s “everything including the kitchen sink” rally, this guy’s fund lost 19%. We couldn’t make this up if we tried! Among other funds with a similar mandate, Hussman is ranked dead last over the last one, five, 10 and 15 years. What about during the previous three years, you may ask? He worked his way into the 98th percentile, which means only 98% of all other managers doing the exact same job outperformed Captain Valuation.
Numbers don’t lie: Valuation is not the foundation for consistently successful investing. If the market is extremely overvalued, it will probably impact the breadth of the downturn once it hits but will not be the catalyst. And as you know, markets can stay irrational longer than investors can stay solvent.
The Bottom Line
Hopefully, this commentary acts as a reminder of why it’s critical to be data-dependent and process-driven in financial markets. Don’t fall into the trap of believing the world is ending tomorrow just because markets are overvalued by a bunch of metrics that no one discusses until after the market crashes. There will be many road signs for the next recession (or even crisis) as we mentioned recently, before the real wealth destruction occurs. Those data-driven road signs will be far more meaningful than all valuation metrics combined.
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