Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
hat old Wall Street adage, "Sell in May and go away," has proven to be of some value this year. From its level of 2,108.29 on May 1, the S&P 500 equity index declined by 8.9% to 1,920.03 at the end of September. The U.S. stock market, having become increasingly hesitant as July wore on into August, fell precipitously, if briefly, on August 24, when the Dow Jones Industrial Average lost 1000 points during the course of the trading session, making for an exciting day in what had otherwise been a rather uneventful year for equities. The averages subsequently recovered some of their poise, if not their previous highs, and ended the third quarter with modest losses for the year so far..
As a result of how dull the year had been prior to the August fireworks, the financial commentariat's reaction to the events was as furious as the market action. Showing the media's bias, headlines treated every 1% decline as a"plunge," while "risk on" advances were cheered. New scapegoats were trotted out to blame for the return of "volatility" to the markets, with "risk parity" the latest investment fad — among them (risk parity involves the use of borrowed money to enhance the returns of certain assets, a strategy that often backfires when the going gets tough). Some also pointed fingers at so-called "passive" institutional investors, such as index funds, that buy securities without discriminating between what is attractive and what is not. These discussions at least made the summer entertaining, even if it was not profitable for traders..
Calmer and wiser observers pointed out, however, that the market's gyrations were not exceptional. After all, the broad market indexes fell by only about eight percent at the lowest point. Historically, declines of 20% occur about one-tenth of the time, so the summer"rout" was nothing major from that perspective. The Financial Times, in keeping with its reputation for being a reliable source of cool reason, observed that the real market anomaly of 2015 took place in the February to August period when price fluctuations (as reflected in the S&P 500) were confined to a narrow range of only 4%. Not since 1926 could such an extended period of tranquility be found — despite currency swings, fears over China and Greece, and uncertainty about the U.S. Federal Reserve's intentions with respect to its monetary policies. It was worth noting, the FT continued, that prior periods of unusually subdued markets tended to presage significant price declines. So far, however, the third quarter's slump, and corresponding jump in volatility, represent little more than a return to more normal market behavior..
Almost overlooked during the excitement were reports that certain well-known investors quietly bought stocks at lower prices and disregarded all of the kerfuffle. This prompts us to suggest a new adage (with apologies to Mark Twain, who once commented on the folly of speculating in stocks): October. This is one of the peculiarly good months to ignore Wall Street in. The others are July, January, September, April, November, May, March, June, December, August, and February.
Although the squawking classes talked as though a major stock market disaster had taken place, figures for the major indexes indicate that it didn't. Prices did decline year-to-date through September, but only in the 5-7% range (including dividends). The NASDAQ index, home to many of the volatile technology-related issues, declined just 2.5% (not including dividends). Nevertheless, 2015 has been a choppy year for the stock market. Underlying weakness throughout the broad universe of issues has not (until recently, at least) been fully reflected in the readings of the popular market barometers, a fact that undoubtedly puzzles many individuals when they find that their own investment results come up short in comparison. Curiously, this phenomenon has also occurred in the past at market peaks, although the recent experience is nowhere near the extremes seen at prior speculative zeniths, such as in 1999, for example.
Concerns about the risks of high stock valuations have been growing, and given the market's sharp rise since 2009, there is definitely good reason. Various valuation ratios are at the upper end of their ranges. Longer-term measures (e.g. the "CAPE" ratio — based on average earnings over ten-year periods) also tend to support the claim that equities are richly valued (even dangerously over-valued, according to CAPE). Such indicators do not have much predictive power in the short run, however, and whether they signal sharp market declines to come, as many fear, is a matter of speculation. What they do strongly suggest is that longer-term returns from equity investments will likely be mediocre on average from these levels (beware, index fund buyers). The fact that it is currently very difficult to find attractive opportunities additionally indicates rich valuations and poor prospects for good results.
Nevertheless, the frothy conditions that typically accompany stock bubbles seem absent at present (notwithstanding the fact that a few industry sectors, such as biotech, have attracted intense interest). While difficult, it is still possible to find the rare attractive situation. As we have often noted, the real excitement for investors will come when bond market bubbles start to deflate and wreak havoc on over-extended borrowers and their incautious lenders. An omen of things to come, perhaps: a few bond indexes, including those for long-term corporate issues and "high-yield" bonds, are already showing negative returns year-to-date.
The traditional view of investing held that securities should be purchased at a discount to their true worth or "intrinsic value." Modern financial theory, on the other hand, maintains that markets are "efficient," meaning that security prices reflect, in a rational manner, all information that might be relevant to determining an issuer's worth. If the latter assertion were, in fact, correct, then how would investing as traditionally conceived be possible? How could discounts ever appear when thousands of observers, analysts, and market participants are constantly digesting every bit of data, all contributing in real time to the price discovery process? A cynic might respond that an assumption of market efficiency is required in order for the statistics underlying modern financial theory to work (we admit to sympathizing with this view). The fact remains, however, that markets are usually quite good at quickly responding to information flow and adjusting prices accordingly. Hence, it is normally very difficult to find worthwhile discounts — ones that persist long enough for the slow-speed trader to take advantage of, and of a sufficient depth to attract the traditional investor's interest. Nevertheless, discounts do appear from time to time, and for reasons that are rooted in the nature of financial markets, as opposed to financial theory.
Most of the time the community of investors and their enablers (brokers, analysts, bankers, etc.) operate within a world of efficiency and rough "equilibrium," to employ a term dear to economists. Decision-makers allocate capital, analysts analyze, and bankers promote securities, all relying on an assumption that a recognizable sort of normalcy will prevail in the future, permitting growth and earnings projections to be met (roughly), businesses to dive or thrive, and demand for new products to appear. In other words, the present will more or less continue into the future and impact it in predictable ways. Note that this stance is to a very large extent backward-looking. As the military prepares "for the last war," according to the common expression, Wall Street looks forward to the last financial crisis. Hence, as a result of the 2008-09 experience, in this world even "black swan" events (a term which became popular during the crisis, it refers to the out-of-left-field, unexpected, and unpredictable occurrences that upend the normal state of affairs) have become "normal" in the sense that they are identified, discussed, and warned against. Investing, for the most part, becomes a routine search for "growth" or some more or less temporary business advantage.
As a great investor once observed, markets change, but human nature stays the same. So when the world acts in unexpected ways, things get truly interesting. Whether it is due to the appalling collapse of the U.S. real estate finance system in 2008, unforeseen consequences of "portfolio insurance" in 1987, or, in the case of an individual company, the Tylenol tampering crisis at Johnson & Johnson in 1983, uncertainty triumphs over reason, and expectations change radically. On Wall Street, earnings projections become meaningless, and neat predictions about the future prove unrealistic (they almost always are anyway). Far from being rational, financial markets can react violently at such times as they are pummeled by the fears of their all-too-human participants. Securities prices, especially for equities, usually suffer, as their valuations had become elevated during times of stability.
Disruptions are also characterized by extreme shortsightedness as participants seek to preserve capital under fearful circumstances. "Efficiency" becomes overwhelmed by emotion. For the investor, who by definition shuns emotion and takes a long-term view concerning values, genuine "discounts" appear. While markets may "abhor uncertainty," as the saying goes, investors love the discontinuity that follows in its wake.
______________Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.:
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Brookline, MA 02446.2822 USA
© Copyright 2015 Dennis C. Butler, All Rights Reserved
Revised: October 8, 2015 TAF
© Copyright 2015 Dennis C. Butler, All Rights Reserved