Although my regular readers may disagree, I don't think of myself as a pessimist. Few successful long-term investors have remained chronically negative on the U.S. economy and stock market, and the stock market has treated me exceptionally well over the past few years. So, after deep reflection, I've arrived at the following conclusion: The investment community has forfeited a significant opportunity.
What was that opportunity? Obviously (at least to me if not to the talking heads and perma-bulls) it was the chance to generate healthy returns on the long side of the equity market. Today's excess returns generate tomorrow's downturn.
The substantial rally from last fall's intermediate bottom has extracted most of the upside from stock prices. Not only are the market-cap-weighted valuation ratios at very high levels, the spreads between cap ranges have narrowed considerably, removing the opportunity in most mid- and small-cap stocks as well.
For the past few years, many of those mid- and small-cap companies have represented excellent values with decent business fundamentals. For more than two years, I've written about the attractiveness of these stocks. But today, the average stock's price-to-earnings ratio of 18 matches the cap-weighted
For much of the past five years, valuations in the bulk of the market's names were considerably lower than those of the S&P 500. For example, in the fall of 2000, with the S&P 500 trading north of 1400, the median stock in the Value Line Index was about 15 times profits. That's right -- most stocks were cheaper then, with the S&P 500 40% higher than it is today. Except for the 1998-1999 bubble, little money has been made on the long side from these valuations.
This elapsed opportunity to make really good money in stocks is important, but just as significant is the misspent chance to make things right. In my opinion, much of "the game" is back in force. If you want to see a glimpse of the bubble, just watch a momentum portfolio manger casually dismiss valuation on a
interview. Or read the average buy-side research report on a technology stock to relive a bit of the go-go days. Or listen to a conference call during which a relentlessly optimistic company management delivers a few-penny "blowout" quarter for a whiff of the new era.
I do not begrudge investors well-earned returns for intelligent risk-taking. That is the only job I have ever had. But I don't approve of rank speculation supported by dishonesty, disingenuity and irresponsibility, especially when it comes from "professional" portfolio managers. All of this is beginning to creep back into the market.
A Chance for Cleanup
A year or so ago, the chance existed to clean up the entire convoluted process. We could have had corporate managements lower unrealistic growth targets and renounce the "penny better than estimate" nonsense. Sell-side analysts could have become more sensitive to the fundamental reality of their companies and could have gained more understanding of managing business for long-term gain. They even could have become more conscious of the risk/reward relationship to equity valuation levels.
Board members could have cut absurd compensation levels and egregious benefits such as multimillion-dollar termination payouts. Professional portfolio managers could have acknowledged the importance of sound investment disciplines. The cheerleading talking heads might have learned that speculation needs little encouragement. The
might have discerned the danger of forcing investors far out on the risk curve. Heck, they may have even learned how to recognize a financial bubble!
But unfortunately, those opportunities expired. Companies still report earnings "ex items." Most of the media, analysts and investors casually dismiss the continuous stream of one-offs. Company managements promote their quarterly results with profuse optimism. Analysts upgrade expensive stocks with irresponsible analysis and nonsensical valuation targets. Perma-bullish financial commentators sneer at a case for prudence and high-five one another over catching the latest rally. The Fed repeatedly champions 0% short-term interest rates as well as the Greenspan put. Investors enthusiastically approve and shovel more money to their overpriced and underperforming mutual fund managers. The current "echo bubble" and the resurrection of 100-plus P/E ratios have obliterated the possibility of re-establishing dignity within the investment profession.
My criticism of "the game" is not a case of sour grapes. I've been too cautious on the equity market this year, but my portfolio is up almost 40%, according to audited results -- not bad performance for being wrong. My point is, you are not reading the diatribe of a decimated short-seller. However, I sincerely believe the entire process, including financial reporting, corporate governance and the investment management business, needs a healthy dose of responsibility, integrity and honesty. Today, I find them sorely lacking.
What to Do Now?
So what's a rational, fundamental investor to do, join the mo' or just say no? The response is anything but clear or easy. Unless the rally develops into another full-fledged bubble, material and sustainable gains from current levels seem remote. Stocks have already enjoyed a powerful move and have become expensive again. But at the same time, the case for a firm tape can be made. Price momentum is strong, fundamentals are improving, and cash is pouring into equities once more. Short term, the rally has a reasonable shot at continuing.
The current kind of market represents the most frustrating environment for value managers. I remember living through a similar situation in 1998-1999. Cheaper stocks seem to trail, while pricey momentum shares outperform. Adding exposure to lagging, value-oriented stocks does not get one back in the game. It increases risk without a commensurate return benefit.
Cash constitutes the largest position in my portfolio today. The remaining equity positions are fully hedged. Because of personal circumstances, including the start-up of a new investment management business, my portfolio must be structured in this manner. However, even without these restrictions, my long equity exposure would be greatly reduced from this time last year.
My investment discipline requires purchasing stocks only after significant declines to low valuations. Few stocks fit my new purchase parameters today. Most stocks fit my sell discipline. And that is the approach I have chosen. Even though stocks may continue to work higher over the short term, the long-term outlook for equities is not favorable.
Participation in the current rally, especially speculative stocks, is quite alluring. The temptation of "easy money" is especially seductive. Unfortunately, opportunity, like paradise, can be lost. Investors have consumed the majority of the current bull market's fruits. Aggressively partake of the equity market here, and you'll risk performance damnation yet again.
Robert Marcin is the principal of Marcin Asset Management, a private investment firm. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). At the time of publication, Marcin had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to