October 1, 2013

Dear Investor:

Traders are turning their focus toward the government shutdown and debt ceiling debate. This is all best left to the gamblers who feel they can successfully time near-term market movements and macro events—an exercise in pure speculation.

As an investor, not a trader, I’m looking farther down the horizon, beyond three or six months (or even a year or two) to find investments that are cheap today—especially in the wake of any debt ceiling sell-off—and should be less cheap in the future. This practice is known as “time arbitrage,” the purchase of undervalued assets that trade cheaply based on myopic concerns, with the likelihood that those concerns will dissipate over time, unlocking the underlying value.

Stocks are no longer cheap en masse. Careful sector and stock selection is necessary to boost future returns. Here is my periodic rundown on the overvalued and undervalued asset classes/sectors, as measured by cash flow yield.


The most overvalued:

Small Cap U.S. Stocks

Treasury Bonds (any duration)

High Yield Bonds

Long Duration Investment Grade Corporate Bonds


The most undervalued:

Emerging Market Stocks

Japanese Stocks

European Stocks

Steel Stocks (and other deep cyclicals)


Not surprisingly, the deepest discounts to underlying value are found in the cyclicals that are being dropped on macro fears of the Fed taper. These include the steel stocks, trading at a very enticing 3x operating cash flow. For example, the SLX (Steel ETF) has an estimated fair value of $59.71 per share according to Morningstar, 34% above its $44.45 market price.

Emerging market stocks, too, have been sold off to levels that demand attention: 5x operating cash flow for above-average top-line growth. Several years ago, everyone felt you had to own the emerging market stocks (even at a lofty 20x earnings) to participate in global expansion. Now, with China’s slowdown, you can’t find any takers at the current low multiple 12x earnings.

Most market participants continue to buy high when things look rosy, and sell low when they get skittish about macro fears. As always, we strive to do the opposite, putting cash to work in both the beaten down SLX as well as the SCHE (the Schwab emerging markets ETF). If the government shutdown and a technical default on the nation’s debt—and it is a technical default, not an actual default caused by the inability to pay—leads to more selling in these sectors, it will almost certainly be a buying opportunity.