April 5, 2017

“Be fearful when others are greedy and greedy when others are fearful.”

                                                                                                     Warren Buffett

Dear Investor:

The contrarian warning above is the mantra of all value investors. It’s what kept us invested at Dow 6,500 in the depths of the financial crisis—and makes us wary at Dow 20,839 today.

Just a year ago, markets were in turmoil. Royal Bank of Scotland said, “Sell everything.” I didn’t agree. But a year makes a difference. Now complacency reigns, markets are silent like a placid ocean just before a tsunami, and domestic stocks are overvalued relative to their underlying cash flows.

We’ve gone eight years without a bear market. This aging bull is long in the tooth. The last vicious bear ended in March, 2009. Even if you date this bull market from the breakout to the new highs in 2013, it’s no youngster. Since 1900, there have been 32 bear markets (as defined by a peak-to-trough decline of more than 20%)—one every 3.5 years on average. A typical bear market lasts 18 months and takes stock prices down 20%-30%. We’re overdue.

Of course, no one knows when the next bear will arrive. Many will pretend to know. They’re called pundits, economists, hucksters, fortune tellers or, best of all, market strategists. Ignore them. The best of them warn of a market tumble year after year, knowing that even a broken clock is right twice a day. The worst of them will tell you to “sell everything” and then leave you on your own. Timing the market is a dangerous game, fraught with opportunity cost and potential failure.

Instead, I believe in doing two things: (1) making sure each client’s asset allocation is appropriate to their needs, time horizon and risk tolerance; and (2) seeking value relentlessly, forsaking overpriced American stocks in favor of remarkably cheap emerging market and other international equities.

Many investors feel we’re due for a bear market due to our current president. That’s not true. We are due for a bear market with or without him. Trump is an erratic, errant sociopath, who will eventually provoke an international fiasco. But we would have a bear market eventually with Obama, Clinton (either one), or FDR as president. It’s just the way it goes.

One big thing—Trump-related—that investors should ignore at their own peril: totalitarian leaders stoke inflation. The last thing I would have imagined myself doing a year ago was researching equity returns under dictators, but that’s how I’ve spent the first quarter. Fortunately, stocks do well during inflationary cycles because corporate returns are denominated in inflated dollars. Stocks generated an average return of 12.2% annualized during the five major inflationary periods of our nation’s economic history.

If you look at the records of stock returns under totalitarians, you see the incredible correlation between despots, inflation and positive equity returns. Since Erdogan first assumed power in 2003 in Turkey, the Turkish stock market has quintupled, as inflation has run above 6%. Putin’s reign has also handed stocks a big boost as the Russian MICEX has climbed eightfold against a backdrop of often double-digit inflation.

I would theorize that the populist activities that such leaders engage in to consolidate power—empire building, printing money and fomenting wars—all lead to too much money chasing too few goods and services. I don’t want to make too much of this point: the data sample is small, and correlation is not necessarily causation. But to renounce stocks due to a fears of a creeping totalitarianism in the United States would be the wrong move. It’s bonds, not equities, which will continue to be decimated by populist political agendas.

Given that domestic stocks are overpriced, with the S&P 500 at 2.7 times book value, it makes sense to reallocate into international stocks. With Japanese stocks trading at just over book value and emerging markets at 1.6 times book, the expected return on these markets is much higher.

So giving up on stocks is a bad idea, but we’re at a point in the cycle where domestic stock weightings should be markedly reduced, foreign stock exposure should be increased, and caution should be the watchword. We’re overdue for a market tsunami to hit these too-calm waters.

With best wishes for the coming quarter.