Guru Focus Interview with a Value Investor; Dissimilar Starting Points, Many Similar Conclusions
Inquiring minds are reading a Guru Focus Interview with Investor Arnold Van Den Berg, a value investor.
Guru Focus: You seem to believe that there will be high inflation risk in the coming years. What is the best strategy in this inflationary environment?
Van Den Berg: It is important to define what we mean by inflation. Inflation rates in the low single digits (1% to 3.5%) generally meet the definition of low and stable inflation. Inflation rates greater than 4% or lower than 0% have a high risk of destabilizing the economy. The primary risk of inflation stems from the potential for monetary policy errors. Monetary policy makers do well when the underlying environment is relatively stable. But when conditions change suddenly, there is a possibility for error. Thus, monetary policy errors can be either deflationary or inflationary. The risk is especially high in unstable monetary environments, like we are experiencing today.
Both inflation and deflation compress valuations. In the 1970s, stocks sank to single digit P/E ratios. We all know what happened to markets in the early 1930s. Generally, economic instability is bad for valuations.
We believe that we could go through a period of above-average inflation (on the order of 5%), but nothing like we saw in the 1970s. This period will be very poor for stocks. Since it is difficult to predict the timing of such episodes, we adjust for inflation (and deflation as well) by adjusting our valuations for lower price multiples. When we find bargains, we will buy them; when we cannot find bargains, we will hold cash. We expect that conditions in the economy and in the market will run counter to our investment philosophy for short periods of time, but we know that over the long run value investing outperforms.
Guru Focus: There was a piece in OID approximately eight years ago where you discussed the post-bubble periods. It was transformative for me but I wonder where you think we are at present. It seems the risks are greater than ever as our government tries to solve an over-consumption problem by issuing massive amounts of debt.
Van Den Berg: A major characteristic of bear markets is that things that would normally cause the market to explode -- like low interest rates -- have either minimal or temporary effects. In bear markets, earnings could continue to grow, but multiples become compressed. This causes stock valuations to trade up one to two years, but then revert back to low levels and start the cycle over. Over the duration of the bear market, the prices of stocks may not significantly appreciate. Stocks that may look cheap on a multiple basis may often get even cheaper. This is exactly what we have been seeing since 2000.
At the end of the bear market, multiples have compressed to very low levels. This sets the stage for the next bull market.
How much longer will we be in this bear market? Bear markets typically last about sixteen years, so I would say that we have about five more years to go. This coincides with our earlier comments on how long we think it will take for the real estate, unemployment, and fiscal problems to be reconciled. The way to invest in this kind of environment is to stay focused on the valuations of individual companies. You can still make money in this environment by buying stocks when they are cheap and selling when they are near fair value (remember that multiples are compressing, so stocks won't go as high as one would expect in a normal environment). When bargains can't be found, hold cash.
The Guru Focus interview is well worth a read in entirety.
Are Stocks Cheap?
Stocks look cheap now but they aren't because of three factors.
- PE Compression
- Earnings are mean-reverting
- Record government stimulus globally
Van Den Berg discussed point number one in detail.
I covered points one and two in Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think.
For a follow-up on those points, please see Anatomy of Bubbles; Negative Returns for a Decade Revisited; Is Gold in a Bubble?
Earnings High From Record Global Stimulus
Point number three should be obvious, but obviously it's not given pervasive bullish sentiment nearly everywhere, including smack in the middle of article with bearish sounding titles. For example, please consider a few excerpts from Dow Has Its Longest Weekly Slump Since 2004
- Michael Shaoul, whose Marketfield Fund Ltd. beat 81 percent of competitors last year, said that while the payrolls report was disappointing, it may also be a signal the slowdown in the economic data is near its peak. He noted that weaker nonfarm payrolls reports in February and July 2004 failed to derail the last bull market, which peaked in October 2007.
- The biggest decline in the S&P 500 since August is creating a buying opportunity for investors, according to Blackstone Group LP's Byron Wien. The price-to-earnings ratio for the S&P 500 has fallen close to its lowest level in 2011, according to Bloomberg data. The index currently trades at 14.8 times earnings, near this year's low of 14.7 when it fell in March after Japan's earthquake.
- “The economy is not as bad as it looks right now. Corporate profits will be good, very good. People are asking me, 'Do you still think the market can get to 1,500 by the end of the year?' I do."
In contrast, I think it is crystal clear much of the recovery is a mirage based on unsustainable government stimulus, that stimulus is fading, there is little chance right now for more stimulus, and that corporate profits have peaked this cycle in conjunction with a slowing global economy.
I discussed the slowing global economy in a video: Mish on Yahoo Finance Daily Ticker on Slowing Global Economy; U.S. Manufacturing ISM Plunge; Order Backlog and New Orders Barely Above Contraction
High Inflation Coming?
Van Den Berg clearly has a different definition of inflation and deflation than I do. I prefer to view inflation and deflation in terms of money supply and credit. He looks at prices. He is calling for "high inflation" but high means 5%.
Can we see a 5% CPI with falling demand for credit? Sure, why not? And if it plays out that way, there will be no hiding places at all. Treasuries and stocks both would be hammered. It is one of the reasons I do not like treasuries now.
It is also a good reason why corporate bond rates at 2.33% for 10 years constitute a bubble. , Bear in mind that a renewed credit crunch might send treasury yields lower but it will not be good for corporate bonds, especially junk bonds.
Dissimilar Starting Points, Many Similar Conclusions
Van Den Berg does not like gold. I do. I gave my reasons in a Yahoo Finance video last week. Please see Why I Continue to Like Gold for a discussion. There are other differences as well.
However, we have both arrived at the similar conclusions regarding equity valuations in general even though we have very different starting points about what inflation is.
- The bear market is not over
- Valuations are not cheap
- When there is little value, then there is nothing wrong with cash