The title to this post could be somewhat redundant for those who follow a value-investing philosophy. As Seth Klarman might suggest, risk-adverse investors should always exercise caution whether the economy is sprouting green shoots or withering away, during bull and bear market alike. In his classic tome, Security Analysis, Benjamin Graham counseled investors to treat the future as a threat to our investments, not as pending confirmation for our theses.
These words of wisdom should guide investors’ actions as the debate between green shoots vs. bear market rally rages on. With a sufficient margin of safety, investors can ignore the macro debate and buy undervalued stocks. This principle underlies the common value investing refrain to ignore the big picture and focus on a company’s fundamentals.
Yet this principle can be misinterpreted and oversimplified to such a degree that it becomes dangerous. After all, if a company’s worth is the present value of its future free cash flows (or future dividends, if we’re going old-school back to John Burr Williams), then a company’s intrinsic value is dependent on the economies and industry in which it operates. At some level, investors must take into account how a prospective investment fits in the big picture in order to accurately gauge the level of risk. Perhaps that is why Klarman prefers asset-rich bargains over viable businesses on sale — liquidation value resembles absolute value more closely than discounted future cash flows.
I do not claim to have mastered this balancing act between focusing on stock fundamentals vs. taking account of the macro environment. On many occasions, I have allowed bearish economic views to wrongly dissuade me from purchasing fundamentally cheap stocks. But in the current market, being aware of this dynamic is crucial and with that said, my opinion on the current market is as follows:
I do not see real “green shoots.” The American economy, as structured over the last thirty years, is fundamentally unsustainable. I am no economist (thank god!) but this premise seems undeniable. Who knows how it will shake out but shake out, it will one day. As I pointed out in a previous post, Marc Faber predicts it will fall out in a hyperinflationary spell. Dr. Faber is not always right but those occasions are notable because they are the exceptions.
Faber is not the only guru making predictions. During the middle of this decade, Warren Buffett stated that corporate earnings growth cannot outpace economic growth, indefinitely. The sum of an economy’s corporate profit can not grow faster than the rest of the economy without “taking share” from a different segment. For much of the last decade, that share has come from the nearly mythical “middle class”, labor, working people, whatever you want to call it. For an economy driven by 70% consumer spending, at some point, the corporate drain of the middle class would damage the overall economy. The popping of the housing bubble finally broke the back of the “resilient consumer” and we are now dealing with the fallout.
Wall Street seems to believe the resilient consumer has risen from the dead, like from a Sam Raimi movie (“Army of Darkness” is my favorite). Economic recovery is in the pipeline and showing up in “less bad” numbers. But Wall Street lives in a bubble — that’s how they missed this crisis in the first place. Both Bill Gross and Warren Buffett believe the US economy will operate from a new, lower baseline for the foreseeable future and from my view down here among the masses, I must agree with them.
But even if the economy is to perform “below trend” for the next few years, cheap stocks may become available and if so, I plan on buying. However, after readjusting my screening criteria with even more conservative assumptions, only 4 stocks come through onto my watchlist which suggests the market is not a bargain at this point.
If I had to predict, the markets will eventually correct in a scary manner. But for me, the key to balancing my macro outlook with fundamental investing is to not get too attached to a specific outcome. If markets do fall again, cheap securities will become available. If markets continue to stabilize, then volatility will subside and we can all step out of crisis mode and get back to “normal” investing — for me, that will mean scanning 52-week low lists, looking at companies with bad earnings surprises, researching out-of-favor sectors, etc.
Either outcome is fine by me.