Saturday, February 9, 2013

ETFs in today’s bull market – a contrarian view

When looking at the S&P500 we’re seeing that prices have similar levels now as at the peaks in 2000 and 2007. Once again the S&P is at 1500. So is the next market crash unavoidably near?  Not really but it is not the best time to buy a lot of stock either. “Godfried, how can you say that when we’re near all-time highs ?”, you may ask. Because today, stock prices are still reasonably valued in terms of book value and P/E metrics.

You see, in spite of the media howling about how bad the economy is, our economies: Canada’s, that of the U.S. and that of the world in general have been growing. Yes, the 2008 crisis was severe but it only stopped economic growth for a short time. Europe overall was most of the time during its credit crisis growing and only lately it is experiencing a recession (contrary to some individual member countries such as Spain and Greece). Did the press not tell you about that?
Over the long term economies grow, inflation goes up and profits grow, even if just nominally (i.e. without correcting for inflation). In terms of P/E (the price we pay for a dollar in earnings; or the years it takes to earn back the money you pay for a share; or the stock price divided by the earnings per share) the market is reasonably priced. At the peak of the 2000 bull market, the S&P500 was close to a P/E of 29. In other words, you would have to pay 29 times the earnings per share to buy a share, or you would have to wait 29 years for the stock's current earnings to pay for the stock purchase, or your earnings yield would be 1/29 or 3.4% compared to the interest rates around 2000 which I recall were typically 6 or 7%.  In 2007 the P/E was around 17 which was not excessively expensive but pricey when compared to historical valuations. In 2009 at the bottom of the market the P/E was only 10.9.  So would you prefer to pay $30 for $1 earnings or $10.9?  Right, and that is why we said that the stock market was on sale in 2009.
So when do you think it was the most risky time to buy stocks? At the peak in 2000 when everybody shouted “Buy, buy, buy!” or at the lows of 2009 when everybody shouted “Sell the world is coming to an end!”? Hindsight is 20/20 that is the difficult thing with investing. We cannot time these market turnarounds but we can prepare for them because just by checking PEs or the Price/book ratios (the stock price divided by the company’s net worth or net asset value) you can figure out what kind of turnaround is in the making and… in the market either kind is always in the making. You cannot time a particular turnaround but you be a good Boy Scout whose motto is “Be prepared”.
What is this thing about ETFs? Well, in general, I like the ETF idea, that is why one of our portfolio strategies is dedicated to market index emulating ETFs. But many investors are today investing in ETFs and mutual funds are apparently in the dog-house. After all, everyone knows that the MERs and commissions combined with the efficient market hypothesis are causing mutual funds to systemically underperform!  Isn’t that true? Godfried you said that yourself just a few posts ago! 
Yep, but the theory also says that if something is known the market will near instantaneously adjust. So why is not everyone in ETFs? Well, because the theory is not perfect. In fact if it was true that markets are efficient then how can the market trade one moment at a P/E of 30 and the next at 11? How would you react if someone told you that your house was worth 30 dollars last week and that next week it is worth 11?  You would probably think that that someone is out of his/her mind, wouldn’t you?  What about the place that you work? Would that be worth $30 today and $11 tomorrow?  What has changed overnight at your workplace? One bad quarter of earnings? Come on!
First of all, markets are not rational they are hysterical. So are the press and everyone who believes them.  You have to look at the real facts to judge what a company is worth – it’s earnings – not for one day or for one bad quarter but for the next 5 or 10 years. You have to look at a company’s financial structure and its state of obsolescence or innovation. You cannot price it based on how you or the world feels right now. If you do that, you’re likely to end up in the poor house no matter what you’re salary is.
I guess the Efficient Market Hypthesis (EMH) is far from perfect contrary what many ETF advocates may tell you. Now remember investment legend Ken Fisher, who likes to try to figure out what is not known by the market and does not go opposite to the market trend but tries to guess what alternative directions the market may take. Well here lies the opportunity, as I see it.

The EMH is about the average market performance. Who determines the average market performance? The bulk of the buyers and sellers in the market of course. Now, ask yourself, in the 1950s to 1970s who constituted the ‘markets’?  My guess, retail investors, banks and some other institutions with the retail investors having a lot of influence. Between the 1970 and 1990s it were the mutual funds and hedge funds who did the heavy lifting and now it may be that ETFs will take over from mutual funds. The heaviest traders today of course are the high frequency traders but they do not necessarily influence market directions, just the level of volatility.
What are the consequences of this change in market makers?  Retail investors were amateur stock pickers (still are); mutual fund managers are professional stock pickers many of whom hold corporate management accountable. When ETFs become mainstream who is going to hold corporate management accountable?  Yep, nobody! Don’t count on analysts many of whom are just corporate cheerleaders who don’t want their brokage being left out at the IPO trough. Talking about conflict of interest!
Guess what else is likely to happen? Indexes such as the S&P are based on market weight; the largest companies (in market capital) make up the largest portion of the index and thus of the index ETFs. When people buy index ETFs these large caps will be highest in demand and their prices will go up and thus the index will go up and then more people are buying the index and so on and so on. This is a self-feeding frenzy that ultimately will form the peak of the next bubble. When the crash occurs, it will be the ETFs that everybody will bail out from and consequently it will be ETF investors that are going to be hardest hit. 
Mutual fund managers buy their stocks selectively and especially those who buy based on valuation metrics like PE, book value and market cap size will likely be least impacted in the crash that follows the ETF-bubble (every investor will lose portfolio value but contrarian managers such as Warren Buffett and David Dreman or past managers such as John Templeton will likely be least affected). My guess is that index ETFs will outperform in this bull market (and several of the following bull markets) but that they will also be hardest hit in the subsequent crash(es) as they will set the ‘average market performance’. When you see index valuations rise significantly start taking profits and accumulate cash for the next major down turn.






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