“Meh”, Again

Here are a couple updated charts courtesy of Aswath Damodaran’s latest data:

Data Source: Aswath Damodaran
Data Source: Aswath Damodaran

I’ve posted similar charts before. These are a bit different in that I switched them over to use an implied equity risk premium and cost of equity derived from discounted free cash flows instead of dividends. The result is some moderation in the steady state multiple. However, the general trends in the data hold.

My reaction to the broad US market’s valuation continues to be “meh.”

Near as I can tell, at these levels you’re being roundabout fairly compensated for owning US equity risk. Yes, a near-term recession would send the market lower. But I’m not a recession forecaster, and I don’t adjust asset allocation on the basis of near-term economic data reads. The lower equities go, the more attractive the forward returns will become.

That said, if you pick individual stocks there are most definitely pockets of opportunity out there. It’s a great time to go bargain hunting if you were prudent about taking off some risk in the last couple years. Cash can be used to play offense as well as defense.

Mental Model: Market Regimes

Markets and economies go through cycles. We’re used to hearing about bull markets and bear markets. We’re used to hearing about economic booms and recessions. But we don’t talk quite as much about market regimes.

A regime is a particular iteration of a particular phase (or phases) of a market cycle. Understanding regimes is important because markets are adaptive systems. Investors respond dynamically to changes in the economic environment, since changes in the economic environment influence their preferences for different cash flow profiles. As I wrote here, these changing preferences are key drivers for asset prices.

What characteristics define a regime? Things like:

  • Economic growth
  • Inflation
  • Interest rates (cost of capital)
  • Credit expansion/contraction
  • Market volatility

Every market regime is a bit different, but regimes tend to influence investor behavior in relatively predictable ways (partly the intuition behind the old saw: “history doesn’t repeat, but it rhymes”). In a deflationary regime, investors sell stocks and buy long-dated Treasury bonds. In an an inflationary regime, investors sell long-dated bonds, while bidding up real assets. In a growth regime, investors will bid up stocks at the expense of long-dated bonds.

Of course, this is a massive oversimplification. Identifying and profiting from market regimes is no easy feat. That’s the goal of the top-down global macro investor, and it’s an extraordinarily complex and difficult task.

So what do us mere mortals take away from this?

We want to ensure our financial plans and investment portfolios remain robust to different market regimes. This doesn’t mean we have to become market timers or macro forecasters. It means we should be thoughtful about the bets we’re embedding in our portfolios.

Unintended Bets

Today, the consensus view is that we’re in a “lower for longer” regime. Low growth. Low inflation. Low interest rates. There are big secular drivers behind this. In developed countries, older populations need to save a lot of money to fund future liabilities. Lots of investment capital in need of a home pushes down the cost of capital. Technological advances have kept a lid on inflation in many areas of daily life.

If the regime is “lower for longer,” what you want to bet on is duration.

We can define duration in different ways. Usually we’re talking bond math. In this context, duration is the sensitivity of a bond’s price to changes in interest rates. The longer a bond’s future cash flows extend out into the future, the higher its duration. The higher the duration, the more sensitive the bond will be to changes in interest rates. The archetypical high duration asset is the zero coupon bond.

If the market regime is “lower for longer,” you have an incentive to bet on large cash flows further out into the future. Low rates and low growth mean the opportunity cost for making these bets is also low.

Duration isn’t just a bond thing. Every asset with cash flows also has duration. It’s just harder to quantify for equities and real estate because of the other variables influencing their cash flow profiles.

Your venture capital investments? They’re a duration bet.

Your small cap biotechs? They’re a duration bet.

Your cash burning large cap growth equities? They’re a duration bet.

All these things are attractive in a “lower for longer” world because they offer Growth! But they’re also sensitive to the cost of capital. In a world of cheap capital, it’s easy to convince investors to subsidize losses for the sake of Growth! If and when the regime changes, that may no longer be the case.

As much as we hate to admit it, our portfolios are products of our environment. It’s what people are talking about when they say “don’t fight the market” and “don’t fight the Fed.” They might as well be saying, “don’t fight the market regime.”

As I’ve written many times before, I’m not a fan of “all-in,” “all-out” calls. That doesn’t just go for market timing. It goes for all the unintended bets that seep into our portfolios over time.

Especially those driven by market regimes.