By Tim Price, PFP Wealth Management

Madness, and sanity

"In investing, what is comfortable is rarely profitable."
- Robert Arnott.

"Valuation," wrote David Merkel, "is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down."

Merkel went on to warn, "you will know a market top is probably coming when:

a) The shorts already have been killed. You don't hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

c) Valuation-sensitive investors who aren't total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he "didn't get tech," he did not mean that he didn't understand technology; he just couldn't understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.

d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.

e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Sell-offs tend to be short and sharp.

f) Markets driven by momentum favour inexperienced investors. My favourite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the
pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing."

Notwithstanding Merkel's caveat about pricing, valuations still matter. Assuming that one is investing as opposed to speculating, initial valuation remains the single most important characteristic of whatever one elects to buy. And at the risk of sounding like a broken record, "initial valuation" in the US stock market is at a level consistent with very disappointing subsequent returns, if the history of the last 130 years is any guide. Without fail, every time the US market has traded on a CAPE ratio of 24 or higher over the past 130 years, it has been followed by a roughly 20 year bear market. The evidence for the prosecution is visible below, for the peak years 1901, 1929, 1966 and 2000. And 2013? Of course, this time might be different.