Valuation matters most in the long run...
...but other stuff happens in the meantime
Benjamin Graham famously said “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” A voting machine counts votes. Votes are based on sentiment of people at a given time. Sentiment can change as narratives come and go and is difficult to measure accurately. A weighing machine is much more precise and accurate. The metaphor suggests that in the short term prices are driven by sentiment and the “story of the day”, while in the long term, trends are driven by something you can measure more concretely, valuation.
The overlapping wave graphic above is a simplified picture conceptualizing the interaction between the long term valuation (weighing machine) reversion cycle, and the shorter term narrative (voting machine) cycle. Obviously, this is an over-simplification as the cycles are anything but regular and perfectly predictable, but it demonstrates graphically some important concepts. A few comments:
- The valuation reversion, or full market cycle is long. Typical equity market cycles follow the business cycle and are 7-11 years. Interest rate cycles tend to follow an even longer generational cycle at 60-70 years. The sentiment or narrative cycle is shorter, typically with a duration less than three years.
- It is the longer cycles that “matter more”. Valuation cycles tend to be bigger from bottom to top than sentiment cycles. They are also easier to quantify. Both of these factors are important to us. Buying relatively undervalued asset classes, and then holding them until they are overvalued is a major component of our strategy.
- “Stacking” of sentiment and value cycles generates the highest highs and the lowest lows. Major buying opportunities always show both demonstrably low historically valuations and terrible investor sentiment. Market tops always show the opposite. Both high prices relative to historical ranges, and also investor optimism that more gains are just ahead.
- Superimposed on top of the cycles is the constant injection of new information with a large degree of randomness. In the very short term (day-to-day, week-to-week, and sometimes month-to-month), markets routinely do “interesting” things. After the fact, some can be explained, and some can’t. Financial media frequently user the terms overbought and oversold to mean nothing more many days or weeks in a row with prices trending in the same direction.
- The long term upward bias (due to the market internal return) is not shown in this simplified cycle model. Keep in mind that stocks represent companies that generate profit and bonds generate yield. This return is independent of the cyclical price variation on top of the return. Therefore, these lines should be visualized as sloping upward to the right. This is the feature leading to likely gains for patient buy and hold long-term investors from any starting point, given enough time.
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