Stock and bond markets have looked richly valued for several years. Until recently, those rich valuations have existed without overt evidence of euphoria. It now feels (and that is admittedly not a precise verb) like a boom. A Da Vinci painting changes hands at half a billion dollars. Bitcoin surges more than 1000% since January to over $11,000 earlier this week. We’ve discussed Bitcoin in previous letters, but suffice it to say that what certainly appears (another wonderfully squirrely verb) to be a mania has now reached far into popular awareness. Ugly Christmas sweaters now proudly feature Bitcoin. Katy Perry discusses cryptocurrencies with Warren Buffett, and then memorializes the event on Instagram to over 200,000 likes. What perfect illustrations of pop culture mind share gained by Bitcoin this year!
Enough about Bitcoin, how about certain junk bonds yielding less than Treasury bonds? How about historically low levels of volatility and Goldman Sachs pointing out last week that US market valuations currently sit at their highest since 1900 (see chart below).
Booms can go on a while and this one certainly may. In fact, from a general economy and well-being sense, we probably should hope for exactly that. Obvious warning signs do pose a challenge to us investors. On the one hand, we would certainly prefer to be averaging into investment positions that are generally and historically undervalued. However, those conditions are rare and while we will certainly exploit those when available, in the meantime we shouldn’t simply be out of the market. It is far too easy to see a perceived overvaluation and sell, only to miss another 50-100% upside. The market doesn’t particularly care about our perceptions of general valuation. It only matters what everyone else thinks. As we’ve seen in recent low interest rate and central bank quantitative easing (QE) driven markets such conditions can continue to grow even more extreme for a while. The ultimate frustration lived out by many would-be market timers, is to correctly see overvaluation, sit patiently on the sidelines, and then miss the buying opportunity because things never got “cheap enough”. The odds of consistently guessing right that many times in a row are minimal and better left to the gamblers.
Far better is to consistently seek relative value at all times and maintain a properly balanced and risk-adjusted portfolio capable of taking advantage of market opportunities that periodically arise. To demonstrate this, we’ve going to use the recent example...
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