February Market Update

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Unless you’re a momentum investor, finding attractively priced stocks to initiate new positions in, has never been more difficult. Case in point. Legendary value investor Seth Klarman who runs the Baupost Group, now has over 30% of his funds in cash waiting for a better time to invest.

“I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone…can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important…it helps you find your bearings when reassuring landmarks are no longer visible …” Seth Klarman.

Like most successful value investors, Baupost has significantly underperformed during periods of market extremes to the upside. Yet they have comfortably outperformed the markets over time. Two of the biggest reasons for their success are patience and discipline. They raise cash, waiting for better opportunities during times of excessive valuations and only invest when they consider the investment undervalued with a margin of safety built in.

Now is such a time. The majority of major valuation metrics are in the 90th percentile historically. Median P/B, P/S and PEG ratios have eclipsed the peak of the dot com bubble. This is making it harder to find good investments.

Trades are becoming crowded as investment managers chase performance. The P/E ratio of the top quintile of stocks is over twice as high as the next quintile. This is a gap larger than at any other time.

Yet, this is all being ignored for a few reasons.

The first is that valuations are not a great predictor of forward 12 month returns. Second, despite the market being over valued for a while, stock prices continue to rise. Third is the promise of regulatory and tax reforms with the expectation that it will lead to stronger earnings growth. It’s important to remember that stock prices are a reflection of the perception or reality, not reality itself.

Market perception will likely not change in the short-term without another market shock or a couple interest rate increases by the FOMC.

The FOMC remains reluctant to raise rates due to the high debt levels the government carries. When they raise short term rates they also raise the debt service burden for the government. Thus, they continue to be data dependent in an effort to delay the inevitable.

That day may be coming to an end. CPI rose rose 1.7% year over year. Testifying before lawmakers on Wednesday, Yellen reiterated that it would be “unwise” for the U.S. central bank to wait too long to raise interest rates.

If they fall behind the curve it creates a multitude of difficult scenarios, none of which are good for the markets in the short term

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