Just round the corner from our City of London office is an unremarkable little alley that rejoices in the name of ‘Prudent Passage’. Barely more than a corridor between two side streets, it is very easy to miss – and, each time we pass by, the name strikes us as highly appropriate. After all, the alley is hidden away in one of the world’s great financial centres at a time when evidence of prudence in markets appears in very short supply.
Prudent to be cautious
As things stand, investors could be forgiven for thinking pretty much everything is in a bull market. Prices continue to rise, be it stocks, bonds, property, oil or – as we have noted recently in articles such as Echo of the dotcom boom – cryptocurrencies. Fuelling the fire is ever cheaper debt and a general ability to access money more easily. Data meanwhile shows both companies and households are increasing borrowing levels.
According to Benjamin Graham, the father of value investing, the secret of a sound investment is a “margin of safety”. What he meant by this is that the price paid for any investment should allow for a range of unexpected adverse outcomes – or, because many things can go wrong at once, it is prudent to be cautious. The actions of many market participants today suggest, however, an increasing lack of caution.
Importance of underlying valuations
While it is the absolute levels of the major stockmarket indices that tend to make the headlines, the far more important consideration is their underlying valuations. That is why one of our favourite metrics, here on The Value Perspective, is the cyclically adjusted price/earnings ratio. Known for short as the ‘CAPE’, this encapsulates the average earnings generated by a market over the last 10 years, adjusted for inflation.
Take, for example, the CAPE of the main US market, the S&P500, which now stands a shade over 31x. The fact its long-term average – using data stretching back to 1881 – is 17x would suggest investors are currently willing to pay an unusually high price for shares. We would also point out this figure has only ever been higher twice – just before the dotcom bubble burst in 2000 and in the build-up to the Great Crash of 1929.
"This time it's different"
So how do those now ignoring these flashing lights from the past justify paying such high prices for company shares today? With those famous last words: “This time it’s different”. Describing this mantra of the bullish investor as the four most dangerous words in investment has, over the years, become something of an investment cliché – but, of course, a cliché only becomes a cliché if it is grounded in truth.
In order to value the future earnings you can expect from owning shares in a business, you need to discount them by reference to an interest rate. The modern-day cry of “This time it’s different” has stemmed from the expectation real interest rates will be lower for longer. That, as we discussed in How interest rates affect stockmarkets, makes future earnings streams more desirable and, in theory, justifies higher share prices.
A world of historically low interest rates has thus led to higher and higher CAPE numbers and yet the more investors are prepared to pay up for a stock, the more risk– whether they recognise it or not – they are taking with their money. In short, they are failing to give themselves any margin of safety – a mistake value investors work hard to avoid making. Each time we stroll past Prudent Passage is just a little extra reminder.