By Ben Michaud, Private Investor (originally posted on Zero Sum)
To borrow from Buffett’s 2008 op-ed, “Buy American. I Am.”, the title of my presentation is….
SELL AMERICAN. I AM.
In summary, the bullish case for stocks as peddled by David Tepper earlier this year is as follows:
1. Stocks are cheap relative to bonds with 2014 operating earnings yield of 7.5% versus a 1.93% 10-Year US Treasury yield
2. Central banks have removed tail risk from the system – most specifically with Draghi’s “Whatever it takes” commentary in July 2012
3. The Fed’s current QE program puts a floor under equity markets – i.e. a free put, akin to the “Greenspan Put”
Just like many value investors on this forum, I’m a valuation guy – in the long-run, little else matters. At a recent price level of 1,557, the S&P 500 is projected to return 3.87% per annum over the following ten years. If we subtract the 10-year treasury yield of 1.93%, we get the so-called “market risk premium”, which is 1.94% at present. I’m going to go out on a limb and say the bull case as outlined above is currently priced into stocks.
Compare the current MRP of 1.94% to the MRP at 10/15/08, the night before Buffett penned his “Buy American. I Am.” op-ed in the New York Times…..5.89%. That was with a 4.04% 10-year treasury yield. The current MRP is with a 1.93% yield!!!! To say the least, I am VERY fearful right now with so much greed in the market.
History is fraught examples of why valuation metrics are not great “timing” metrics – look no further than GMO and Baupost sitting out a massive bull run from 1996 through 2000 (off the top of my head). If so, why do I think NOW is the “time” to short the market? Well in addition to being a valuation guy, I’m also a market guy – I’ve tried, but I am unable to plug my nose and ignore two facts: the market moves in long secular valuation cycles and the crowd is ALWAYS wrong at extremes. Thus, I like to view the risk-reward of the market with a multi-faceted approach, and not JUST valuation. So in summary conclusion, I believe the market at current levels presents an attractive asymetric short opportunity for the following reasons:
1. S&P 500 approximately 49% overvalued
2. U.S. secular bear market likely still in progress
3. Extreme optimism among fund managers with long exposure at multi-year highs
The trade has a 3.85 year duration and a projected IRR of 15.5% per annum from a recent SPX level of 1,557.
Please refer to the attached presentation for a detailed outline of the thesis.
***A note on market timing – When I say “timing”, it is not in the typical derogatory way that “market timing” critics use it – rather, I mean timing of the risk-reward equation. In other words, one can never know precisely when the market will decline, BUT one can determine the “time” the risk-reward equation is as such that the market does not sustainably rise above a particular level. For example, the market never fell back to its 1996 level of between 600 and 700 in the 2000-2002 bear market – so if you were bearish in 1996, your short position never even broke even in the decline you were ultimately looking for.***
See the full presentation here.