A recurring theme in my work is a rejection of “value” based methodologies to analyze markets. I’m a big believer in fundamental analysis and especially top down macro work, but I have never found valuation metrics to be particularly useful because they don’t provide us with sufficient information about what we’re really trying to achieve.
Take the price earnings ratio for instance. The forward PE ratio is comprised of the market’s GUESS about the current value of equities divided by the GUESS of the analyst community about future earnings. You divide this guess by a guess, generally place in some historical context based on a handful of business cycles (totally insufficient data set to make any reasonable conclusion) and then predict the future of prices.
Or take the trailing PE ratio. All that is is a rear view mirror look at earnings divided by the market’s current price guess. While it’s arguably superior to the forward PE it involves a backward looking indicator in a market that is forward looking. It’s like driving with your face glued to the rear view mirror.
Throw behavioral biases into this mess, the fact that most investors know much less than they think and you’re involved in a Keynesian beauty contest where you might actually have a more well informed opinion about things and it just doesn’t matter because the rest of the market doesn’t agree. As Keynes described, it’s like thinking you know who the most beautiful model is in a beauty contest, but if the other judges don’t agree it really doesn’t matter what you think.
I bring this all up as I was reading this tremendous post by Jesse Livermore who confirms much of my thinking here. He shows in rigorous detail how many valuation metrics we rely on are based on inadequate data or curve fitting. He concludes:
“What I’m taking issue with is the notion that we can use valuation to build “historically reliable” prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific” or “empirical” privilege to our bullish or bearish opinions. That, we cannot do. Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear. These are not worth the effort.”
As Jesse shows the valuation metrics don’t reliably mean revert. That explains why, for the last 20 years, we appear to be in a “new normal” where many valuation metrics have remained elevated for abnormally long periods of time. It makes one wonder whether we’re in a “new normal” or if the data and concept of mean reversion is reliable for predicting future market outcomes. I’d argue that they’re not. And my reasoning is simple:
- Value based approaches rely on historically useful data sets (which is a flawed assumption in a world with such a small sample set of business cycles).
- Value based approaches rely on rational agents who will come around to your “more rational” perspective at some point. In other words, it assumes you’re smarter than the market despite using a metric that is likely being used by tens of thousands of people like yourself.
- Value based approaches assume that you know what “value” is better than anyone else. In other words, it assumes that you’re the only person with an understanding of “beauty” in the beauty contest. Of course, this doesn’t even matter if the other judges don’t agree though. Therefore, your definition of “value” can be entirely flawed to begin with even if it’s technically right in a textbook sense.
- Value based approaches often assume the validity of concepts like mean reversion which can’t be reliably dependent for sustained periods of time.
- Value based approaches assume that each business cycle can’t be its own uniquely evolving cycle therefore leading us to believe that it can never be “different this time” even though we know that the monetary system and markets are complex dynamical systems constantly evolving and adapting.
Of course, this doesn’t mean valuations don’t matter. It just means that relying on valuation metrics can be extremely misleading and unreliable for periods that will likely lead to significant underperformance.