PWA 2024 Year-End Letter, Part 3: Finding Value, Globally

In this year's year-end message Part 1 we touched on three investing rules to live by.

Essentially: 

1. Control risk

2. Buy value

3. Be patient

So, while controlling risk may be accomplished in a number of ways, it's generally-speaking pretty easy, but it ain't free.

If we're talking diversification, cost comes by way of missing out on concentrated returns when a particular asset class, or, say, a small group of stocks realize outsized upside relative to the rest (à la recently, in record fashion!)... If we're talking insuring against massive declines in a given asset class, security or group of securities, there's the options premium we pay.

As for #2, buying value is easy enough, when you can find it, and of course you have to know how to measure it.

#3, patience, depending on who you are, can far and away be the most difficult rule to follow!  Particularly when you see a given tech stock or, say, crypto currency, rocketing -- without you -- to the proverbial moon... Or, on the other hand, when it feels like the world is melting down all around you, and panic begins to grip your decision making process.

Ideally, if we satisfy #1 well enough, we can keep panic-driven reactions at bay... As they, along with greed-driven decisions, are inevitably the worst decisions investors make!

Here, in Part 3, we're going to focus primarily on rule # 2, buying value.

But first, let's quickly recap parts 1 and 2:

In Part 1 we acknowledged, and illustrated, that US stocks are presently expensive to a degree where history virtually demands that we walk softly into whatever the current cycle has left in it (yes, we are late-cycle right here).

We showed the makeup of our current core allocation, which presently emphasizes diversification across asset classes, across regions, and with a healthy allocation to short-term treasuries.

We also illustrated how utterly easy it would be for even your garden variety bear market to erase years worth of stock market's gains, even back to the Covid bottom in 2020...  Hence, at these historically-high valuations, along with what we'll call the mediocre state of general conditions, investing like we did, for example, during the runup from the '09 bottom to fall '19 is simply not an option, at this juncture. 

In Part 2 we acknowledged that the recession concerns we expressed heading into 2023, and ever since, have not yet come to fruition... In fact, I pointed out that our own general conditions index had improved to a near-neutral overall score... Well, as of last weekend, it actually hit neutral right on the button... I.e., 42% of our indicators are now evenly split between positive and negative scores, with the remaining 58% scoring neutral.

We also explored the equity market prospects for 2025 in a recession vs a no-recession scenario... We even offered up competing narratives from two of the world's top macro research firms. 

Fascinating how two different teams, both brimming with education, experience and expertise, can parse all of the same data and come up with two vastly different conclusions — on the economy, that is... Even the team that remains bullish on the economy is not all that bullish ("lower returns" and "greater volatility" loom) on equities going forward.

Here again is how we summed up Part 2:

"Per our own assessment of current general conditions, as well as the featured competing views of two of the world's top research firms, suffice to say that the go-forward setup presents a resoundingly mixed picture for US equities...

Leaving us therefore inspired to remain very diversified across asset classes, and across the globe, while staying plenty liquid, and to continue hedging our US equity exposure with options."

While I can offer up volumes more to support our current, call it guarded, point of view, I think that at this point parts 1 and 2 — along with our equities valuation commentary below — probably suffice... With "current" being the operative word, for, as we meander into 2025 and beyond, make no mistake, things will indeed change (evolve) in terms of our go-forward view and what we'll find to be the optimal risk/reward setups to exploit.

Okay, let's dig into what it means to buy value.

As I stated above, it's not hard, when you can find it.

It seems only natural, if not mandatory, that when we're on the topic of value in the stock market we delve into what the individual many believe to be the greatest value investor of all time is up to.

Well, alas, Warren Buffett is simply not finding much value these days... Here's from Investopedia on December 15th:

"Berkshire Hathaway said earlier this month that its cash pile had swelled to a record $320.3 billion in the third quarter from $271.5 billion the prior quarter. Of that amount, $288 billion is invested in short-term Treasury bills.  Berkshire has accumulated cash in each of the past nine quarters.

Investors watch Berkshire's cash hoard closely for its potential as "dry powder." One potential reason Buffett's keeping that powder dry: The "Oracle of Omaha" may not see much room for growth in the market."

In Part 1, alongside several other metrics that reflect historically-lofty valuations for US equities, we featured "The Buffet Indicator," which the article referenced as well:

"The ratio of stock market capitalization-to-GDP, also known as the "Buffett Indicator," is used to determine whether an overall market is undervalued or overvalued. The stock market's total value hit a record high of $58.13 trillion on Monday, "an unprecedented 198.1% of U.S. GDP last quarter," Business Insider wrote, citing Wilshire Indexes data.

That number is a major red flag for Buffett. In a famous Fortune article from 2001, Buffett said, "If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.""

Note the 1999 reference, also per Part 1.

And from Business Insider last month:

"Warren Buffett has been selling shares and stacking up cash at a terrific rate, fanning speculation as to why the world's foremost stock picker is pulling his money out of the market.

Berkshire Hathaway roughly tripled its pile of cash, Treasury bills, and other liquid assets to a record $325 billion over the two years to September 30 (or $310 billion after subtracting almost $15 billion of payables for Treasury bill purchases).

The conglomerate's cash hoard now exceeds Berkshire's total market value just over a decade ago. It accounted for at least 27% of Berkshire's $1.15 trillion of assets at quarter end — the largest proportion in many years."

Lastly, to sum up the current state of affairs for US stock market valuation, here's from John Hussman's December commentary (he’s known for his excellent, deep and prescient work on valuation) 

“ On Friday December 6th, the U.S. stock market pushed to the most extreme level of valuation in U.S. history, based on the measures that we find best-correlated with actual subsequent 10-12 year S&P 500 total returns, as well as the depth of subsequent losses over the completion of market cycles across a century of data. That’s not a forecast. Rather, it’s a statement about current, measurable, observable market conditions."

Okay, so, again, US stocks are simply expensive, big time, right here... Which, by the way, in no way whatsoever -- by itself -- means they're going to get dirt cheap anytime soon... For those betting that they will, I totally get it, but... well... you know:

"Markets can remain irrational longer than you can remain solvent."  -- J.M. Keynes

So then, what, if anything, in the world indeed looks "cheap" right here?

Well, I did say that buying value is easy, when you can find it... I.e., the thing is, finding it!

When seeking value, we can think of it in terms of "absolute" and/or "relative."

For quite some time I've been pointing to the "relative" (to the US) value offered up by foreign equities.

As for the numbers, let's forget about US vs foreign for a minute, and just take at look at US (SP500) valuations relative to where they typically trade. 

They currently trade at 27.2 times last 12 months earnings, while the 10-year average has been 21.5 times... That's quite the premium!

In terms of price-to-book value, we're looking at 5.2x vs 3.7x 10-year average... That's a huge premium!

Current price-to-cash flow 22.5x vs 14.4x !!!

Current price-to-sales 3.1x vs 2.3x. !!!

Make no mistake, those are historically lofty -- to put it mildly -- comparisons! Heaven forbid, if/when the economy contracts and these multiples simply descend to recession-level norms... well... like I keep saying, US stocks are not currently pricing in any recession risk whatsoever!

Now let's consider what the valuation setups -- relative to their own respective histories -- look like beyond US borders.

Beginning with the Eurozone:

Current price-to-earnings: 14.5x vs 15.8x 10-year average.

Current price-to-book value: 1.9x vs 1.7x 10-year average.

Current price-to-cash flow: 10.1x vs 7.9x 10-year average.

Current price-to-sales: 1.4x vs 1.2x 10-year average.

I certainly wouldn't say crazy-cheap right here, but I wouldn't say historically-expensive either.

How about Asia-Pacific:

Current price-to-earnings: 14.9x vs 16.1x 10-year average.

Current price-to-book value: 1.6x vs 1.6x 10-year average.

Current price-to-cash flow: 9.3x vs 9.7x 10-year average.

Current price-to-sales: 1.3x vs 1.2x 10-year average.

More compelling than the Eurozone, but I wouldn't say dirt-cheap right here either.

As for emerging markets:

Current price-to-earnings: 13.8x vs 14.1x 10-year average.

Current price-to-book value: 1.7x vs 1.7x 10-year average.

Current price-to-cash flow: 7.0x vs 8.5x 10-year average.

Current price-to-sales: 1.3x vs 1.3x 10-year average.

We'll call them reasonably priced, by their own historical standard.

As for how foreign equities stack up relative to the US, let's visualize:

Here are some 2-year charts for the US green, the Eurozone purple, Asia-Pac blue, and Emerging Mkts orange:

Price-to-earnings:

Price-to-book value:

Price-to-free cash flow:

And price-to-sales:

So, while non-US equities are attractive enough relative to their own respective histories -- my how they just keep getting cheaper compared to the US!

Now let's take a look at what, in terms of income, US stocks have to offer compared to their relatively cheaper counterparts.

12-month dividend yield:

Ouch!! Those are some big yield differentials favoring non-US equities.

So, what does all this tell us?  Simply put, US stocks, despite their high valuations, and low dividends, have been THE place to be for quite some time now!

Per this 5-year price performance chart:

Interestingly, per the next chart, the past 5 years -- in terms of overall performance gap -- look very much like those last 5 years of the 1990s (although the Eurozone saw a massive catch-up run in late '99):

Thing is, per the next chart, when the bubble finally popped, cheaper valuations didn't buffer foreign equites, not in the least:

March 2000 to October 2002 price performance:

That said, during the following bull market, the valuation mismatch indeed turned into significant outperformance for non-US equities -- emerging markets in particular:

Hmm.... 

Note (per the 2nd 5-year performance chart above) that Asia-Pac and Emerging Mkts (the winners during the '00s bull market) were notable underperformers during the tail end of the late-90s cycle, very much like they have been this go-round (the 1st 5-year performance chart above)... 

Again, Hmm...

So, yes, you guessed it, we indeed see odds favoring non-US equities during the next cycle.

But why? Is it all about valuations going in?  

While indeed relative valuations have something to do with it, they, frankly, by themselves simply aren't enough... I mean, for some reason, per the charts above, this US outperformance amid a notable valuation mismatch has been existing for quite some time... And nothing says that it can't go on even further, despite the evidence that US equities are now dangerously -- by historical standards -- out over their skis!

So, what else then? 

Well, while there are numerous fields of macro weeds we can explore, the main thing to watch with regard to the above narrative is, without question, the still-all-mighty US dollar.

To close part 3, we'll simply illustrate for you how the dollar has trended during what remains an extended period of US outperformance, versus the preceding period when US equities lagged notably.

March 2009 to current (US dollar yellow, bottom panel):

Tech bubble bottom (2003) to real estate bubble top (2008):

Yep! Make no mistake folks, if we get the dollar right longer-term going forward, we'll get a lot right in our asset allocation strategy.

Now, and lastly, let's be very clear that we're talking about opportunities that will exist in THE NEXT CYCLE!  I.e., the present cycle is not done yet, and IF it ultimately shakes out true to historic form, the values we anticipate will likely become... well... yet more valuable (attractive) along the way.

We'll tackle the dollar in Part 4.

Link to Part 1

Link to Part 2