Warren Buffett, the world’s greatest value investor, once said, “Price is what you pay; value is what you get.” The leading U.S. and European stock market indices have risen to record highs over the past weeks and months. The blended price-to-earnings ratio of the S&P 500, the most diversified U.S. stock market index, is at a 17.86 multiple, based on the SPY ETF that tracks the index.
Identifying value in today’s stock market challenges even the most savvy and experienced investors.
Warren Buffett has made billions as a value investor. In a 2001 Fortune Magazine article, he described an indicator that measures the total market cap of all actively traded U.S. stocks to the latest estimate of quarterly gross domestic product as “probably the best single measure of where valuations stand at any given moment.” Mr. Buffett explained:
“If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart.”
He noted that when the ratio is in the 70% to 80% range, stock purchases tend to be highly beneficial for investors. Conversely, a ratio near or exceeding 200%, like what was observed in the late 1990s and early 2000s, suggests a highly risky market environment.
Today, the ratio is in the danger zone, causing investors to look elsewhere for value.
U.S. stock market indices are near record highs
- The S&P 500 Index rose 24.23% in 2023, 10.16% in Q1 2024, and over 4% higher in late Q2 2024.
- The Dow Jones Industrial Index rose 13.70% in 2023, 5.62% in Q1 2024, and is around 0.80% lower in late Q2 2024.
- The tech-heavy NASDAQ Index rose 43.42% in 2023, 9.11% in Q1 2024, and 7.6% higher in late Q2 2024.
- The three leading stock market indices rose to new all-time highs in Q2 2024.
The issues that could cause a significant correction
- The U.S. Fed has paused its monetary policy tightening, waiting for inflation to fall towards the 2% target before cutting rates. Higher rates for longer could weigh on stock market indices.
- The geopolitical landscape remains a hornet’s nest of potential conflicts. Wars in Ukraine and the Middle East and China’s reunification plans for Taiwan could escalate, causing sudden selling in U.S. stocks.
- The 2008 global financial crisis, the 2020 global pandemic, and the 2022 Russian invasion of Ukraine were surprises that hit stocks like a ton of bricks. The most significant stock market corrections tend to occur when market participants least expect them.
- Stock market valuations are at sky-high levels, and future earnings must validate the current levels and increase to support higher highs.
Mr. Buffett’s former sidekick favored China for the long term- FXI has lagged
- Warren Buffett’s long-term partner, Charlie Munger, passed away in late 2023.
- Before his death, Munger, a long-term investor with a successful track record, said his position in China has been that “the Chinese economy has better future prospects over the next 20 years than almost any other big economy. The leading companies of China are stronger and better than practically any other leading companies anywhere, and they’re available at much cheaper prices.”
- The Invesco China Large-Cap ETF product (FXI) moved 15% lower in 2023, was virtually unchanged in Q1, and is 11% higher so far in Q2 2024.
- At the $26.70 level, the FXI ETF is 63.5% below the all-time 2007 high, while the U.S. leading stock market indices made new record peaks in Q2 2024.
Alternatives to stocks in the stock market- Pros and Cons
- Some alternatives to U.S. stocks are bonds, commodities, real estate, and cryptocurrencies.
- While bonds are highly liquid, U.S. debt levels at the $35 trillion level could weigh on the bond market, making rates remain higher for longer.
- Commodities are highly volatile assets. Traders often embrace the high price variance, while it can be a nightmare for passive investors.
- Real estate investments are highly interest-rate sensitive. Commercial and industrial real estate portfolios depend on economic growth, while residential real estate depends on supply and demand fundamentals and mortgage rates.
- Cryptocurrencies are a burgeoning asset class. The potential for substantial rewards comes with commensurate risks. Cryptos are not for the faint of heart, given their penchant for volatility,
Caution is critical when red flags are waving
- Markets reflect the economic and geopolitical landscapes.
- The bifurcation of the world’s nuclear powers, wars, and rising tensions have created trade roadblocks that could distort prices in markets across all asset classes, increasing the potential for volatility.
- The price of any asset is always the correct price, as it is the level at which buyers and sellers meet in a transparent marketplace.
- There are no wrong prices, only wrong risk positions.
- Approach all investments and trades with a risk-reward plan and stick to that program.
- It is appropriate to adjust risk-reward levels when prices move in the anticipated direction but never let a profit turn into a loss. Adjust stops higher when seeking greater rewards to protect capital.
- Stick to stop levels and admit you are incorrect in your investment or trading thesis when the market moves contrary to expectations. Small losses are acceptable, but a stubborn and undisciplined approach to risk can turn a small loss into a devastating one.
The U.S. stock market has risen to levels where earnings and economic conditions must validate current prices to keep the bullish path intact. Alternative investments provide diversification but come with associated risks. A plan and discipline are critical when trading or investing. If Mr. Munger was correct, Chinese companies could offer some of the best value in today’s market. Time will tell if his legacy as one of the world’s top value investors will continue to shine.
Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!