Due to the duration of the mother of all bubbles in China and years of global central bank recklessness, we simply don’t sense that enough attention is being paid to the implications of a return to a more normal landscape, though it’s clear that changes are afoot. Given that median valuations have never been higher than now, we think it’s critical to heed lessons from the past.
If we had not been through this all before (at least twice), we might not believe how various participants discuss markets and allocate capital when it seems to them like “the sky’s the limit.” In our experience, including ten years at an institutional shop, even professional investors and plan sponsors generally have higher risk exposures at cycle tops than at bottoms because they are prone to the same emotional pulls as the masses. They forget that historically the second half of a cycle wipes out a good chunk of the gains from the first half. As a result, many decide that meaningfully hedging risk is foolish and cash is trash at precisely the wrong times.
While long-only strategies definitely have their place, so do hedged strategies. We often find arguments between proponents of these two camps to be a waste of time because both have merit. Those making cases on both sides can seem like warring factions. Together these strategies can enable investors to allocate capital according to risk preferences with an eye on overall market valuation as their guide. Allocating more to hedged strategies as valuations rise should be the general rule, but the opposite often occurs.
We think it’s always important to ask if those proposing an investment idea are heavily invested in whatever they are espousing at the moment and do they acknowledge the downside risks of pursuing their game plan. We have seen a good deal of capital incinerated on strategies based on forward earnings estimates, which prove too high late in the cycle. The same goes for equity models predicated on comparisons to Treasury yields. As a result, we strongly favor comparing market caps to revenues as a valuation metric because that has worked the best over time.