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John Paulson - Gold Equities: Myths, Dreams And Reality [SLIDES]

Investment opportunities are quite limited, in part due to the legacy of quantitative easing (QE) engineered by central banks in response to the 2008 crisis. Those actions lowered costs of borrowing and boosted asset prices, especially for U.S. equities. The Fed will enter uncharted waters as it begins to reduce its balance sheet, in addition to raising short-term interest rates.

How should investors respond?

Investors should look at reducing risk in their portfolios. They can sell assets that have rallied and retain a portion of the proceeds in cash to protect capital, in case market prices deteriorate sharply, as occurred in 2000-2002 and again in 2008-2009. U.S. stock valuations are an excellent candidate. Based on a number of metrics, including the cyclically-adjusted price/earnings (CAPE or P/E10) ratio, U.S. stocks are at stratospheric levels that have only occurred twice since 1881. Non-U.S. stock markets look more attractive.

Investing in overvalued asset classes eventually impairs capital. Twice since 2000, U.S. equities have fallen by 40%, generating significant losses for investors. Seth Klarman at Baupost Group recently stated: “When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.” That sentence is well worth reading at least twice, if not three times! Similar to a house of mirrors, the optics often are at odds with the underlying reality, making investment choices even more elusive and challenging.

A decision to hold cash and forego potential returns is sensible when assets are overpriced, as they are today. In the words of Warren Buffett, we do not need to swing at every pitch. In 2005, in an annual letter to shareholders, Seth Klarman noted: “we prefer the risk of lost opportunity to lost capital.” We agree that the current focus should be on preserving capital. The generalized belief that there is no alternative to U.S. equities is at odds with this approach. If we face poor investment choices, given valuations, macro risks, etc. opportunities may well improve over time. Markets are cyclical, even those momentarily distorted by central bank policies.

U.S. equity valuations

Using any number of metrics (including CAPE, market cap/GDP, Tobin’s Q, etc.), U.S. equities are expensive. Doug Short and Jill Mislinski have generated the chart below, which illustrates the history for U.S. equities going back to 1871.

S&P 500 Versus Cash Decision

According to Robert Shiller, at the end of September, P/E10 ratio for US equities was slightly above 31, a level seen only two times since 1881, first, just prior to the Great Depression in 1929 and then again before the tech bubble burst in December 1999. The P/E10 is not a particularly useful trading tool, with one very important exception. Namely, when it reaches extreme levels, either high or low, it provides very useful information to mitigate risk.

For example, in August 1982, the P/E10 declined to 6.6, suggesting that stocks had become cheap. And conversely, when the P/E10 approaches extreme highs, as in September 1929 (33), in December 1999 (42), and once again today (31), a decision to reduce exposure makes sense. Needless to say, we cannot predict whether the P/E10 will continue its surge in the short-term, perhaps hitting 35 or even 40. However, given current levels, U.S. stocks are vulnerable.

By John M. Balder, read the full article here.