James Montier – This Is The Time To Sit There And Do A Winnie the Pooh. Here’s Why.

One of the firms we like to watch closely at The Acquirer’s Multiple is Boston-based asset manager GMO, and one member of its asset management team, James Montier.

Montier recently did an interview with Finanz und Wirtschaft (Finance and Economic) in which he discusses the current over-valuation in U.S. equity markets saying, “Equities are currently the third highest in valuation terms we have ever seen. Only in 1929 and 1999 were they more expensive. And you do not hear many people telling you to buy because it’s like 1929 and 1999.”

Montier provides four paths you could follow in such an environment where nothing is cheap, it’s a must read for all investors.

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Here’s an excerpt from that article:

Montier, member of the asset allocation team at the Boston-based asset manager GMO, is convinced that the US stock market is in bubble territory. However, European equities aren’t particularly cheap, either. Only emerging markets value-stocks appear vaguely attractive to him. Investors should be patient and hold a lot of cash in their portfolios in order to be able to buy when markets are correcting.

James, markets have been very excited about the election of Donald Trump. How long will this honeymoon last?

You never know, because the trouble with Trump is his «policy-by-tweet»-approach. Today’s message is this and tomorrow’s is something entirely different. And between tweet and executive order you do not really know what is going to happen. I believe markets have priced in the best possible outcomes from a Trump victory without any evidence he can actually deliver on any of his promises. The health care bill failing was therefore interesting, because this was his first big legislation – and it failed. What fails next?

What would happen if Trump delivered on his promises?

If he succeeds, wages rise – assuming he will get through some big fiscal stimulus package through -, while inflation probably picks up and the Fed tightens interest rates. And none of these are particularly helpful from an equity market perspective. So there is pretty limited upside.

What is your take on US-equities?

US-stocks are in bubble territory. According to our definition that is the case when the S&P 500 is more than two standard deviations above its fair value. At the moment, this bubble-threshold is at 2350 points.

When will the bubble burst?

Nobody knows. All you know is that when markets are exceedingly expensive it takes very little to disappoint them. Equities are currently the third highest in valuation terms we have ever seen. Only in 1929 and 1999 were they more expensive. And you do not hear many people telling you to buy because it’s like 1929 and 1999.

Are markets headed for a crash?

I think you never know what triggers a correction or even if there will be one. All you know is that if you buy at these prices, future returns will be low. My view is that at some stage a crash is quite likely.

Why do you think that?

We are seeing the typical bubble-like behavior of over-confidence and over-optimism. One retort is that there is no euphoria. For instance, we do not observe the kind of massive surge in IPOs that we witnessed during the dotcom bubble or hear arguments that «this time is truly different».

So why do you think this is bubble-like behavior?

Because I do not think people are rationally buying equities expecting very low future returns. I think they are buying them because they expect good returns. And when the returns do not materialize, that is probably when a correction or a crash will occur, because people will be disappointed

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Which path do you follow at GMO?

In our portfolios we are taking elements of most of those approaches. So a fair share of the risky assets we hold are in emerging markets value stocks, where we get at least some return. We also invest in alternative assets. And then we hold nearly 30% in cash and short duration bonds. Another 7% is in treasury inflation protected securities. So we have nearly 40% of the portfolio in dry powder. This is not because we like cash, it is just that we think the alternatives carry the danger of seriously impairing capital significantly.

Many people don’t like holding lots of cash when interest rates are essentially zero and inflation is picking up.
Cash is like death by a thousand cuts: Inflation eats away a bit every year but at least it is not the kind of big 50% loss that you get when stock markets re-price. So we are trying to build a portfolio that can survive different outcomes and it is going to have a conservative bias because the one thing we know is most assets are expensive. This is not a time to be a hero. This is a time to sit there and do a Winnie the Pooh: When there is nothing to do, do nothing.

What would make the US equity market attractive again – how much would it have to correct?

To get back to our sense of fair value tomorrow, it would have to fall by more than 50%. Then we would be on average valuation, which again we estimate based on profitability going back to normal.

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This article was originally posted by Johnny Hopkins at The Acquirer’s Multiple.

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The Acquirer’s Multiple® is the valuation ratio used to find attractive takeover candidates. It examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization. The Acquirer’s Multiple® is calculated as follows: Enterprise Value / Operating Earnings* It is based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by Tobias Carlisle, founder of acquirersmultiple.com. The Acquirer’s Multiple® differs from The Magic Formula® Earnings Yield because The Acquirer’s Multiple® uses operating earnings in place of EBIT. Operating earnings is constructed from the top of the income statement down, where EBIT is constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–earnings that a company does not expect to recur in future years–ensures that these earnings are related only to operations. Similarly, The Acquirer’s Multiple® differs from the ordinary enterprise multiple because it uses operating earnings in place of EBITDA, which is also constructed from the bottom up. Tobias Carlisle is also the Chief Investment Officer of Carbon Beach Asset Management LLC. He's best known as the author of the well regarded Deep Value website Greenbackd, the book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance), and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law. Articles written for Seeking Alpha are provided by the team of analysts at acquirersmultiple.com, home of The Acquirer's Multiple Deep Value Stock Screener. All metrics use trailing twelve month or most recent quarter data. * The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.”