The market pendulum swings from undervaluation to overvaluation on a continual basis. Very seldom is the market (or individual stocks at that) in perfect equilibrium. By perfect equilibrium, I mean perceptions of value (market price levels) equaling the true value. This is a concept that Howard Marks describes in detail in his book “Mastering the Market Cycle”.
While the true value of the market or a stock is “in the eyes of the beholder”, a general idea of where it is at can be gleaned by putting the current market in a historical perspective. No mathematical formula that anyone can calculate is definitive on assessing the “true value”. This is a “squishy” subject, in other words.
Using a historical perspective, I think that most valuations are on the hot side. Think of the story of the three bears and goldilocks; I sure don’t want to burn my taste buds off! As such, I like to assess portfolio values on a defensive basis.
A defensive basis means considering certain factors. Here are some of the factors to consider:
- Do holdings have definitive earnings that will not evaporate should the economy turn south?
- Are securities owned at much less than the current market levels?
- Does a solid margin of safety exist should a storm blow in?
- What kind of anticipation is reflected in historical price earnings ratios? Is it on the high side of things?
Another thing I do is do a quick and dirty analysis to see if the market fell 25, 30, 35 or more percent and stayed lower for 2 to 4 years. Would I be able to stomach the pain? I call this mental preparation. The market can be robust, but a change can come quickly and sharply. This has been proven time and time again in history.
Some of the other mental preparations I engage in are actively avoiding fear of missing out, comparing my returns to others and blindly following the crowd. Not avoiding these behavioral actions can cause the “Wile E Coyote” effect where market participants go off the cliff and hit the ground. Ouch!!
A good military leader knows when the odds are on their side and when the odds are not on their side. Taking unmeasured actions at certain times can lead to very bad outcomes. The same thing goes in the investment realm.
Be smart, be well-read, be aware and be successful.
