The Right Price

Is the stock market a bargain buy in 2023?

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Jack Byrne, the chairman of Geico, would often golf with friends in Pebble Beach, California. There would be a lot of good-natured betting during the games. In one session in the early eighties, he made what was an irresistible bet: He would pay out $10,000 to anyone who could hit a hole-in-one. All they had to do was put up $11 as a “premium”. Everyone in the group reached for their wallets, except one - Warren Buffett. He said that the premium of $11 was too high given the odds of scoring a hole-in-one. His friends thought that this was absurd, but Buffett was adamant - He would apply the same standards to an $11 wager as to an $11 million wager.

An $11 fee for a $10,000 shot

Buffett is a master of probability and he applied this same principle to the insurance business in the early ‘80s. While other insurers slashed premiums and took on more risk for the sake of growth, Buffett knew what the right price was given the odds, and he focused on keeping his businesses profitable even if it meant scaling down. In 1985, the insurance market crashed. Buffett was flush with cash and could afford to charge high premiums to corporate customers because there was no competition. He could underwrite reinsurance contracts because his competitors had taken too much risk for too little reward and faced insolvency. Berkshire Hathaway soared.

The stock market is similar to an insurance program. The twist is that the investors are the insurers, and the market borrows the money that you underwrite. Just like in the above case, it makes sense to lend your money to the market only if the “equity risk premium” presents good odds. As we enter the New Year, some think that the market is bottoming and this is a great buying opportunity while others think the odds are in favor of treasury bonds.

Let’s look at what the options are, what the market looks like in 2023, and the strategy you should use to make money in the market.

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Cheap and expensive risk

To understand where the market will go from here, we need to see why it got here in the first place. It all started in 2020 when the pandemic started shaking up the debt market. Before that, companies that needed capital would raise them by selling corporate bonds to banks that would issue a loan against the bond. When the economy faced a confidence crisis, institutional investors started backing out and saving their capital in cash rather than investing in companies. This prompted the Fed to buy treasury bonds and corporate bonds, which was a polarizing move.

After the market stabilized, the Fed reversed its stance. It has been following a strategy called Quantitative Tightening - by selling assets from its balance sheet i.e collecting its loans and not reinvesting them. Parallelly, the hike in Fed rates is putting pressure on the market, and this is shifting some money away from stocks. The reason is simple: If you get a “risk-free” return of 5% by investing in treasury bonds, why would you take on extra risk for an average equity return of 7%?

Low risk-free rates imply more risk-taking | Source: Voxeu

This was confirmed by a study performed in 2018 on several thousand participants: When risk-free rates are low, people invest up to 70% of their portfolio in risky assets like stocks but they cut equity down to 50% when interest rates are greater than 5% even when the difference between stock and bond returns is constant at 5%! i.e People will invest in stocks for a 5% return when interest rates are 0%, but will not invest in stocks for a 10% return when interest rates are 5%.

This holds across different levels of investors regardless of their education, background, or income. But suppose the tides turn and there is an incentive to take risk: what are your odds of making the right pick?

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Bad news and Good news

Here’s the bad news: You are probably not going to get rich by picking a winning stock. Professor Hendrik Bessembinder of Arizona State University looked at 26,000 stocks from 1926 to 2015, and he found that:

• Most stocks go to zero. The average stock lasts only 7 years and loses money even considering reinvested dividends.

• Only 1000 stocks were responsible for all the gains in stocks relative to treasury bills since 1926.

• 86 stocks - 0.3% of the sample - were responsible for more than half the gains!

The outsized returns of stocks are due to these few outliers, some of which have 1M% returns! The survival rate for equities is terrible. 87% of Fortune 500 companies from 1955 are no longer around. The lifespan of companies in the S&P 500 was about 33 years back then and it’s less than 20 years now. Here’s where the good news comes in.

Source: Statista

The good news: Despite the difficulty of picking stocks that survive, it’s possible to make money with the stock market - and to even beat it. The Market Sentiment newsletter did an excellent analysis on this that I highly recommend. Here’s the gist:

Passive index investing should be the go-to strategy for everyone who wants to make money. Passive investing is a relatively recent invention… If you were born before the 60s, it would have been incredibly difficult to manage your own index-tracking portfolio for a low cost, but passive investing has become so popular that its market share beat active investing for the first time ever in 2019!

Only 6% of all actively managed large-cap funds managed to beat the S&P 500 over a 20-year period, so your option is to either take a guaranteed return 94% of the time or pick a portfolio that has only a 1-in-16 chance of higher returns. Index investing works while individual stocks fail because indexing is a strategy and not a static portfolio. The strategy is quite simple: You buy into a basket of stocks of the top companies that drive the majority of growth based on three key requirements:

1. The company is U.S based and shares are highly liquid

2. The market cap of the company is a minimum of $8 Billion

3. The company has positive earnings in the recent quarter and positive total earnings in the previous year

The best part is that this list is evaluated every quarter by a committee, and the companies that don’t keep up are replaced by new ones. You save on transaction costs and follow the best-performing stocks as they keep changing!

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Beating the market

A closer look reveals that even in the S&P 500, 20% of the stocks are responsible for almost all of the gains. Do they have something in common?

Source: A wealth of common sense

Wall Street veteran Jim O’Shaughnessy backtested almost 100 years’ worth of data to predict the next market movers before they outperformed, and he found two factors that were consistently linked with great returns:

1. The company must be in the top 50% of its field in terms of market cap, outstanding shares, cash flow, and sales. Under these conditions, companies gave close to double the returns as the S&P 500 with only slightly higher risk.

2. Pay close attention to the Price-to-earnings ratio. Stocks with high PE ratios underperformed and low PE ratios outperformed the market. Since lower PE ratios signal that a stock is cheaper relative to its earnings, this makes intuitive sense, but it’s a good reminder that high valuations are rarely sustained.

The takeaway is that among the biggest companies, the ones that are financially better and cheaper compared to their earnings do better on average. But remember Hendrik Bessembinder’s analysis above before picking stocks with abandon! If picking the right stock is a losing game, what about predicting the market bottom to buy in at the right time?

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Timing the bottom

The yield curve is one tool we can use. In general, treasury bonds pay more for longer terms as uncertainty increases with time. But if short-term uncertainty drives up rates, the yield curve inverts and stays that way for a while. One analysis found that the bottom has never occurred until the yield curve is non-inverted and now we are the most inverted we’ve been in more than 40 years.

Another angle is to look at the sentiment - Panic in the market is captured by the VIX (Volatility Index), and historically, the VIX had to hit a market bottom of 45 or more for a bear market to end. Another way to track sentiment is to look at the ratio between puts and calls. If the put-to-call ratio is more than 1.8, it’s a sign of retail capitulation, and the worst is already priced in.

Source: Ally Invest

None of these are great in isolation, but combining them can give you some indication about whether the market is finally turning.

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That’s a lot of information to take in, for sure. Even the experts are divided… JP Morgan thinks that the recession has already been priced in after a drop of 20% and that the market tends to move upward in situations like this. Goldman Sachs and Morgan Stanley on the other hand believe that the market will remain unchanged through next year until interest rates stabilize.

I’m no expert, but for what it’s worth, I think that all the information we have is already priced in. The tools we have can help us fine-tune our judgment, but it’s unwise to base your entire investing philosophy around stock picking or market timing tools, because the market has a curious way of doing the exact opposite of what you think!

Do you have a bull or bear case for the markets next year? Let me know in the comments.

Stay safe, stay invested and I will see you next year - Graham Stephan. Wish you a happy New Year!

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