When you make your living in and around the financial markets the most frequent question you will get is “Whats the market going to do?” or “Hows the market these days?” For a long time my stock answer ahs been “No Clue” but recently I have changed that up a bit. These days my go to response is “We can argue about whether the market is fully valued or overvalued but under no circumstances can we say it is cheap and represents an exceptional opportunity.” I am very fond of Chalrie Mungers observation that he didn’t get rich buying mediocre opportunities. The trick according the Charlie is to have lot s of cash when an exceptional opportunity passes by. Outside of the community banks I see fee exceptional opportunities in the current market.

You don’t have to take my word for it. A lot of folks that are a lot smarter than I am are telling you the same thing .The partners at Tweedy Browne have decades of experience and world for a firm that was one of Ben Grahams brokers back in the 1920s so I suspect they know a little something about valuation. In their second quarter shareholder letter they wrote” Anecdotally, there are a number of factors that suggest valuations are stretched in today's markets. While these factors are primarily associated with US markets, we believe the direction holds true in developed markets abroad as well. The S&P 500, the DJIA and the MSCI World Indexes hit all time highs earlier this year. Simple P/E ratios are at 18 to 19 times trailing earnings. The Schiller Cyclically adjusted P/E ratio is at 26 as compared to its historical average of 16. The Buffet Valuation indicator (total market capitalization/GDP) is at approximately 132 or nearly twice its historical mean. 2014 marked the biggest year for US-listed IPOs, by both number and proceeds raised, since 2000. Private equity investors are routinely quoted in the press indicating what a wonderful time this is for selling businesses. Corporate lending standards are beginning to deteriorate as large LBOs are being screened in the context of 6X to 7X debt multiples (proforma debt to ebitda). CLO issuance reached $124 billion in 2014, higher than the previous peak of $97 billion in 2006. Covenant lite loans represent greater than 50% of new leveraged loan volume and PIK (payment in kind) toggle loans are back.”

James Montier has written several books on value investing and is on the asset allocation committee at GMO. He is an outstanding investors with a solid track record so I think we can acknowledge that he knows a little something about valuation. In his latest paper “The Idolatry Of Interest Rates-Part II he concludes “Would I need to believe that today’s U.S. equity market valuations represent fair value? Exhibit 16 tries to answer this question. It assumes that equity market valuations are a function of the real rates of interest, and asks a very simple question: How long would you need to see real interest rates stay at -2% p.a. in order to be able to call today’s cyclically-adjusted P/E fair value? The answer is a staggering 60 years! According to data from Reinhart and Sbrancia (2011), the average length of a period of financial repression is 22 years plus or minus 12. That puts 60 years of negative rates at a 3-standard deviation event, and twice as long as any period of financial repression ever actually observed! Seems like a pretty extreme belief to have to hold to me.”

Josh Harris Chief Investment Officer at Apollo Global makes his living- and a really good one- finding undervalued companies and assets and selling them a few years later for several multiples of what he paid for them originally so we can assume he knows a little something about valuations. Back in April he said “The quantitative easing and the excess money and the low interest rates have driven pricing up of almost all financial assets to beyond what their intrinsic value might be. So even though we can all chat about the benevolent growth environment that exists in the U.S. and to a lesser extent globally, the ability to make money and invest wisely on that is very, very challenging right now because you're starting at a point in the valuation cycle that is very, very aggressive. Almost every asset is overvalued.”

Sam Zell has made a fortune buying and selling assets and has such a good nose for value he is dubbed the Grave Dancer for his ability to uncover bargains. He has commented several times in the past year or so about the disconnect between stocks and the economy and just last week he told GlobeSt.com “The confidence level among lenders is unjustified. The stock market reflects an almost perfect world scenario, but Main Street is not feeling the euphoria.”

I can go one like this for an extended period of time but you get the point. The stock market is a long, long way from cheap and it is hard to develop a scenario where you see high returns from buying at current levels. For the market to be an exceptional opportunity we need to see a large drop in current valuations. Until then we keep kicking over rocks n market corners looking for special situations and focus on the small banks.

The small banks do represent a true exceptional opportunity. My buy list last week had more than 25 stocks trading at a discount to book value and all the banks on it were in sound financial condition. Most of them have one or more banks stock activists or specialists as shareholders so there is some pressure on management to reward shareholders or sell the bank at a premium from the current level. There ia an enormous amount of money to be made here over the next few years and investors would be wise to focus on this sector right now.

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If you have not already I hope you join us.

Cheers,

Tim

Song of the week

A little caution, a lot of cash and a healthy dose of community banks can keep us all from getting the

https://www.youtube.com/watch?v=WaBTHu9JSB0&list=RDWaBTHu9JSB0