I wrote this in October 2020 as a reply to an email on the current market situation…
In the current market environment the trend towards more expansive stocks is purely driven by a) cheap (free) money and the lack of alternative investments. More money is accelerating the process. Both effects then lead to an overflow: cash available > then investment opportunities = everybody is running towards the only place where you still can find returns.
This is on top accelerated by negative interest rates in Europe and other countries around the world. The ECB currently has up to -0.50% which bank started to pass on to the customers with a deposit of more then 100k. This again leads to more and more people with no choice, they have to invest if they dont want to pay. And they are usually people with a lack of experience, so what do they buy: ETF’s. And the ETF purchase just increases the average P/E ratio (for example in the S&P500).
2. P/E ratio in total vs. selected stocks
But, the problem in markets like that: we dont know how long this will be true. But we know as long as the interest rates don’t change we know it will be like that. But that leads to a different problem. While the average P/E ratio is going up due to the accelerating effects described above, the differentiation between real growth in value and growth in value due to these effects get mixed up (using a different language (forgive me), you can’t distinguish shit from gold, because it looks and smells alike from a distance. But the truth is that these trends always end. Always. ALWAYS. Buffett reminds us of that all the time.
But remember, these trends can last for a very long time and if cheap money is printed, prices rise which means that revenues will rise, cost will rise and the balance sheet of companies will rise too….. (AND THERE IS ANOTHER REASON, WHY THIS TIME IT CAN CONTINUE FOR AN EVEN LONGER PERIOD, SEE BELOW)
But, if money is cheap and prices rise, even shitty companies with a very low margin and a very bad business model can get cheap money to grow or buy competitor. And this is not a problem until interest rates rise again. But if they do, the ripple effect is crazy. The all default just by a little spike.
4. Long-term (many years) vs. short-term (1day to 24 months)
This leads to a general decision any investor will have to make in these times of high uncertainty and even higher volatility. Are you a short-term investor or a long-term investor or a trader? Let’s talk about the trader first. We are living in times of huge volatility, in the market, but also with single stocks. This is a huge chance for people who like to trade. Boeing, Apple, Amazon are just examples. The drug companies are a good one too. [comment 2/2021: or look at GAMESTOP]. There are many opportunities out there to trade and to generate a gain. On the other hand the long-term investor never has problems, he knows the price he is willing to pay for an asset and if the price is alright, he will act on it, if now he wont. He doesn’t care about one or two or four years of higher P/E ratios or inflation or volatility. But lets not forget the short-term investor. He among the three is facing the biggest problems. Because if he is not in the market and wants to buy and hold (for months or a year or so) picking the stock is very very hard. The risk that he will buy high and sell low is not only existent, but it is very real. And since he isn’t looking for value stocks and since he can’t separate the shit from the gold, he probably won’t [comment 2/2021: again, look at GAMESTOP].
5. Digitalization and not-asset stocks
While all this is happening a general trend which has already started is getting overrun by the current situation and therefore not visible to many investors yet. THE INTERNET, it is spreading much stronger than any disease. With almost 4bn people connected and 1–2bn more within the next 12–24 months the business models that don’t depend on assets dominate the market. [comment 2/2021: Starlink is online, people almost everywhere in the world can now connect]. If you think that amazon and google and facebook are big, think again. TikTok only was launched in 2017, but it has reached billions of people and a value comparable to digital companies that have been around for years. And the youtube video Despacido reached 7bn views last week. Next year we will see a video surpassing this within 12 months or less. [comment 2/2021: Babyshark from 2016 has surpassed Despacido and is now at 7,895,426,977 views]. So companies that depend on assets or sales of goods have a competitive disadvantage in regards to earnings and therefore rate of return. AND: this was true before COVID. And COVID actually has accelerated this trend and made it visible to more and more people. So a P/E ratio of 22 might not be high at all for high growth companies like TikTok and other, before they grow exponential…..
6. Risk of the opposite reaction
So understanding all this you have to understand the biggest risk. The perfect storm. What if the markets turn around. Due to an increase in interest rates or China liquidating on the US assets or a country like Italy defaulting or the internet being disrupted. In March we were able to get a very glimps view of what happens: EVERY ASSET class crashed. In march there was not one single asset class that was not effected by the down-turn. Not gold, not stocks, not bonds. And technically, not even cash. So if you plan for the long-run you need to think about one more thing: what do you want to hold if the stock market closes for 24 months and you are not able to sell one stock.