The standard Efficient Market Hypothesis has been widely mocked lately. If it was true how could anyone beat the market long enough to rule out luck, or avoid a loss by leaving an overpriced market? In fact, why not go buy some gold today since all those people bidding it up must know what they’re doing? While I don’t believe that markets are efficient in the sense that it’s impossible to get any sense of their future direction, maybe that’s looking at it the wrong way.
The standard efficient market hypothesis is that all known information, such as declining future profits, is priced in already so it has no advantage to anyone else. You can in fact get information which gives you an advantage (that’s exactly what it is when you decide a market is too expensive), although it’s never guaranteed.
But markets are very efficient at pricing emotions. For example, in March 2009 when the market hit the bottom it was pricing in the fact that we had reached the maximum expectations that the market would fully collapse. Since that possibility was priced in those who bought got a great price and protection from that very event as confidence started to rise. Rather than having the market collapse we found out the price associated with the lowest expectations of its survival.
This provides a boost and a margin of safety for contrarians. However it’s no simple signal that tells you what to do since everything is relative. March 2009 simply marked the lowest point of opinion that we reached in the last 5 years and had no absolute significance to indicate it was the bottom. The mistake many investors make is thinking that negative emotions mean prices will fall in the future, when in reality the market is so efficient that the foreseen disaster is already in today’s prices. Only future emotions will affect future prices. And the best part is that this information is actually easy to access. Almost anyone will tell you exactly why you’re an idiot for not investing like them and the media loves it too. Let’s support our efficient markets and profit from them!
After some big changes, I’m closing out some large short-term holdings and finally moving towards a more consistent long-term investment plan. This makes it a good time to review my allocation! I did some quick data gathering and found the following information:
- DEX Universe Bond Index – 3.22% yield to maturity, 6.21 duration
- S&P TSX – 19.73 P/E, 5.1% earnings yield, 2.43% dividend yield
- S&P 500 – 19.58 P/E, 5.1% earnings yield, 1.77% dividend yield
- EAFE – 18.6 P/E, 5.4% earnings yield, 2.35% dividend yield
The first thing that jumped out at me is that the equity indexes are remarkably similar. Although there are additional transaction and taxation costs for the foreign ones it’s close enough that trying to put a few more percent into one would be all but worthless based on a look at current valuations. If you have an opinion about which market will do better that’s another matter but I’m not going there at this point. Based on these I will follow this allocation going forward in the next year:
- 20% medium-term bonds (DEX Universe)
- 26.66% Canadian equities
- 26.66% US equities
- 26.66% International developed equities
This is not complicated at all, and you can see that I’m not putting a whole lot of fine-tuned predictions into it. At the current stage TD e-Series funds make it simple and cheap so the choices are limited a bit but that’s ok with me. Although I’m not worrying about 26% vs 28%, I do have a few expectations behind these allocations.
First, with equities getting close to a 20x P/E they still have room to rise quite a bit if more money flows into the markets but if that happens they’ll become increasingly overvalued. It’s also entirely possible that equity markets could drop over the next year with fresh news. If investor expectations decline they don’t have the support of undervalued prices to soften the fall. In the long run if we keep the number of investors who were in the market from the 80s to the 2000s, 19x is not an exceptionally high ratio and on that basis a heavy tilt towards equities works for me.
You may say that I can eliminate bonds entirely and just diversify the equities to get a higher return. This is a valid point as diversification works most of the time. So why do I keep bonds? The premium in the equity earnings yield is around 2% more than the bonds, which may not be far off the long-run average but doesn’t suggest that the additional return they may have over the next 3-5 years comes at a low relative risk like a 5% premium would. The bonds may reduce the returns but it’s not a certainty.
Finally, everyone knows that interest rates will rise and hurt long-term bond holders. Why not use a shorter-term index? If I was using the full range of ETFs I might well split the allocation, but I wouldn’t give up on longer bonds at this point (and they’re still less than a 10 year duration). I know that everyone knows interest rates will rise, and I know that yields have already been pushed up to some degree by the expectation. There will undoubtedly be rate increases and capital losses, but if those coincide well with volatility in equities I may actually get a profit from rebalancing.
The main weakness in this line of thought is that another thing driving bond yields down is the number of investors who are avoiding equities. Regardless of expectations, if there is a rapid exit from the bond market values will fall. This is a possible threat but overall I’m comfortable with the returns and potential for rebalancing this gives me.
The latest post here about Facebook’s valuation has been included in the Canadian Finance and Investing Carnival over at Investing Thesis – check it out today, and look around on the site a bit to see many excellent interviews with people in Canadian finance!
The latest Wealth Builder Carnival features the latest post here and many other great blog posts. Check it out here for more posts on investing and personal finance (I liked Mike Piper’s article on what is and isn’t market timing)
The recent media coverage of Facebook’s new investments has been heavy enough and excited enough to doubt the accuracy, but a recent story from the Financial Post reveals some very interesting details (not officially confirmed of course). Even though this type of investment would be far outside my plan it’s a useful and timely exercise in valuation. According to the summary in the article, the net earnings this year are likely to be around $0.5B and the recent activity places the theoretical market cap at $50B, which makes it a neat 100X P/E ratio and draws a few comparisons to Google. This is right in the pre-2000 range of valuations – is it worth it? (interesting side note – Richard Bookstaber makes the case that in the 90s the actual supply of shares available for many tech companies was very limited and nowhere near the demand, driving up prices)
No sane investor would pay this much for a company without expecting top-level growth in the next year; if the possibility of failure is being discounted properly the implied growth if everything goes well is even higher. I haven’t worked out the implied growth rate but it’s not just 20%/year (of course if you discount future earnings using only today’s interest rates that could be pushing the valuation up). This much is clear to everyone. Now of course everyone will come out and ask if the valuation makes sense. I wouldn’t be surprised if this gets as polarized as gold in the next 3 months.
Following Tom Bradley’s example I won’t tell you my answer (I’m still working on that time machine), but I will ask one question. Many people will be focusing on the standard tech startup questions – is it really a business? Will it reach too far and collapse? But if we take the rumored financials as answers to those questions and assume survival and some growth, the big question is whether the growth is worth 100x earnings. According to a quote in the story, many of the actual investors are looking at the potential if past growth rates are extended into the future. Is that a reasonable assumption?
There are actually two sides to the earnings growth rate – one is the increase in the user base (simply getting new users), and the other is the increase in revenue per user (selling services to more people, selling new services, and selling higher-value services). Taking these into consideration, has Facebook reached a point not far from where Google is now, where the pool of potential new users is getting smaller and smaller? Will the advertising services be able to provide more revenue in the future or are they already reaching their full potential? Will new services contribute added revenues at an increasing rate? At this price some growth or strong growth isn’t enough – the effect will need to be dramatic.
I believe the answers to these questions are the key to the valuation; we can see how people with access to invest are answering them but fortunately most of us have the luxury of speculating without risking, at least for the remainder of this year 🙂