Value stocks are cheap!

The 20th century physicist Ernst Rutherford famously said, “if you can’t explain your physics to a barmaid it’s probably not very good physics.” A quote I came across when trying to resolve an insight I had regarding how the economy has evolved under the Federal Reserve’s dual mandates of price stability and full employment while employing a risk free tool referred to as “Full faith and credit…”. The quote seemed appropriate because if one tries to model out where these mandates lead the economy, they are confronted by the inescapable conclusion that it falls into a class of problems known as three-body problems. Only certain stable solutions to which are known to exist but are more generally understood to behave in a chaotic an unpredictable manor. Since no definitive solutions exist, models to explain the financial markets behavior are more reliably done using statistical frameworks like those of Chaos Theory. In this case I refer to the modelling of the market prices of certain asset classes: technology stocks, certain rare metals, popular art, crypto currencies, and the “Full faith and credit” securities of first world sovereign treasury debt securities. The prices of which seem to have become so untethered from there rational and explainable economic value that to the untrained observer the only possible explanation is their prices are being driven by “magical thinking,” that uniquely human phenomena that beliefs can influence the external world. Chaos theory is built on the premise that there are unmeasurable variables in the system you are observing, and hence predicting its behaviors becomes probabilistic at best and sometimes completely inexplicable. One must step back and accept that they can only reliably explain where market prices are headed and why, at best 50 % of the time. Trying to be like Rutherford I offer an explanation, as to why the stock market appear so much more volatile this year, that someone you are talking to at a bar might understand.

Price risk, a stock’s price movement over time, is a statistically measurable quantity which can itself be priced. Companies with better than average future prospects, referred to in the vernacular as "positive alpha” risk, will be charged a lower cost for their capital then companies which are more subject to the whims of economic flux, referred to as “beta” risk. When a technician expresses a company’s alpha risk in a financial model as high it could mean upside risk (the good kind) or downside risk (the bad kind), skewed one way or the other. A company that has an upside or downside skew to their alpha risk is modeled asymmetrically and is expected to perform differently than the economy or stock market in good times and bad. A well-designed computer model can generate higher than market returns for a diversified portfolio tilting long or short using a stock’s “alpha” as its driving metric. Hedge funds and pension fund consultants love this kind of risk. A lower risk premium calculates greater intrinsic value, a higher price to earnings ratio, and just like a low rate of interest charged on a bond or mortgage it is an indication that the market interprets a company’s trad business risks or beta as relatively low, and its future prospects risk or “alpha” as relatively high and skewed positively.

As an example of business risk consider the traditionally high "beta" stock auto industry. Tesla Motor, recently trading at a trailing price to earnings multiple of over 133. The CEO, Elon Musk, declared recently that he only expects a 1% return on equity for the foreseeable future. So, as he sells $5 billion worth of shares into the market, he is telling the buyers of his shares to only expect a 1% return which is in alignment with a reciprocal price to earnings ratio of 100. The market is willing to accept a return of 1% over the next year because, as the thinking goes, it will be 2% or 50x earnings in 2022 and perhaps 15x in the 2028 range with the prospects of a modest growth rate after that. Positive alpha like that is modeled as attractive when held in comparison to the yield on the ten-year treasury at less than 1%, but there are plenty of well establish companies with stocks that are trading at prices offering returns like that today, not 5 to 10 years from now! As another example look at Amazon, Jeff Bezos’ baby, with a stock trading at over 100 times earnings has said much the same thing when regarding the take over of other companies “Your margin is my opportunity.” Meaning that he can use his stock which is only charging him an expected 1% return to buy retail companies that have much lower price to earnings multiples and leverage the difference to his companies advantage (notice I didn’t say “his shareholders”). His takeover of Whole Foods, a grocery chain operating in what traditionally has been an extremely competitive business with relatively low profitability, being a prime example. A high stock price can make the takeover of any business look good, even the low margin delivery business. FedEx is only trading at 20x earnings, a purchase of FedEx’s high beta low alpha stock using Amazons lower beta high alpha stock offers financial leveraged of over 4x. Whether the business succeed financially with high earnings returns in the distant future appears to be untethered from the stock price. High alpha risk growth stocks can be used to leverage higher beta risk low alpha companies.

Today an options matrix can easily be exhibited by a retail investor, and they can see how big the bets are at any fixed price level at any discreet expiration date in the future. This allows them to piggyback on “smart money” trades. Unfortunately, most of these investors are not sophisticated enough to understand that these bets have yet more offsetting alpha risk trades against them. They only see the market one level down, whereas hedge funds and algorithmic black box trading systems are working two and three levels down. They are looking at order flow, volume, and relying on split second timing that lets them make money on relatively small price movements. Front running your clients orders, the practice of buying a stock before your client and then selling it to them at a markup is unethical and prohibited for stock brokers but it is not for the black-box computers that are now running much of the market. Machines are assumed to be free of ethical dilemmas. Last year most of the retail brokers switch to a low commission model. They make up for some of what they used to earn in published brokerage commissions by steering trading volume to third party black box systems, collecting unpublished fees on the backend based on the volume they direct. Fewer brokers now assure more consistent pricing across the market by charging a risk premium in their commissions. The black box systems rely on measuring real time market price risk down to the split second, and the lack of a value perspective and the volume driven milking action of the black box algorithms amplifies price risk, which feeds back on itself. Driving the prices of growth stocks higher slowly and then lower faster as the machines instantaneously hedge risk. I believe this has also resulted in lesser traded small capitalization and value-oriented company’s stocks to be undervalued because they do not drive volume, and the market has become lopsided. The machines are causing high alpha risk and low beta risk companies that can drive volume to be priced too high. Volume is driving price, not value. U.S. Treasuries trade at a negative real yield because there is tremendous demand for the hedging liquidity they provide. So, they do. Amazon (ticker AMZN), Tesla (ticker TSLA), Apple (ticker AAPL) and the like trade at unbelievable price to earnings multiples because volume makes it so.

Mr. Market can be wrong for a long time, and price volatility will likely remain at historic highs and story stocks will continue to trade at extremely high multiples regardless of any realistically imaginable long-term value. As I look out at the ETFs universe my model rates the most attractive long term return profiles in the value space like the Vanguard high yield index ETF (ticker VYM) and the Vanguard small cap value index (ticker VBR) which rank BUY! The broad large cap weighted market represented by the Vanguard S&P 500 index (ticker VOO) which is now heavily weighted in technology is priced to SELL! History has shown that eventually, all be it longer than one might expect, the market rights itself, and a balance is achieved between what can actually be earned today and what might be earned in the future.

Invest Wisely!