Dow 21,000 and the Wisdom of Ben Graham

Since the election, our advisors have been fielding several questions related to the recent dramatic advance in the stock market. The questions generally revolve around whether or not the market has come too far, too fast. Is a “correction” imminent? With the Dow closing March 1, 2017 above 21,000 for the first time this seems as good a time as any to address these concerns. To assist us in this effort we employ the writings of one of history’s greatest investors and Warren Buffet’s mentor, Ben Graham.

To preview, and as no surprise to our long-term clients, there is no satisfactory yes or no answers to questions regarding short-term (weeks or months) fluctuations in the overall price level of the Dow or the S&P 500. Incipient bear markets cannot be reliably predicted. The market strategists, seen on cable networks, who make suspiciously specific predictions on the year-end price of the S&P 500, exist, in our view, to make palm readers look good.

So, long-term investors should generally stay exposed to the stock market irrespective of their estimate of short-term risks. There are, however, solid principles to guide investment decisions during times like these, when the market has moved very far, very fast. As always we (and Mr. Graham) start with value as a first principle.

The Value Principle – Is the Market Very Expensive?

Figure 1-Market is expensive by most measures

Figure1 shows that the market has only been more expensive than it is today during the tech bubble.
If value were everything, rational investors would buy shares when they are “cheap” and sell them when they are “expensive” like they are today. The problem is that expensive markets can stay “expensive” for a long time.

For example, the market approached its current lofty valuation in early 2015 when the S&P 500 stood just above 2,100. As of Friday, March 24th, the index stands at 2,355, so the rational value investor who sold their shares in 2015 would have missed out on a 12.1% rise in the value of their shares between then and now. He or she would have been holding cash waiting on a substantial market decline and a new entry point for the past two years. It would have been difficult standing on principle as the market raced ahead following the election.

Today’s elevated market prices have risen in the context of increasing optimism and accelerating global growth, conditions that support continued improvement in stock prices. But have prices gotten ahead of themselves? How do you balance an optimistic outlook with a richly priced market? Ben Graham addressed this conundrum in his book “The Intelligent Investor”. A relevant paragraph is reproduced below;
“It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities. “ – Ben Graham (emphasis ours)

So, to paraphrase the wise Mr. Graham, respect value but do not let it keep your marginal investment dollar out of stocks, unless the market is far more expensive than average. The chart above, to us supports the idea the market is expensive enough to justify a cautious position (take some profits, hold some cash, let dividends accumulate) as it has been since early 2015, but even at these levels does not justify a wholesale exit from stocks. Another approach is to stay fully invested but concentrate in stocks that are likely to perform better than the market as a whole during potentially tough conditions. Which brings us to Graham’s second relevant observation.

The Quality Principle- Do I Own Durable Stocks?

If the first principle is value, what is the second? In our view the answer is fundamental financial soundness or quality. If an investor is going to hold a substantial portion of their investment capital in stocks through bull and bear markets, he or she should be convinced that the companies underlying their stocks have the financial strength and the management competence to thrive, survive and adapt through changing economic conditions. The stock price of such a company will likely decline in price during a bear market but the underlying sound business will lead to a price recovery when, inevitably, the bull follows the bear The redoubtable Mr. Graham had something to say about this as well;

Figure 2-High quality stocks outperform in tough markets

Again to paraphrase Professor Graham, paying too much for a quality company is a hazard one faces in what may, with 20/20 hindsight prove to be an expensive market. Such a stock will decline in price along with most other stocks if a bear market takes hold. But this risk is at least somewhat offset by the resiliency that a quality stock offers. The investor who purchases riskier, less tested securities amid the euphoria of a late stage bull market faces a more profound risk, that of a permanent loss. Such stocks (speculative, heavily indebted, transitory profits) should be avoided most of the time, doubly so in a rich market. Figure 2 shows that high quality stock hold up better than low quality stocks during bear markets.

Value and Quality in Practice

A long-term investor during their lifetime will experience calm and volatile markets, expensive and cheap markets, better and worse times to invest. To be successful, we believe you must stay substantially invested during lean and fat times. Occasionally, the market trades at a level that gives one pause. The value and quality principles give us the tools to navigate such conditions. Allowing a bit of cash to accumulate is reasonable under current conditions. As importantly investors should be certain durable high-quality issues dominate his stock investments. Investors are not prognosticators and so must balance the probabilities in their favor.

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