The Contrast Principle and Investing (“Is a market crash coming?”)

As Donald Trump noted on August 3rd on Twitter:

“Business is looking better than ever with business enthusiasm at record levels. Stock Market at an all-time high. That doesn't just happen!”

Indeed. We are not macro folks here. When I think about long-term hold ideas I think about how certain macro factors will affect a business (How would they handle higher interest rates? What is a company’s customer base vs demographics like? Etc..). However, I do not make day-to-day decisions because of macro factors and daily noise like S&P year-end targets and the latest economic forecast for GDP growth next quarter.

However, even with this attitude we are all subject to psychological biases like the Contrast Principle. Robert Cialdini’s book, Influence: The Psychology of Persuasion (a must read) has my favorite explanation:

If we are talking to a beautiful woman at a cocktail party and are then joined by an unattractive one, the second woman will strike us as less attractive than she actually is.

The same principal applies in reverse and to investing. Is that stock you are looking at actually cheap? Compared to what? The last ten grossly overpriced companies you looked at? You might consider yourself a value investor and frugal but if every single one of your neighbors on your block has a Lamborghini you might start to think a Mercedes-Benz C class is a “cheap” and economical car (it is less than half the price!). It’s only human nature.

Frankly, I’m worried about getting caught up in the market and decided to sit down and make note of where we are today. How is Mr. Market feeling? Let’s take a look at: 1) The S&P PE Ratio, 2) The Shiller PE Ratio, and 3) the VIX or volatility index.

1) The S&P PE Ratio

Looking at the S&P PE (price to earnings) multiple gives you an indication of what people in the overall market are willing to pay for a dollar of earnings. A great source is: http://www.multpl.com and this is where the next two charts below are from.

Currently the S&P PE multiple is about 25x, or, inversely, if you buy a stock today the stock is “earning” 1/25 or 4%. Is this cheap? It’s all relative. As I look today 30-year U.S. government bonds (the closest thing we have to “risk free”) are trading around ~2.85% and 20-years are trading at a bit less. Is ~1%- over treasuries enough of a risk premium? Maybe earnings growth will be strong but are we about to start a wave of growth eight years into a bull market while interest rates are at generational lows?

2) Shiller PE Ratio

Another measure that I like more is the Shiller PE Ratio, a more conservative ratio where it takes the average inflation-adjusted earnings from the previous ten years. At around ~30x today it is lining up ominously with Black Tuesday.

3) VIX

Another commonly used measure is the Chicago Board Options Exchange (CBOE) Volatility Index, or “VIX,” showing how volatile S&P options investors expect it to be over the next 30 days. It is at a 10-year low meaning people just don’t seem very concerned with volatility and, in turn, aren’t pricing much volatility in.

Source: http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index

So where does this leave us?

  • While overall earnings have increased, a big part of the stock market boom is multiple increases, where people are just willing to pay more for the same dollar of earnings than they were ten years ago.
  • We are eight years into a bull market in an environment of very low interest rates, very high valuations, and not much volatility priced into the market.
  • Based on the Contrast Principle, some stocks out there today might look “cheap” compared to current bond rates or the overall market, but would sure look expensive compared to comparable stocks ten years ago. 

Some argue that “it is different this time” because interest rates are so low that these high PE multiple are justified. I would agree that to be technically true, but that also means the market is dependent on rates staying low (as they now start to go up) and earnings to stay strong and very stable (eight years into a bull market).

Where are we going? I would never claim to know where markets are going, but I would say that there is not much cushion or room for error from an overall valuation standpoint. However, I also think that there are opportunities in any environment (such as a wind-up situation or a turnaround for example). I just have to make sure that what I am buying really is “cheap” and not just a bit less overpriced.

In the words of Benjamin Graham:

“A serious investor is not likely to believe that the day-to-day or even the month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psychological problems are likely to grow complicated. A substantial rise in the markets is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. Your shares have advanced, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or–worst thought of all–should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd”.

The Intelligent Investor, Revised Edition, page 196-197.