Today we’re going to talk some more about valuations. The market is really quiet right now and when the market is quiet it’s easy to get distracted from the things that are most important.

Ultimately, valuations are what drive the bus. Over large windows of time, they’re the only thing that really matter and we must continually ask, “is this investment a compelling value at today’s price?”

I also had a brief exchange with Barry Ritholtz over Twitter a few weeks ago, the result of which was some research that led to a new way of looking at valuations. I have no idea if it’s any good or of any use, though. And I really have no idea why someone of Barry’s stature chooses to engage with an obscure guy like me. But there are very few people in that corner of the industry that I respect more than him and I’m thankful for the inspiration.

I guess that’s one of the rare happy, positive things about the financial industry. On occasion, it really is a community where people can share ideas and dialog that leads to productive new research. The truth of the matter is that none of us in the business have any idea about what’s going to happen. Not really. But we’re good at faking it, and we’re good at telling stories, and the most interesting and useful of us are legitimately focused on honest insight & data that can give us any sort of edge, however slight it may be.

Sentiment Stagnates

I know that sentiment is really “meh” right now. The latest AAII survey shows slightly below average levels of both bullishness  and bearishness. Valuations, however, are the truest measure of psychology.

Valuations represent what investors are willing to pay for one dollar of earnings. This isn’t theory. This is law.

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Are you loving this market or hating it?

Data would suggest that this market doesn’t exactly have you enthusiastic. The latest sentiment readings show very average sentiment, which is not the sort of thing I would have expected with the market making new all-time highs. The fact that the market has gone straight up for six months without any meaningful decline makes it even more bizarre. Isn’t that the sort of thing that’s supposed to fill investors with confidence?

In fact, right up until this last week, sentiment was well below historical norms.

So today we’re going to talk about why. Why there is such a disconnect between sentiment and reality?

Because it’s relevant, I’m going to re-print a brief passage from the February issue of Alpine Advisor. At the time, I was sketching out a basic strategy for the year as the market was approaching a new all-time high and key technical resistance levels. One of two things was going to happen, either the market would get up into that new high range and then correct, or it would bust on through and carry itself higher.

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It’s May.

Does that mean it’s time to sell and go away?

People always ask this question at this time of year and I usually write something about it. Don’t worry, I do have an answer for whether or not you should sell and come back later.

As much as I hate heuristics like this that have tenuous reasons for fundamental legitimacy, they are fun to talk about. In the case of the the “Sell in May” adage, it supposedly dates back over 100 years to traders in the London Financial District. Wealthy families like the Crawleys would spend the winter shopping and consuming in London before retreating to their country estates for the summer months. (Although if I was the Earl of Grantham or one of his daughters’ myriad suitors, I’d want to stay in the country all year ’round.)

The adage only really became famous when Stock Trader’s Almanac did a study on it and showed that performance during the summer & early fall months is generally much weaker than during the winter and spring months. Plenty others such as Ned Davis and these guys have also done high profile studies and have reached similar conclusions.

I suppose investors do have reason to be concerned about the summer months. Historically, May has been one of the worst months and September, the month after which you are supposed to return to the market, has a history of being the real troublemaker.

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As long as man has been able to keep record of his thoughts, he has repeatedly asked himself one simple question.

How’s it going to end?

It’s a question that matters above all others. It haunts us when we are young and naive, and it haunts us still once we have grown old and wise. It haunts us because we do not know the answer and never will.

Some day we will die, each and every one of us. You, me, John Paulson. And whether that’s an event that ultimately resolves the great mystery for us, our question will remain unanswered until that moment. It is the “we” of the present who are forced to dwell perpetually in the dark, albeit a different kind of darkness.

We erect all sorts of belief systems to shine a light on this darkness, this unknowable outcome. We look to the ideas of others about how it’s all going to end. We pick the one that feels right, the one that brings us the most comfort.

This isn’t just philosophy. This matters very much in the real world. If you pursue a basic course in economic theory at any major university, you will eventually dabble in game theory. And when you dabble in game theory you will eventually learn about backwards induction.

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