FUNDAMENTALISTS like to say it’s hard to beat a well-functioning market, but easy to beat a dysfunctional one. That’s the optimistic thinking behind value models, including BV. Value models tell you when investors have departed from fundamentals and entered their own unreal world. What value models do not tell you is when the fantasy will end, or where. So as a precise way to time your exits and entrances, they don’t work. Yet investors use value models for that purpose and head straight into one of the following four pitfalls.
Sell too soon, leave money on the table (lesson learned: wait to sell)
Buy too soon, stocks keep falling (lesson learned: wait to buy)
Sell too late, give back profits (lesson learned: don’t wait to sell)
Buy too late, miss the move (lesson learned: don’t wait to buy)
The first pitfall awaits investors who sell too soon, worried by evidence that the market is expensive. The problem with valuation yardsticks is that they appeal to your powers of logic, but they don’t account for irrational markets . That’s why your favourite metric can indicate the market is overvalued, yet after you sell, the market runs for years to the upside without you.
In the reverse situation, the second pitfall, a tempting bargain often looks so cheap relative to previous levels that it is hard to imagine how it could go any lower. Then it falls another 50 percent. In both cases, acting too soon on the say-so of valuation eats away at your credibility and confidence as much as — if not more than — just being plain wrong.
The other two snares, pitfalls #3 and #4, trap the unwary when markets stop short. They top or bottom early. They don’t travel to the extreme you were waiting for. That could mean you ride the market into a serious downmove because it never got overpriced. Or you miss a new bull market because stocks never got low enough to buy.
Staying out of trouble
About half the time — judging by Brock Value since 1919 — the market trades outside its normal range. These are the bubble years, when the stock market floats above the red line on the dreams of a new era. Or they are the years of sorrow, when the market habitually trades below the green line, weighted by the end of days.
Both extremes bring out misleading arguments. In the bubble years, investors argue that the market is overvalued according to a trusted ratio, and should be avoided, with the implication that a return to sanity will come soon. On the flipside, when markets are far below normal, investors expect fast recoveries.
When markets are functioning normally, these arguments are valid. But in extreme years, the rules don’t apply, and investors end up in Pitfall #1 and #2, respectively. They sell out and the market keeps rising, or they buy into a falling market.
To stay out of trouble, learn not to argue with the market. Do not cling to rules that markets do not follow. There is a fine line between value investing and mindless, instinctual contrarianism. That’s why good investors work on appraisal, not opposition. And the truly great ones barely feel anything about their investments.
Valuing the market has nothing to do with where it’s going to go next week
or next month or next year.
The limitations of Brock Value
Brock Value by itself does not indicate when to enter or exit the market. BV tells you the level and trend of intrinsic value. It doesn’t predict what the market will do next. However, if BV is rising, generally the market will also rise. If BV breaks its uptrend and starts to decline, the market often does the same.
But the market does not always top out when the underlying fundamentals peak; it tops out only when expectations reach their maximum. When the market does not follow the fundamentals, and instead goes far in the opposite direction, it’s in the grip of a dangerous circularity, when buying begets buying, and higher prices lead to higher prices. This loop can lead to a bubble. In reverse, to an age of anxiety.
Extreme conditions call for extreme detachment. To stay safe and prosper in bubbles or slumps, you will need other tools besides Brock Value, like trendlines.
Predicting future returns
Brock Value can help you estimate future returns. Valuation is functionally equivalent to expectation, which is negatively correlated with ten-year returns. Expectations are perverse. High expectations, like those observed during manias such as the Go-Go Years and the Internet Bubble, come before periods of low returns. Low expectations, formed in the gloom and despair of hard times, herald years of high returns. Use BV to define your own expectations, apart from the crowd. Extreme valuation is a window on the future — and your future — in the market.
Beware the numbers
To buy and sell based on a mathematical formula, on substance — on fundamental analysis — makes sense to investors who need logical reasons to buy and sell. But as Ben Graham relates, in the stock market the old order always gives way to a new order. And the more complicated the formula, or the more it depends on predictions, the sooner it stops coming up with the right answers.
Fundamentals look objective, but they are slippery. We’ve seen how the market won’t honor intrinsic value, not without a struggle. Such is the nature of value models. Brock Value may tell you that the market is low, but it cannot tell you how low the market will go, or how long it will stay that way.
In the stock market, overconfidence breeds best on limited understanding. And mere confidence in a market theory is enough to validate it, at least temporarily. When investors follow a theory, they move prices. In turn, price moves attract investors and confirm the theory in a self-energising spiral. P.T. Barnum said nothing attracts a crowd like a crowd. In time, the crowd disperses, revealing a flimsy cardboard theory destined for the dump, along with the crowd’s money.
Confidence is contagious. So is lack of confidence.
The best use for Brock Value is to counteract excess confidence or undue gloom after dramatic moves in the market. It’s funny how money rots your brain. Brock Value confronts false expectations and relieves your fuzzy vision. Brock Value cannot eliminate stock market excesses, but it can help you see through them.