The biggest challenge for me right now is maintaining a strict valuation discipline, with a focus on individual companies and margin of safety, while attempting to filter out the deluge of broader, often contradictory noise.

While some companies have certainly gotten cheaper over the past few months, most are still quite expensive unless one utilizes heroically optimistic assumptions. For example, Morningstar thinks Southwest Airlines (LUV) is “undervalued” on the basis that operating margins will expand to 16.7%, despite the facts that: the average operating margin over the past 20 years has been 8%; operating margins have only exceeded 16% twice in Southwest’s history (in 2015-2016, after oil prices had collapsed); and Southwest competes in a notoriously commoditized, cut-throat, and low margin industry. With that said, Southwest is a well-run company and doesn’t appear to be terribly expensive, but it is only cheap if you assume historically unprecedented prosperity going forward.

Another example is Bausch & Lomb Corp (BLCO), which Morningstar views as “significantly undervalued” on the basis of a “terminal year price/earnings multiple of 35 times” (i.e. a 2.86% earnings yield). This seems aggressive in a world of 3%, risk-free Treasury bonds.

While these examples are from Morningstar, they are probably among the least pollyannaish I have seen. At least from the companies I have looked at, this optimism seems to be present in both “deep value” and “high growth” stocks. Almost everything still looks quite expensive on an absolute and historical basis.

Taking a higher level view, the broader drop in the S&P 500 this year has been rather unremarkable. The average intra-year drawdown in the S&P 500 has been -14% over the past 42 years, roughly on par with the -16% decline year-to-date. Furthermore, the modest drop in valuations has merely brought us back to 1999 dotcom bubble levels:

Source: https://www.hussmanfunds.com/comment/mc220707/

Much has been written about how the S&P 500 looks reasonable on a forward PE basis, but this assumes that historically high, COVID-stimulus fueled profit margins will persist indefinitely. If margins simply return to pre-COVID levels, the index could fall a further 25%+ while maintaining the same PE. Psychologically, too, there seems to be little diminishment in the desire for rampant speculation.

I try not to let broader market levels influence my thinking, and I constantly question whether or not I am being too bearish. The price of Tesla or Bitcoin shouldn’t affect my valuation of an overlooked small-cap in a completely unrelated industry. But I think it’s important to have some understanding of the broader currents in which we swim, and that, on the margins, this may influence how aggressive or defensive I am willing to be. There will be a time to be aggressive. But I don’t think that time is now.

This Time Is Different

July Update