In the Long Term, the Absolute Trumps the Relative

Most of us remember the dot com bubble.

We would buy a technology stock trading at 60 times its earnings estimates and think this was a tremendous deal as compared to other technology stocks trading at over 100 times or even 1,000 times their earnings. When the bubble popped, almost all technology stocks got crushed. Perhaps your “cheaper” stock went down less than some of the others, but it was a small consolation to say that you lost ¾ of your shirt when many others lost their entire shirts. Once the ship sinks in the middle of the ocean and there are no lifeboats, the idea that you were in one of the safer cabins doesn’t help much.

The argument of relative attractiveness worked for a while, but I think most of us would now agree that almost all technology stocks were expensive in an absolute sense. An important question to ask ourselves for any investment is what its valuation is currently and how does this compare to where it has been historically. Valuations tend to revert to their long-term average and an investment must be inexpensive in an absolute sense for it to perform well for you long-term.

I am not suggesting we are in a bubble currently, but there is a very common “relative” valuation argument being used today that could be dangerous moving forward. The belief is that most risky investments are attractive relative to short and long-term interest rates. Currently, savings accounts and money markets pay close to nothing while US government bonds will pay you the “hefty” sum of 1.5% annually (but only if you are nice enough to lend them money for the next 10 years). Investors are left searching for higher returns. Certainly, almost anything else is better than this.

A lot of money has poured into risky investments based on this notion that anything is better than cash or government bonds. However, many investments that have seemed relatively attractive are now quite expensive in an absolute sense. If your preferred stock is currently yielding 4% when it has historically yielded 6%, it is expensive in an absolute sense even if it yields much more than cash. The same can be said of a utility stock yielding 5% when it has historically yielded 7-8%. If you are buying real estate in a city where prices average 10 times the average household income when it has historically been 5, local properties are pricey.

I would always recommend determining the downside risk if an investment’s valuation reverts back to its historical average. When the downside risk is quite large, you may want to reconsider the investment.

If you buy an expensive asset, it can perform quite well for a period of time. However, unless you can guess the perfect time to exit, you may be caught in a game of musical chairs where there are no winners. Not many of us were able to ride the wave of the dot-come bubble while escaping unscathed just before it burst. Buy assets that are reasonably priced in an absolute sense!

Riding the wave of relative valuation can be fun for a while, but it can lead to a long-term wipeout.