We wrapped up yesterday’s case studies at our monthly CEO Lunch and a new member asked me what I thought of the markets. This is not the sort of question I am asked very often. My response was, “I don’t know.” Everyone went quiet and he asked a clarifying question: “What do you think happens if the stock market goes down? Do you think it will go down soon?”
This got me talking. Maybe I should have stayed quiet. I’ll let you be the judge. My basic theme remained, “I don’t know, but I do think about it, and I do have to act based upon my thoughts.” I will try to summarize my thoughts and share a few actions. I will also try to add more details (I write better than I speak.)
First off, I do not think the market is grossly over-priced right now. There is still an equity premium over risk-free rates. However, interest rates are low compared to long term averages, so the multiples are high. Prime interest rates were 2%+ lower a couple of years ago. Furthermore, there are companies trading with safety. There are companies that are over-priced. Overall, things are within an expected price range.
Secondly, I worry more about the credit cycle. The inverted yield curve is weird. The credit cycle seems like it is getting long in the tooth again. Tighter credit will likely be the source of a decline. Credit is often the source of broad equity decline so this is not particularly insightful. However, I don’t know when credit will tighten. I do think credit will tighten and the stock market will go down >20% in the next 10 years. That’s also not very helpful. I have no idea if it will be sooner. It might be within the next six months.
Regarding his first question: ‘What do you think happens if stock market goes down?’
I think about this a lot. It is a bit like running drills in my head. If this occurs, then I should do that. Allow me to point out the obvious first (people sometimes forget this): the stock market goes down because sellers over-take buyers. Buyers retreat and sellers continue selling. So, what happens when this occurs? Prices go down until buyers advance. So that’s what I think happens. Insightful? No. Important? Yes.
What do I think happens to private companies if stock market goes down? At lunch I responded with the following: “I worry that private business owners refuse to sell at cheaper prices.” This is what I worry about. Private business owners may simply wait out the downdraft. Another lunch guest pointed out that some level of sellers are forced because of age or other outside circumstances. I agreed. However, I don’t think the baby-boomer generation is broadly selling right now because they feel forced. I think they’re selling because they want a change of pace. They want a lifestyle change. They want less managerial burden. However, they are hard working and willing to stick it out if prices are entirely illogical. The decision must still make some basic financial sense to them.
So, what are we doing to prepare for a steep decline? First off, I’m trying to maintain extra borrowing capacity. Next, I am preparing to buy more marketable securities. Third, we are diversifying industries. If we can borrow when other private companies (and individuals) are tight, we can grow more easily. Secondly, if we can buy equity in well established large companies at discounted prices it is safer and easier than buying private companies in our geography. And, finally, I believe prices will show us where to buy. We need to build breadth of competency while small.
Right now we earn a liquidity premium and a control premium compared to marketable securities. Sometimes marketable securities sell for absurdly low prices. We were provided some larger purchase opportunities in late December/early January and again in July. We have also made more sales this year than in the last few. Still, the proportion of our portfolio in marketable securities is very small. It is unlikely to ever be the majority. Why? Because we are the best buyers of private companies in our geography. We have edge here. The only edge in the public market is our temperament toward business ownership.
I think the market is manic. Crowds over-react in both directions. Individuals on the other hand are able to learn new industries and grow as managers. I’m investing in that now.