JPM’s Wide Value Spread

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During their recent episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed JPM’s Wide Value Spread. Here’s an excerpt from the episode:

Tobias: This is a nice segue into my topic. I said everything I was going to say the intro, I’ll rehash it again. Just [unintelligible [00:32:44] JP Morgan has this fun chart. I just really liked the chart. So, I tweeted it out a little bit earlier, but basically, it’s got– I think it’s about 25 years, it might be longer than that. Actually, I think it’s a lot longer than that, because 2000s about midway through. 2000, very widespread, we’ve talked about this a lot of times. JT wrote the article in real-time, in about 2014 I think it turns out and I retweeted on Greenbackd, which was my blog pre Acquirer’s Multiple.

When the spread gets very wide, that means the most value companies are very overvalued, the cheaper companies are cheaper relatively. Typically, that means basically returns follow the– they do eventually follow multiples. I know that that’s anathema. You don’t have to say that anymore, but that’s what the data shows. [laughs]

Jake: Wrong.

Tobias: Wrong, yeah. Expensive stuff is bad as expensive as it ever gets. The cheap stuff is not super, super cheap but it’s way, way cheaper than the expensive stuff. The spread is very, very wide. JT wrote a great article in 2014 in real-time saying that he thought the value spread was so tight that it portended bad returns for value coming forward. 10/10, you got that exactly right. You just didn’t tell us to go and buy growth at that time. So, only half marks for that. I read it and tweeted out and thing about–

Jake: Can I launch a small defense of that?

Tobias: Yeah.

Jake: At the time, that average that was tightly clustered was a relatively expensive average. I didn’t think that that offered a very good risk reward even on the growth side. I understand why it was relatively a better bet than value at that point. But I thought the whole thing was relatively expensive, and then it was more likely that everything would come back down to a cheaper level and that was where I was 100% wrong. We just got more expensive.

Tobias: Now, we’ve got a really wide spread and everything is going to come back down.

Jake: Value stayed where it was, everything else got more expensive, pulled the averages up, blew the spread out. So, I missed that upper half of the blowout.

Tobias: What happens now? We get the spread closing with value staying exactly where it is.

Jake: Well, here’s how I’ve been thinking about it lately, and it’s kind of scary. We’re walking this path where if we fall over to the left, we fall into a debt deflation. All this expensive stuff gets repriced because all of a sudden risk is back again, maybe the confidence in central bank omnipotence comes into question like it has in other times. Lots of different problems that we can all recognize right now start mattering again. Nothing matters at the moment, but all it takes is a little bit of shift in the sentiment and price change to all of a sudden, every data point is already there and lined up for it to matter. That’s like, okay, everything is catching down at that point.

Then, we have on the other side of this little trail that we’re walking, we have currency totally gets out of hand, melt-up, indexing Mike Green type arguments, where you don’t want to be in anything except equities in the longest duration that you can. You definitely don’t want to be in bonds or cash or maybe even like cheap stuff. Then against that, you have maybe some kind of value rotation as well on that side of the falling over. We’re walking along this path and every single stimi check that we send out, every single problem, gunshot wound that we band-aid over, is just narrowing this path further and further until we’re just on this tightrope where, at some point, we have to fall one way or another. I don’t really know which way we’re likely to fall.

Tobias: That sounds a little bit like Chris Cole’s– he likes vol because both tails are hedged in both of those scenarios. Vol hit just both those tails. Which one’s better for value? That’s all I want to know.

Jake: [laughs] Which one does value rip? Probably [crosstalk] melt away, if I had to guess.

Bill: I think value’s got shorter duration cash flows, more of the cash is upfront. If rates were to go up, all else equal, I would think that value is going to outperform quite a bit. I don’t know that for your particular strategy, you need values jaws to collapse. What you need is the businesses to continue on a similar path to what they’ve been doing. And then you need them to eat themselves, and they should do really well over time relative to more expensive stuff that is buying in shares at a less attractive return of capital. That said, that more expensive stuff probably has a more attractive reinvestment return on capital. So, it’s all about whether or not that’s priced correctly.

The thing is, if you have, I don’t know, 10 years, I guess I was just looking at the median P/Es, the median P/E on the S&P seems to be just by my eyeballs somewhere around like 17 historically until the 2000s, then it sort of went nuts.

Tobias: Single-year P/E?

Bill: Yeah, I don’t think that you can look at like this year’s and say, “Oh.” When you’re buying a PE this high, earnings are clearly depressed. So, you’ve got to be cognizant of the denominator.

Tobias: That’s why I don’t like the single year. That’s why I prefer the Shiller P/E. The average is a little bit more useful in that scenario. The Shiller P/E is at 35 at the moment.

Bill: Yeah, I guess all that I’m saying is, I don’t know how much valuation bleed you need to underwrite over 10 years in some names. I don’t know, but I do think there’s– the thing that I continue to come back to and I know that I cheerlead the melt-up and make jokes and stuff, but to me, the higher the market goes, the further away the American Dream gets for the person that needs to save their way up the ladder.

That really concerns me. If I am right on the melt-up, it’s going to be really bad societally, in my opinion. Then, if I’m not right, then you get all these pensions that are underfunded. So, that’s not great either. I don’t really know. I just think you’d try to find companies that are reasonably good bargains and you try to buy them, and you find stuff that you think is going to be bigger in the future than it is today or smaller, but knows how to return capital and just try to remain flexible.

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