Profiting from Structurally Broken Equity Markets!

David Einhorn Explains why Jr. gold stocks and other small caps are being crushed!

The chart below displays a model used by economist and hedge fund manager John Hussman to provide a sense of the relative valuation of the S&P 500 to US Treasuries. The red line measures the 12-year S&P 500 annual total return in excess of Treasury Bonds. It shows a current total return 12.5% above U.S. Treasuries. A more normal return for stocks over bonds is 4%. Accordingly, the blue line at this time suggests that stocks are 8.5% overvalued compared to U.S. Treasuries. The chart also shows that based on this model the S&P 500 was this overvalued only two times in history. Those two times were late 1929 and in late 1999. We all know what happened to stocks shortly thereafter.

But the vast majority of stocks in the S&P 500 are not overvalued. That’s obvious because just a handful of stocks—the magnificent seven (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla) are responsible for almost all of the gains in the S&P 500 over the past few years.

This past week, I was driving around my neighborhood in Queens to run some errands when I heard an interview aired on Bloomberg radio with host Barry Ritholtz. He was talking to legendary hedge fund manager David Einhorn. David’s declaration that the equity markets are structurally broken suddenly helped me understand why the share prices of gold exploration stocks covered in J Taylor’s Gold, Energy & Tech Stocks have been performing so miserably despite some of the greatest new gold discoveries I have seen in many years.

The magnificent seven are great companies. But the S&P 500 is a weighted index. So every time more money from investors seeking to invest passively goes into the index, a very large portion of that new money flows blindly toward those super large cap stocks while largely ignoring a large number of smaller cap companies that often offer superior profitability. Thus, because of dominance of passive investing through index funds, capital is diverted away highly profitable companies leading to their undervaluation and lessening their ability to optimize growth. Not only new money entering the market but also old money sells out of smaller cap companies due to FOMO (fear of missing out). That’s bad for society because it results in less production of goods and services that society needs.

My history professor Dr. Paton Yoder at Hesston College made an economic prediction that I took note of back in 1967. He predicted that when governments debase their currencies as the U.S. began to do in 1971 by removing gold from money, the work ethic of a society and longer-term morality in general will decline.  I saw that happen personally as a credit analyst in the 1970s and 1980s at multinational banks in New York City. Especially during the 1980s, banks began to eliminate costly credit analyst jobs in favor of bundling many loans into large packages with little or no attention paid to the credit worthiness of each borrower. That eliminated costly credit analysts from bank payrolls. The idea was that a percentage of loan losses could be predicted statistically and priced into the loan packages designed for investors.  Indeed, those kinds of loan packages along with a general moral decline on the part of brokers selling these products to investors were partly responsible for the 2008 financial crisis.

The same kind of thinking and structure has now infiltrated the public equity markets to such a degree that we are at a point of equity market overvaluations akin to major stock market peaks of 1929 and 2000. As David explained on Bloomberg, weighted index funds have become akin to a perpetual motion machine that sends a few stocks higher while starving small caps of much needed capital.

A structurally broken equity market such as now exists hurts the economic well being of the masses. But rather than jumping on the momentum band wagon, David has remained true his value orientated approach. To make it viable, he has had to seek companies selling at PE ratios 4- or 5-times rather than the more traditional 10 x PE he looked for in prior markets because with indexing, investment banks have laid off security analysts just like commercial banks did in the 1980s. Without coverage from securities analysts, prices of these smaller cap companies not only declined but a lack of liquidity and ability to exit from those investments was no longer possible.

But, smart investors like David Einhorn find ways to adjust to existing market conditions in order to survive and thrive so his business model now takes him to strong companies with PE ratios of 4 or 5 times. Those companies that can compounded earnings at a rate of 20% to 25% can throw off cash to shareholders, making an exit strategy via a market sale is less necessary.  Its hard work to find such quality companies. But its honest work that has served not only David’s investors well but I would argue society as a whole by channeling capital to smaller cap companies they would not otherwise have.

You can listen to David Einhorn explain how he has successfully adjusted his value investing approach as the broken equity markets hobble along toward a day of reckoning. At some point, there will be a switch to value and judging by John Hussman’s chart displayed above, we may be approaching that day very soon.

David’s interview on Bloomberg reminded me of another very smart investor named Roy Sebag the CEO of Goldmoney. That company recently changed its business model to include some undervalued high quality real estate U.K. assets in its portfolio.

From what I can see Goldmoney is set to generate steady earnings and free cash flow with tangible net worth rising significantly year after year. Goldmoney is now a true value proposition selling at ~ 5 times annualized projected earnings without assuming any change in the price of gold or the company’s long-standing precious metal custody and investment businesses. Given my view that gold is due for a major run higher, returns might well exceed 20% during up years for gold. But again, gold market mania is not necessary to make Goldmoney a great buy right now.

While I passed along the Goldmoney story to my paid subscribers this past weekend, I plan to publish it here over the next couple of days because I think it provides the kind of investment that specially makes sense in these structurally broken equity markets until healthier markets reemerge.