Analysis

Ben Graham’s greatest fears about the market are being realized—valuations indicate a ‘voting machine’ market

July 6, 2020

The greatest investors in history make money by taking advantage of dislocations in the market. Many of those dislocations are created by human emotion.

As far back as Ben Graham, the best investors have understood that the market acts more like a popularity contest in the short-term, while reality only begins shining through over long periods of time.

Market valuations are currently showing signs of outsized emotional drivers, which could set up a massive sell-off in the coming months.

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Over the past 100 years, not much has changed about investing. Of course technology has changed the way we invest and research companies, but the philosophy of investing is still intact.

As far back as 1934, we have written proof that the best investors already understood that the stock market is emotional.

In his book, Security Analysis, Ben Graham created a concept that the market sometimes acts in different ways.

Ideally, the market would act like a “weighing machine.” By this, Graham meant that the market should be objective, with stock prices rising and falling exactly in line with the value of their companies.

In reality, the market isn’t a very good weighing machine, at least in the short term.

As Graham pointed out, the stock market acts more like a “voting machine” than a weighing machine, implying prices are tied to public opinion, which is inherently subjective, emotional, and reactionary.

This analysis has stuck with the value investors’ canon ever since. Many years later, Warren Buffett expanded on Graham’s musings, explaining that “in the short run, the market is a voting machine… but in the long run, the market is a weighing machine.”

There’s no actual record of Graham saying the second part of that quote, about the market being a weighing machine in the long-term. However, Buffett says he recalls Graham completing the thought.

The whole point of this concept is to say that short-term market fluctuations don’t always reflect economic reality, which can create buying opportunities. Eventually, the market will come to its senses and trend towards intrinsic valuations.

Despite the fact that good value investors try to ignore short-term fluctuations, it’s still important to understand how the market is acting and what the market is “thinking.”

Often, the emotional response of stocks or the market are the opposite of reality. For instance, a company that is cheap and getting cheaper is often viewed as a declining firm with bearish prospects.

That’s what investor sentiment would say, but it might be the exact opposite. If the company’s fundamentals have not changed, that means it’s a great time to buy the company. Eventually, the market will realize its mistake and the stock will trade in line with its fundamentals.

This “realization” often makes stock rallies more dramatic than they otherwise would be.

The same mechanic works in the other direction, too. During strong bull markets or when a stock has a lot of momentum, investors sometimes become euphoric, which can cause a stock to rise above its value.

Eventually, the market will once again come to its senses and the stock will plummet. These wild swings happen when trade opportunities start drying up. Eventually, every investor who wants to own the stock at that price will already own it, and nobody can sell.

As we mentioned above, the same mechanism works for the market as a whole, and we might be seeing that now.

We discussed last Monday that market valuations were back at all-time, pre-pandemic highs, expanding back to a 2.9x Uniform P/B.

While these valuation levels aren’t impossible, they’re reaching increasingly difficult-to-justify levels. You could say that investors, getting caught up in the market’s rapid rally, are currently pricing in the best case scenario for the market.

While you could say that’s a good thing, it could also be a sign that investors are acting emotionally, getting caught up in recent momentum. This could potentially be setting up a setback, especially considering the likelihood that Q2 earnings season is a disappointment to investors.

If the market does pull back, it will likely do so more than it really should. We’d urge you to consider the voting/weighing machine metaphor, keeping in mind that the market will eventually come to its senses and align with reality.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research