Preview: What Does “This Time Is Different” Really Mean?

This is a preview of an upcoming column.

“The four most dangerous words in investing are: ‘this time it’s different.’ ”  -Sir John Templeton

What do these words actually mean to investors today? As of late, more than a few pundits have been misinterpreting their meaning. With a wave of a hand, they dismiss data and fundamental metrics that are in fact very different – sometimes, by a lot. When a significant input to corporate earnings is several standard deviations away from its historical mean, that is different. This is not what Templeton was referring to. This misinterpretation has been costly.

What does ‘this time it’s different actually mean?

Stated simply, Valuation always matters. There is no new paradigm that will ever change that. What you pay for a stock or index will ultimately determine the return it generates over time.

What is never different is the behavior of investors. It is always driven by greed and fear. That is simply human nature at work.

We all understand the basic formula for valuation: Price relative to earnings, or P/E ratio. And as I noted yesterday, there are many ways to measure valuation. “Stocks can be defined as cheap (the rule of 20, which adds the inflation rate to a stock index’s price-earnings ratio) or fairly priced (forecast P/E), somewhat overpriced (12-month trailing P/E) or wildly overpriced (Shiller’s cyclically adjusted P/E).”

What Templeton was not suggesting was for investors to ignore the many factors that actually impact valuation. Metrics such as GDP, Unemployment, Inflation, Interest Rates can move to extremes, and this should be noted. He was not suggesting these factors should be ignored because they are “different” than they were previously. Rather, he was warning that you should check your own behavior if you believed a new era was upon us and that valuations no longer mattered.

Should one ignore inflation rates of 12% or bond yields of 2%? Of course not.

This is a nuanced but important difference.

In 1974, the P/E ratio of the S&P500 was 7.33, but inflation was running at 11% and the 10 Year bond yield was 7.4%. Real returns were negative. Should investors have ignored that different data? By 1981, P/E ratios were about the same, but risk free yield of the 10 year was over 15%. Some investors of that era dismissed the fundamental differences. Those investors in the early 1970s who bought stocks because they were cheap were surprised when they got much cheaper. Real returns in the decade of the 1970s reflected a near 75% loss.

Identifying when metrics that matter change is very different than recognizing when the collective madness of the crowd no longer believes valuation makes a difference.

This is an enormously important difference.

More on this tomorrow . .  .
 
Update: Sunday’s column is posted here