For the past century, stocks have been on a pedestal above all other asset classes. While everything from government bonds and housing to various commodities including gold, silver and oil have delivered positive nominal returns for investors, none of these other asset classes come close to the average annualized returns on equities.
But just because stocks have consistently outperformed for extended periods doesn’t mean Wall Street’s major stock indexes are rising in a straight line.
In 2024, the timeless Dow Jones Industrial Average (DJINDICES: ^DJI)benchmark S&P500 (SNPINDEX: ^GSPC)and growth-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) have reached record highs several times. But based on the actions of some of Wall Street’s most prominent value investors, trouble could be brewing.
Wall Street’s most successful value-oriented money managers are issuing a silent warning
The sails for the Dow Jones, S&P 500 and Nasdaq Composite have been hoisted by the artificial intelligence (AI) revolution, stock split euphoria, a resurgent US economy and the prospect of a cycle of rate easing by the Federal Reserve that will dampen loan demand. will stimulate.
Despite this positive news, select billionaire money managers haven’t been shy about hitting the sell button lately. While trading among active hedge funds and predominantly growth-oriented asset managers has been mixed, some of Wall Street’s best-known value investors have been decisive net sellers of stocks.
Arguably no value-oriented money manager is better known than Berkshire HathawayBillionaire CEO Warren Buffett. The aptly named Oracle of Omaha isn’t afraid to sit on his hands and wait for emotion-driven sales to cause price dislocations in proven companies with sustainable competitive advantages.
For seven consecutive quarters (through June 30, 2024), Buffett and his investment team have been net sellers of nearly $132 billion in stocks. Berkshire Hathaway is at a record $276.9 billion in cash, cash equivalents and U.S. Treasury securities at midyear.
But Buffett is far from alone.
Bill Ackman of Pershing Square Capital Management is an undeniable value investor who seeks out contrarian stocks. Although Pershing Square’s Form 13F shows two new holdings added during the quarter ended June – Nike And Brookfield — sales activity in five other companies, including Alphabet And Chipotle Mexican Grillfar exceeded purchasing activity.
It was a similar story for Britain’s Warren Buffett billionaire Terry Smith of Fundsmith in the second quarter. Smith, who has a knack for finding great deals hiding in plain sight and prefers to hold proven companies for longer periods, has cut his fund’s holdings in 37 of 40 positions.
Appaloosa’s value-oriented billionaire chief David Tepper was also active in sales transactions during the quarter ending in June. While Appaloosa’s 13F shows that nine positions were added in the second quarter, two were sold immediately, while 26 other positions were reduced. Interestingly, some of Tepper’s most notable downgrades were in growth stocks, including Nvidia, MetaplatformsAnd Microsoft.
While this selling activity may be nothing more than mere profit-taking, it’s more likely that it’s a silent but ominous warning from some of Wall Street’s smartest investors of trouble ahead.
Stock valuations are in historic territory – and not in a good way
Let me preface this discussion by stating that “value” is in the eye of the beholder. Every investor experiences value and risk differently when putting their money to work on Wall Street. That being said, we are currently witnessing one of the most expensive stock markets in history, dating back to the early 1870s.
There are many ways to measure value, the most well-known of which is the traditional price-to-earnings (P/E) ratio. The price-to-earnings ratio divides a company’s share price into its trailing twelve month earnings per share (EPS). This figure can then be compared to the TTM P/E ratios of comparable companies or major stock indexes to determine relative cheapness or price.
While the price-to-earnings ratio has its uses, it can also be easily distorted. When shocking events occur (e.g. COVID-19 lockdowns), the price-to-earnings ratio becomes ineffective in helping investors pinpoint/decipher value.
The only value measure that is more comprehensive and has a flawless track record of predicting big moves in the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite is the Shiller price-to-earnings ratio, also known as the cyclically adjusted stock price profit ratio (CAPE ratio).
The Shiller price-to-earnings ratio of the S&P 500 is based on average inflation-adjusted earnings over the past ten years. Examining ten years of earnings history and adjusting for the effects of inflation creates an apples-to-apples comparison that minimizes the impact of shock events.
When backtested to January 1871, the Shiller P/E of the S&P 500 averaged 17.16. But as you can see from the chart above, it has been above this level for almost all of the last thirty years. The Internet, which makes it easier than ever to access information and place stock trades, coupled with lower interest rates, has increased investors’ willingness to take risks.
But there comes a point when risk-taking becomes excessive. The unofficial line in the sand that poses a problem for Wall Street is a Shiller price-to-earnings ratio above 30. For context, the S&P 500’s Shiller price-to-earnings ratio closed above 37 on October 9, which is the third highest marks during an ongoing bull market throughout history.
There have been only six occurrences, including the current one, in which the S&P 500’s Shiller P/E has crossed the 30 mark, dating back 153 years. After all five previous cases, the Dow Jones, S&P 500 and/or Nasdaq Composite lost at least 20% of their value, if not significantly more. In other words, the Shiller P/E has an impeccable track record in forecasting eventually bear markets on Wall Street.
What the Shiller P/E can’t tell us is when These declines will happen. There is no rhyme or reason as to how long stocks can remain pricey in the short term. History only shows us that extended valuations over long periods of time are not sustainable.
I don’t believe the selling activity we’re witnessing from four of Wall Street’s most respected value investors is a coincidence. More than likely, this is a response to the stock market being historically pricey. It can be a smart move to have dry powder on hand to take advantage of potential price dislocations, just like Buffett, Ackman, Smith and Tepper did.
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Randi Zuckerberg, former director of market development and spokeswoman for Facebook and sister of Mark Zuckerberg, CEO of Meta Platforms, is a member of The Motley Fool’s board of directors. Suzanne Frey, a director at Alphabet, is a member of The Motley Fool’s board of directors. Sean Williams has positions in Alphabet and Meta Platforms. The Motley Fool holds positions in and recommends Alphabet, Berkshire Hathaway, Brookfield, Brookfield Corporation, Chipotle Mexican Grill, Meta Platforms, Microsoft, Nike and Nvidia. The Motley Fool recommends the following options: a long call in January 2026 at $395 at Microsoft, a short call in December 2024 at $54 at Chipotle Mexican Grill, and a short call in January 2026 at $405 at Microsoft. The Motley Fool has a disclosure policy.
An ominous warning for Wall Street: Four of the most prominent value-oriented billionaire investors are net sellers of stocks, originally published by The Motley Fool
