Seeking: a margin of safety

If you ignore the secular calls that we are at the beginning of another generational bull market and look at the data, you quickly see that the cyclically adjusted price to earnings ratio (CAPE) reached 31.28x in January 2021. The peak multiple in the roaring twenties was 32.56x during September 1929. The historic peak was 44.2x in December 1999. The historic low is 4.78x during December 1920. In the modern era the low was a 13.32x during March 2009. It is hard to tell if this time it is different: if near zero interest rates will incentivize investors to remain over-weight on equities, if the Federal Reserve’s accommodative outlook will backstop market liquidity, if the $900-$1,800B in stimulus will continue the bull market.

The data on the share of equities as a percentage of total assets is the highest it has been since the dot-com bubble, i.e., 25%. Equities (directly or indirectly held) are 45% of personal income. This latter statistic’s magnitude is possibly amplified equally by COVID-induced reductions in income and the lofty valuations equities achieved by the end of 2020. So this statistic feels meaningful, but it is inconclusive.

From Connel Fullenkamp’s Crashes and Crises: Lessons from a History of Financial Disasters we know that part of the Great Depression was triggered by excessive margin trading. The Federal Reserve publishes this data. In the future below we see that margin accounts are at $385B in asset value. Not quite at the $402B peak seen in Q3 2008, but well above the Q1 2000 peak of $286B.

Benjamin Graham recounts in The Intelligent Investor how:

the very people who considered technology stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2020 — even though, in Graham’s exact words from an earlier period, “the prices depreciation of about 905 made many of these securities exceedingly attractive and reasonably safe.”

We know from other crash post mortems that sell-offs happen much faster than melt-ups and other bull market moves. Indeed, by March 23, 2020 the S&P 500 had dropped 34% from its January 2020 high’s. It would take the rest of 2020 to get back to its old high. What separates many of Jack Schwager’s Market Wizards from me and you is they know that the probability of a 20% return in December 2020 is not the same as April 2020. Mr. Market has the edge now. Standing on the railroad tracks to read if the next train is bound for Omaha or Humdinger is not a margin of safety. Graham put it this way: “keep away from ventures where you have little to gain and much to lose.”


If you are seeking to diversify away from US equities, consider the Luna Capital Fund’s debt fund focused on e-commerce and software as a service businesses.