David Einhorn is one of the most influential hedge fund managers in the world. His investment strategy involves buying undervalued stocks and shorting overvalued stocks while remaining invested in major economic trends. This allows his fund, Greenlight Capital, to generate returns that are significantly different from the overall market in any given year.
One of Einhorn’s most famous trades was his short position against Lehman Brothers in 2007. Unfortunately, the fund hasn’t had the same success since that short sale paid off.
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It performs mostly worse than S&P 500 Index Since then, it has been the only outperformer in the 2022 bear market. But modest performance in bull markets and strong performance in bear markets have enabled Greenlight Capital’s average annual total return since its inception in 1996 to reach 12.7%, exceeding the S&P 500’s average annual return of 10.2% during the same period.
So Einhorn is worth watching, especially when he talks about a potential market downturn. In his latest letter to investors, he issued a major warning that could lead to another outperformance from his fund.
Einhorn has been warning about rising market valuations for several years. His letter to investors reinforced this warning:
We believe that the U.S. stock market is the most expensive market we have seen since we began managing money, and arguably in U.S. history. It’s not just our skepticism about AI stocks; The speculative behavior of retail investors is evident. … From a long-term perspective, we continue to believe that now is not a good time to make a large equity investment.
Greenlight opened in 1996 during the dot-com bubble. Many unprofitable stocks were trading in the billions of dollars at the time. The S&P 500’s forward price-to-earnings (P/E) ratio climbed above 24, while the CAPE ratio, which adjusts returns to reflect inflation, climbed above 44 in late 1999. Today, the S&P 500’s forward P/E ratio is trading at about 22, and its CAPE ratio is over 40 — both historically very high levels. When these ratios are this high, market returns tend to fall.
Meanwhile, the Buffett Indicator, which measures total stock market capitalization relative to gross domestic product, peaked at 144% in March 2000 at the height of the dot-com bubble (70% to 80% is considered favorable). The Buffett indicator is currently around 224%. Buffett said this number is the best sign that the market is overvalued.
The large, fast-growing artificial intelligence (AI) stocks that make up the majority of the S&P 500 are a big reason for the higher valuations. Expectations for these stocks to grow earnings rapidly in the coming years have driven up valuations across the market.
But Einhorn believes that the capital expenditures of many of these companies amount to hundreds of billions of dollars per year, which could lead to huge capital destruction. It is almost certain that AI companies will overbuild capacity in an attempt to stay ahead of the competition. This pattern has repeated itself with every major technology boom in history, including the dot-com bubble.
Einhorn also called out retail investors for speculative behavior. He expressed concern about large AI stocks, but valuations of many smaller companies have also climbed, even those not related to AI. These valuations may be even more unreasonable.
Prominent investment manager Howard Marks also expressed this concern in a memo from Oaktree Capital Management, as many such stocks have risen on speculation that artificial intelligence will eventually improve the productivity and profits of these companies.
Einhorn’s assertion that “now is not a good time to own a lot of stocks” needs some context. He runs a hedge fund that aims to generate returns that differ from the overall market.
Most investors would do well if they just matched the market. Even if you believe stocks are currently overvalued, investing in simple, broad-based index funds is not an irrational strategy. Einhorn believes stocks have been overvalued for several years, but they have proven to be extremely resilient.
As legendary investor Peter Lynch said: “Investors lose far more money preparing for or anticipating a correction than they lose from the correction itself.”
Still, for investors who want to take a more aggressive approach, there is still value in the market despite higher overall valuations. Einhorn highlights several new Greenlight acquisitions in letter: Natural gas specialist Antero Resourcesfootwear dealer Dex Outdoorand payment processor global payments, Among other things.
Given the speculative behavior of many investors in the market, now might be a good time to look at value stocks. Finding individual stocks that the market is underestimating for their potential and offering discounted prices is a great way to strengthen your portfolio and allow it to participate in the upside while maintaining downside protection. Value stock index funds can do this, too, but they may also include some low-quality stocks that deserve low valuations.
Einhorn has a strong track record of adjusting funds for bear markets. But his track record also includes preparing for bear markets that never materialized and making big bearish bets that didn’t pan out. Investors should be mentally and financially prepared for a correction in stock prices, but not at the expense of missing out on the potential for continued upside.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has an position and recommends Deckers Outdoor. The Motley Fool has a disclosure policy.
Billionaire investor David Einhorn issues big warning to stock investors Originally published by The Motley Fool