thinking is that as long as the Fed is QEing, stocks will keep going up. Everyone feels they can get out before the music stops –we heard this before, in the late ’90s. Few got out. “Dancing” is not investing, it is speculating. One of the problems with QE is that the Fed is forcing people to buy riskier investments than they otherwise would have. The immorality of their actions aside, they create a significant psychological mismatch between assets and their holders. Stocks are in weak hands, insuring one great stampede for the chairs when the music stops.
Despite how it may sound, I am not issuing a market timing call. I have no idea when this market will turn; nobody does, and if they tell you they do they are liars. Market timing is a loser’s game. It is impossible to put market timing into a repeatable process, because on top of getting a plethora of global events right you have to time human emotions.
When the market is making all-time highs it is easy to become complacent, let down your guard, and let euphoric media headlines go to your head. A joke that Warren Buffett told a long time ago comes to mind here:
A very successful oilman dies. He faces Saint Peter, who says, “You’ve been a good man, and normally I’d send you to heaven, but heaven is full. We only have a place for you in hell.” The oilman asks, “Any chance I could talk to other oilmen who are in heaven? Maybe I can convince someone to switch places with me.” Saint Peter says, “It’s never happened before, but sure, I don’t see any harm in it.” The oilman goes to heaven, finds an oilmen convention, and yells, “They found a huge, cheap oil discovery in hell!” So oilmen are stampeding out of heaven straight to hell, and our oilman is running with them; he’s leading the pack. Saint Peter shouts to him, “Why are you going to hell with them? I have a spot here in heaven for you now!” The oilman shouts back, “Are you kidding, what if it’s true?”
The moral of the story: don’t drink your own Kool-Aid. Don’t pour money into stocks for the sake of being fully invested or to “participate” in the stock market, sacrificing on quality or valuations. Don’t dance, invest. Look at your portfolio and ask yourself a question: “If I didn’t know what the Dow is doing today, would I still want to own these stocks?” If after re-examining your portfolio you find that you own a lot of overvalued stocks, do the painful but correct thing – sell.
I promise you it will be a very painful decision, because those stocks will go higher … until they don’t. Cash is a four-letter word today because it earns nothing (thanks to the Fed) and because it drags down the returns of your portfolio in an appreciating market; but cash is king when no one else has enough of it and when investors who could not get enough of stocks are stampeding for the exits.
Footnote: Revisionist’s Earnings
The best way to normalize earnings for short-term profit-margin volatility is to compute 10-year trailing earnings for the S&P 500 and compare them to the average 10-year trailing P/E, which over the last 100-plus years was at about 18. This approach does a great job of normalizing earnings for profit-margin volatility, except when your look-back time period includes the recent Great Recession, when S&P 500 (INDEXSP:.INX) earnings collapsed from $85 to $7. You can argue that the $85 number in 2007 was inflated by exuberant earnings in financial stocks, and you’d be right, but it is also important to remember that in first quarter of 2009 American International Group Inc (NYSE:AIG) suffered the largest loss in corporate history, $61.7 billion. 2009 was not a great vintage year for Citigroup Inc (NYSE:C), Bank of America Corp (NYSE:BAC), and others, either.
Since the Great Recession distorts earnings power of the S&P 500 (INDEXSP:.INX), I decided to normalize it. I went back and revised history: I turned the mother of all recessions into a garden-variety one. I assumed that earnings had bottomed at $50 a share (see chart below) – a nice round number, a decline of 41% from their peak. (During the 2001 recession S&P 500 earnings declined from $53 to $25, a 54% decline.) Then I computed the “revised history” 10-year trailing “E”, and to my mild surprise, “E” went up only $4, from $61 to $65. In other words, the average stock was trading not at 26 times but at 25 times 10-year trailing earnings, and not at 41% above average valuations but only at 38%.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book
