Stock Market, Overall Economy Out Of Synch: Tread Lightly

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Is This The Year You Lose Your Entire Life Savings?

Written by Evan Bleker Website

Since the beginning of 2009 the S&P 500 (INDEXSP:.INX) has increased by 175%.

Over the last two years it’s risen 47% — and in 2013 alone the index surged nearly 32%. That sprint is far ahead of the historic ~10% average yearly gains the index has made since inception.

Looking at the cyclically adjusted PE of the S&P 500 (INDEXSP:.INX) is sobering.

The price of the market is just a hair short of the 2007 high of nearly 27x earnings reached in July of that year. This high is well above the historic average of 16.5x earnings and speaks volumes about current market sentiment.

While the stock market pretends that all is well, the economy continues to sputter.

Unemployment figures are down over the last couple years as mobs of people have decided that participation in the never-ending arms race of higher education is their best bet after being forced out of the labor force.

Legions of 4 or 6 year college graduates have swarmed online employment sites and now stand behind counters asking you whether you want paper or plastic.

Full time work has been replaced with part time or contract work and everybody but the crem de la crem seem to be taking home less in absolute or inflation adjusted dollars.

“…we also have the re-emergence of the Russian empire to contend with, under the leadership of Prince Putin…”

While the urgency of the credit crisis is now 4 years behind us, the situation is no less dire.

There’s a lot of talk in the media of deleveraging but little evidence for it. The ideological fools on capital hill, in the most indebted nation in the history of the world, seem more interested in bickering over small ideological differences than making real changes that are desperately needed.

American gross national debt stood at just over $10 trillion in 2008, but has risen to over $16.7 trillion as of June 2013. GDP, on the other hand, was estimated to be $17.1 trillion in December 2013.

Greece is a mess with a debt that’s risen from 105% of GDP in 2008 to 157% today. Spain, Italy, France, Britian… Even Germany is struggling with a national debt that’s topping 81% of GDP. So much for the saviour of the Eurozone?

And those are just a few economic pain points — we also have the re-emergence of the Russian empire to contend with, under the leadership of Prince Putin, and the inevitable economic fallout that would come with escalating the crisis. As of 2014, Russia accounts for nearly 30% of Europe’s energy and this could come into play if sanctions are imposed on Russia.

Stock Market, Overall Economy Out Of Synch: Tread Lightly

Yet somehow investors feel confident enough to push the stock market’s PE to 25.4 — a hair under the high reached back in 2007?

This insanity has to stop.

It’s no secret what happened to investors who gorged themselves back in 2007.

The pigs got slaughtered.

It’s the same thing that happened back in 2000 during the new wave economy and greedy investors pushed the averages up to depressingly high levels.

The pigs got slaughtered.

Any time investors get carried away and prices get divorced from fundamentals, nasty things happen.

So what is your plan?

The cowardly may feel compelled to sell all of their holdings, get out their crash helmets, and brace for impact. This isn’t the best course of action to take.

Here’s the thing — even after all of that, the stock market still does not have to go down.

It’s foolish to predict the direction of the stock market — even with the mess that we’re seeing in early 2014! Alan Greenspan, former chief wizard at the Federal Reserve, once quipped that economic forecasting was better than a flip of a coin but not by much.

Generally there are three paths that the stock market can take:

  1. The market can go up
  2. The market can go down
  3. The market can go sideways

Given our current global economic and political situation, the cards are definitely stacked against favorable returns going forward …but what actually unfolds can’t be known in advance.

Despite the danger and uncertainty we face as value investors I do believe that we can drastically reduce our risk exposure while still leaving the possibility open to achieving adequate returns going forward.

So what should you do?

Let’s look at the four most practical options available to you. You don’t need to be an experienced Wall Street trader to take advantage of any of them — you can adopt them from the comfort of your tablet at home:

A. Business As Usual

The business as usual approach is simple: just invest as usual, ignoring current valuations, economic issues, and political problems.

Depending how you invest, this might be a good option for you. But if you’re buying value stocks based on current earnings, cash flow, or future projections… look out below!

When stock market tumble they take fairly-valued or overvalued stocks down to ridiculously cheap levels. If your portfolio is made up of these kinds of stocks…. well…

It could take you decades to recover from losses suffered after buying stocks trading at only a shallow discount to fair value based on current artificially inflated earnings.

B. Sell it All and Hide in Cash

This strategy has some pretty significant benefits and drawbacks. Being in cash would eliminate the risk that your entire portfolio would be pulled down with the stock market.

The problem is, the stock market might not collapse — this is that whole unpredictability thing I mentioned earlier. It means that while the value of your savings slowly erodes due to inflation, stocks could continue to rise, or could possibly go sideways while fundamentals improve. Worse, if the economy got significantly better, not only would you be out of the rally but you could possibly face significant inflation.

C. Buy Bitcoin

(Lolz… buy Bitcoin…)

D. Buy Classic Benjamin Graham Deep Value Stocks.

This is the strategy that I’ve elected to take. The idea is simple: you stick to rigorous investment standards that have been proven successful over time, buying firms at significant discounts to a conservative estimate of intrinsic value, and keep the rest in cash as you wait for more opportunities.

The cash in your portfolio acts as valuable insurance against a market collapse and gives you significant leverage during a massive market downturn.

When the stock market crashes you could help end the pain of paper losses that some investors suffer by exchanging their shares for an unbearably small amount of cash.

The key to this strategy, though, is maintaining a very strict buy discipline — such as I do using my NCAV scorecard. This should keep the number of picks in your portfolio modest, and cash bountiful.

The companies that you buy should be very cheap yet conservatively financed, such as the stocks I suggest to those who opted to get free NCAV stock ideas.

I try to buy when a stock is trading for less than half of its NCAV. A discount this steep means that, not only is there a significant chance for large capital gains but, my stocks should be partly buffered from large stock market drops.

You could call this the insurance strategy, as it insures against both the risk of holding all cash and the risk of an all stock portfolio when the market turns. Owning well-chosen deep value stocks means you have a great chance of seeing significant profits that will pull up the rest of your portfolio if the market goes sideways or up.

Owning a comparatively small number of ultra-cheap stocks means smaller losses during a crash since your holdings are already dramatically depressed and the rest of your portfolio is made up of cash.

What’s the right split between cash and stocks?

That really comes down to how many great opportunities you find in the stock market.

Right now deep value investors who have failed to look for stocks outside of their home country are feeling a lot of pain.

Sophisticated value investors, by contrast, are starting to wake up to the fact that it doesn’t make sense to spend time building a portfolio of value stocks only to ruin it by not including the best opportunities available — so many of these investors have chosen to look for stocks in friendly international markets.

I, myself, have holdings in Australia, America, Canada, and Japan. In Australia, I found an industry that has taken a hammering not seen since the depths of 2008. In Japan, one of my net net stocks is debt-free, has improved earnings over the last 4 years, and currently trades at a PE of 6x earnings!

While the market as a whole is extremely expensive, looking internationally ultimately means finding more great investment candidates that fit your strict buy criteria.

(Hint: Opt for option “D”)

There’s only one or two great opportunities available in any one western market these days; and I should know… it’s what I do.

Oddly enough, if you open your investment universe to include a range of friendly foreign markets, you suddenly have a lot more investment opportunities available. This is why forward thinking value investors have started to hunt for deep value stocks in international markets and why I recommend that you should, as well.

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