On March 20th, I published the following quote in my regular money.ca blog entitled: Reacting to headlines is perilous!
Most worrisome: Jim Cramer (wait long enough and you’ll eventually be right) is more wound up than a four-year old high on chocolate. I do believe that stocks are a better investment than bonds over the next several years, but the trend in corporate profitability (and consumer sentiment, GDP and job growth) will be interrupted – count on it – affording convenient opportunities to get invested. With nothing but good news and euphoria, what happens if we get some bad news? A chance to invest at lower price levels. Right now, ‘risk-on’ is exactly what you should expect if you respond to headlines.
As I expected, everyone who decided to buy into the rallying market after March 20th found themselves in the red by mid-April.
As always, the word “bubble” only begins to surface after-the-fact. I saw this quote in yesterday’s Business Insider:
From Sebastien Galy of SocGen, a quick meditation on the current state of world markets, and what seem to him as clear signs of a bubble.
“Why do bubbles accelerate when identified? The cost of not participating is too high as performance falls vs peers or benchmark. Timing the correction and its intensity is also much harder than participating, while I am sure a bunch of behavioral biases are at work…”
What he describes as a ‘bunch of behavioral biases’ I like to summarize into two words – personal risk. If everyone is optimistic and bullish (friends, associates, senior management) then the personal risk of appearing deviant is huge.
We also tend to give unreasonably greater weight to recent experience rather than struggle with conjecture. This is certainly evidenced by the willingness of the FBI to investigate the Boston bombers thoroughly after detonating a bomb (experience) rather than devote time and money profiling a suspect on a hunch (theorizing) provided by the Russians. The personal risk of doing the work and being wrong didn’t warrant the effort.
I’ve discovered over my career that financial risk in capital markets is at a maximum when personal risk is at a minimum. It may also be true that in general we are most vulnerable to risk when we believe our asses are covered.
The market has of late bounced back some from its lows, but is the worst is behind us? Back to fundamentals. A rule of thumb that has served me well (helped me to anticipate the strong market post-crisis and predict periodic overbought/oversold periods) is to estimate a fair value for the index based on actual current earnings ad infinitum discounted by the junky bond yields. There’s no scientific explanation I can offer, but it seems to work. Based on this the S&P 500 can easily trade down to 1440 levels (down another 7%) if earnings growth stalls completely and the FED continues its easy money policy.
What do I believe? Earnings growth won’t stall completely, and the FED can’t continue its easy money policy forever. If (when?) the FED caves, it will do much more damage than a slowdown in earnings.
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Aren’t you just best to invest monthly and have the majority of your assets in diverse equity holdings? That way the dollar cost averaging and exposure to different assets and asset classes should negate some of the risks whilst still allowing you to be exposed to the market?
It works, but is not necessarily “best” Richard. If cashflows are small relative to total assets, market values will still become inflated and bias risk. Many underestimated the impact of AAPL (one example of hundeds) on their total savings by passively letting it appreciate.
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