By Chris Hunter, insideinvestingdaily.com
Last week, investors got more happy news. The Fed announced it would
keep printing $85 billion a month to buy Treasury and agency
mortgage-backed bonds.
By printing money and buying bonds (aka monetizing debt),
the Fed is going to keep shooing investors out of bonds and into
stocks… funding government spending… and pushing up inflation rates
to make outstanding debt easier to pay back.
And not only that, but it’s also going to keep doing so until the
unemployment rate becomes “acceptable” again – in other words, as far as
the eye can see. The one thing that has not responded to the Fed’s
credit and cash deluge is the unemployment rate, which is still at 7.7%.
Against this backdrop, stocks have been rallying. And the big question everyone is asking is: Should they join the party?
Frankly, this is a terrible question. I can virtually guarantee that
if this is the way you think about investing, you’re going to have a
miserable time in the markets over the long run.
Here’s how my friend and legendary resource investor Rick Rule put it recently (with my own emphasis added):
Speculating on the events that are
certain or almost certain to occur is almost always more profitable than
gambling on a long shot, unlikely occurrence. Make investments based on
unlikely scenarios only when the potential risks and rewards are disproportionately in your own favor and you can afford the loss that you may incur.
This is the only question that matters: Are the potential risk and rewards disproportionally in your favor?
Usually that happens when you can buy a stock… or other investment
asset… at a price that is below its intrinsic value. It certainly
doesn’t happen when you rush out and buy something because: (a) everyone
else is buying or (b) because you think you can find a “greater fool”
to buy something that is already overvalued.
So are the risks and rewards of following the crowd into U.S. stocks disproportionately in your favor right now?
To answer that question, let me share with you an observation made by
bearish fund manager John Hussman recently. Then you can decide for
yourself.
[Two weeks ago], Investors Intelligence
reported that the percentage of bearish investment advisors has
declined to just 18.8%. The last time bearish sentiment was below 20%,
at a four-year market high and a Shiller P/E above 18 (S&P 500
divided by the 10-year average of inflation-adjusted earnings – the
present multiple is 23) was for two weeks in May 2007 with the S&P
500 at about 1,525.
The next instance before that was two
weeks in August 1987 (bearish sentiment never dipped much below 27
approaching the 2000 peak except for a reading of 22.6 in April 1998,
just before the Asian crisis). The next instance before that was for
three weeks of a five-week span in December 1972 and January 1973, which
was immediately followed by a 50% market plunge.
Now, I realize this isn’t the kind of analysis you’ll find on CNN
Money or CNBC. But it’s vitally important because it shows you what has
happened in the past when we have had the same kind of market setup we
have today.
Here’s a chart of what happened after the most recent instance of this same setup – in May 2007.
I am not saying that stocks are destined to plunge again. They may or
they may not. I’m simply pointing out that the kind of sentiment
readings we’re seeing today mixed with the kind of valuations we’re
seeing today have not been a recipe for profits in the past.
The risks and rewards, in other words, have NOT been disproportionately in investors’ favor.
Forewarned is forearmed, as they say.
Good investing,
Chris
