Pay to Play

By Bob Wood, MMNS

Last week, an acquaintance of mine, one who’s fairly well versed on the financial markets, asked me why the fundamentals of our economy aren’t being considered by investors who seem bent on piling their money into a rising stock market. I told him that as far as I could tell, the state of our economy doesn’t seem to be much of a concern to the ones doing the buying. So how can you use that information to appropriately allocate your savings in the markets?

Perhaps a better question to ask is whether you should consider that point or not. Let’s face it, when investors ignore the basic tenets of investing success, it’s no longer investing; it’s gambling. The dynamic that we’re seeing at work is scarcely discussed in classic investment texts. Today’s investors are simply betting on which stocks will rise the most, a replay of the 2003 “beta trade” when shares that exhibited the most violent price swings were the most sought-after.

This has nothing to do with investing for the long run as advocated by famed investor Warren Buffett. You can throw out all of those old Peter Lynch books, too. Today’s market environment bears little resemblance to those quaint old days when basic investing fundamentals were considered meaningful.

I’m sure you know which important fundamental considerations the old school investors emphasized when deciding which risky assets to purchase for their portfolios. For most of us, valuation would obviously top the list. After all, it’s what you initially pay for an investment that determines how much, if anything, you’ll make over time.

Oddly, today’s investors appear oblivious to the historically high average price-to-earnings ratios posted for the major averages. In my latest copy of Barron’s, which is read by most investors, the P/E for the S&P 500 is listed at 122, and the Dow is selling at 41 times earnings. Does that look cheap to you?

Of course, the people promoting stocks and mutual funds tell us to ignore those numbers since they represent trailing earnings, including lots of bad stuff like massive balance sheet losses by the banks, insurance companies, and automakers. They ask you to accept on faith that earnings will rebound strongly, and based on their best guesses for operating earnings minus the bad stuff, stocks look cheap.

Is that rationale good enough for you to risk your savings? If you said yes, perhaps you should go lie down and take a nice nap until you regain a little clarity. First, operating earnings disregard meaningful events sometimes classified as “one-time losses.” Exactly how many “one-time losses” has General Motors declared over the past five years?

Those earnings estimates are also based on optimistic assumptions about the health of our economy. We hear that every year, though, don’t we? We were told that the housing mess would be contained, and to expect nothing worse than a soft landing in home prices. We were also assured that the economy wouldn’t sink into recession territory. Now that we’re about 18 months from the officially recognized beginning of the current downturn, can you think of any reason to listen to today’s rosy predictions? From the same people that fed us that nonsense a couple of years ago?

When the price of oil began falling from its old highs of about $145 per barrel, we were assured that the decrease would be a good thing for both the economy and corporate profits. That didn’t happen, either. Profits are in the tank, and GDP numbers are far worse than anyone suggested they might be a year ago. And now the price of energy is again on the rise, but no recommendations on how an already struggling economy might adapt to higher fuel costs appear forthcoming.
The jobs market is worse than anyone predicted a year or two ago, and continues to offer fresh rounds of bad news each week. This trend is important, since it suggests consumer spending won’t rebound (in any meaningful way) any time soon. Shouldn’t that have an impact on corporate profits and those high P/E ratios for the major averages? Yes, it should, but it doesn’t.

California, our largest state, is now bankrupt, and hoping to borrow billions of dollars despite a credit rating that’s already the lowest of any state, meaning their costs to borrow money are rising and constraining economic activity. Given California’s size, and the amount of economic activity usually observed there, shouldn’t that make us more bearish than bullish?

Again, those and many other fundamentals of our economy suggest that stocks are still overvalued and poised for a nasty meeting with reality. Of course, by the time you read this, the big Spring rally of 2009 may have ended under the weight of worsening news about our economy.

And that’s what secular bear markets are all about. Once the economy spots trouble, stock prices fall (some by significant amounts,) and then the promoters work their hardest to convince us that the worst is over, and that we’ll miss the big rebound if we don’t buy at the day’s low prices. Then reality sets in again and share prices fall, and on and on it goes.

Stock rallies fail, and investors grow frustrated enough to sell and raise cash, just in time for the next bull cycle to begin. This has much to do with the relatively small number of investors who’ve managed to make money investing in stocks, even in long-running bull markets!

So what should you do if you remain committed to your investments? I ask myself that very question at times like these, knowing that it’s my job to aim for growth and profits in any and all market cycles. And while I can easily tell you what I’m doing personally, that doesn’t mean you should follow my lead.

Remember that with the markets, you are ultimately on your own. Everyone on the other side of your trades is after your money, and the best managers will, in time, get it. In secular bear markets, individual investors pay to play. And since I’ve already established that this is not an investor’s market, it must therefore be a gambler’s market, and you aren’t investing, you’re playing.

You already read in this space a few weeks back that I have gotten out of the domestic markets on both the long and short sides. I just don’t want to have anything to do with a market that’s dominated by gamblers and short-term traders, especially given the horrific fundamentals of our economy.

This strategy is working out quite well, as foreign and emerging markets are outperforming the domestic markets by a very wide margin. And while I’m enthusiastic about the prospects for the foreign markets to continue proving themselves the most profitable to invest in, I’m still concerned about a potentially large drop in the domestic markets that might drag all markets lower in sympathy.

So I’ve been adding cash to all of my managed accounts like never before. My target allocation is to hold roughly half of each portfolio’s assets in cash, with the usual allocation, about 15% in gold shares, a small allocation in energy shares, and the rest in foreign shares. Those long side allocations are hedged against downside market movements with small share amounts in inverse index funds for those foreign markets, leaving me with only about a 30% exposure to upside potential.

In this type of market environment, there’s little reason to think that a sustainable move higher is in the cards. It’s the worst of times for investors, and caution is well warranted. There will surely be better times in the future, and it’s important that you’re around to participate. That means preserving your capital until then, and holding plenty of cash is the safest way to get there. If you’re going to pay to play, don’t pay much. It just isn’t worth the risk of being taken out of the markets when a real rally ensues.

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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