Soap In Your Eyes

 In Value For Money Investing

I have come to realize that there are some fundamental problems with our understanding of the news that we are reading and hearing. The messages are often very unclear because the time frame and applicability of the news item is not included in the message. First, when we get a piece of news it rarely draws your attention to the time frame applicable to the item nor are those time frame terms themselves well explained. What is meant by long term or short term or in the near term? Does this mean that this is “true” for this month, this year, a few years or long term? Secondly, what is the information intended to be used for: investing, trading or speculating? What do those terms even mean?

These two problems came to me as I was trying to sort out the simple question: are the North American stock markets overvalued at this time? We went searching for the answer by reading others peoples research and commentaries and this is what we discovered. It depends! We also noticed what it seemed to depend on. First, are you looking for an answer applicable to the next month or the next decade? Second, are you going to use that information to invest long term, speculate this year or trade tomorrow? It matters that you know these two things to get the proper perspective.


A couple of examples:

Morgan Stanley says equities are ‘crazy cheap’
(Helen Kearney, Reuters · Wednesday, Nov. 10, 2010)
“NEW YORK – Global stocks are in the middle of a multi-year bull market that began in March 2009 and will last for at least two more years,… One of the great investment decisions someone could make today is to be invested in the equity markets… said there are still plenty of opportunities… and stock prices are “crazy cheap” relative to bonds and cash…”

Bulls, listen up.
The research group at Credit Suisse recently published an interesting macro economic piece. They believe we are entering the second phase of a cyclical bull market and are forecasting the S&P 500 will reach 1,350 by mid-2011.

To support their argument, Credit Suisse pointed to a few key reasons:

  • The global economy is starting to catch momentum…
  • During the first round of Quantitative Easing, the markets nearly doubled.
  • The last time credit spreads were at this level, the S&P 500 was at 1,500.
  • Historically, the markets tend to outperform during the third year of a presidential term.

Now that sounds a lot like markets are undervalued and buying is what we should all be doing. How do we reconcile that with the fact that at our firm we are not recommending clients buy into these markets? Well, look at the terms “for at least 2 more years, “make today” and “by mid 2011”. Ask yourself, what are they telling me about tomorrow or what happens after 2 years?

Big questions if you are planning to still have an investment portfolio 3 years from now. Also consider whom was the message directed at. Traders are concerned with the very short term. They are happy to buy high and sell higher, since they will be in and out before the markets are lower (hopefully). Speculation just requires you to pick current direction well. Buy gold at any price as long as it is still going higher. What about long term investors? They wish to acquire good investments to hold for the long term. Should they be a buyer if the markets are going to only go up for two more years and then stop going up? I read these messages as consistent with our position, still room to go up, thus make money as a trader or speculator, but likely to be lower in two years. Same message requiring different action from different people.

So where are we currently? If you frame the arguments with an overall view, then our conclusions will be clearer. First we must realize that much of the global market directions are originating in the US. Currently the US Fed is manipulating their economy. This is spilling to the rest of the world. They are unabashedly using the “wealth effect” as a tool to stimulate consumer spending. If you feel wealthier, you will spend more is the thesis. They have shown they do know how to stimulate the stock market; very low interest rates and high liquidity. Accordingly, the US Fed is getting what it wanted, a higher stock market. However, the signs of the wealth effect are lagging as the economy and the consumer remain tentative at best. As the Fed pushes, markets will probably continue to rise. This is the basis of most bullish articles you are reading. We certainly agree that markets will likely continue to rise…

…but please tell me the longer story! All artificially driven markets will eventually break. Bubbles are dangerous, but we know this is not evident until after they burst. So just say no! Do not play with over priced assets. The Fed is driving the S&P from substantially overpriced currently to very dangerously overpriced. From these overinflated values you will likely only see inflation plus one or two percent compounded over the next 7 years. Do you really want to risk a huge fall in your asset values to make those kinds of returns? How about some fixed income? Well bonds are even worse on a seven year basis. Fed action has driven their value to lofty heights as well. However, they might make money in the next year or two. There is that mixed message again. So just say no! Do not play with over priced assets unless you are a trader or plan to speculate. Wealth conservation starts before the burst and if you do want to “Not fight the Fed”, you should speculate very nimbly. You might have a few more quarters to do so.

Now, not wanting to choose between two overpriced asset classes leaves us with our third alternative, cash. However, the US Fed is trying to make cash so ugly, you are forced to go out and speculate with it or commit it to poor ongoing future returns. Remember, the Fed is getting what it wants and why shouldn’t they? Their past action has sent the message, speculate and if it goes bad we will jump to the rescue. Do not count on them being able to the next time around though. Unfortunately, every dollar of wealth effect will be given back. Beauty is always in the eye of the beholder and cash has a virtue in its ability to be a resource to buy stocks and bonds, when value returns.

So what have we concluded? Currently, stock markets are higher than their long term value will prove to be. They still have much room to move up and may do so for possibly up to two more years. If you are a trader or speculator, make your bets! You might get one more year of up trending. If you make money in the following quarters, take and protect the gains. Remember always, the trouble with bubbles is, they just go! And go they will, all the way down past fair value by 15% or 20%. This may be half of the 1400 we might see on the S&P as the bubble continues to expand. Dollars are available to be made as long as the direction remains up, but an investor should not buy until after the deflation. In less than three years (possibly in three days or three months) markets will be lower than they are today. Be an opportunist not a follower and hug your cash. Be patient and avoid the stress of the roller coaster. Rinse the soap from your eyes. Repeat. Merry Christmas!!

Value For Money Investing means we wish to allocate and use our hard-earned resources in order to improve investment outcomes in a continuous and sustainable way at a fair and equitable price. In other words, achieve good investment returns AND receive fair value for the services provided. Costs do matter!

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