Dear Diary,
The Dow rose back above 17,000 yesterday. All clear. US stock market investors: Your money will probably not die today. Maybe tomorrow.
But does it really make sense to be in the US stock market now?
There may be apples higher up in this tree, but it is dangerous to reach for them.
We came up with our Simplified Trading System (STS) a long time ago as a way to tell us when it was time to put away the ladder. We weren’t completely serious about it then… and still aren’t now.
Still, it’s a great system… but only for people with the life expectancy of Methuselah and boundless patience.
The original idea was that there was a time to be in stocks and a time to be out. When you were out… you just stayed in cash. And because we’re talking about long periods of being in cash, you should be in the “cash” that holds up over time: gold.
P/E > 20 = Sell stocks.
Otherwise = Gold.
Simple?
Well, yes and no. You have to decide how you’re going to calculate the P/E ratio, for example. And therein hangs a long and complicated tale…
Artificial Earnings
Forward earnings estimates? Last year’s “as reported” earnings? Earnings averaged over the 10 years and adjusted for inflation? Normalized earnings?
To put this in perspective, we are suspicious of “as reported” earnings. The Fed and other central banks are artificially pushing down interest rates. This artificially pushes up earnings.
That’s because ultra low rates push down corporations’ interest expenses on their debt. Meanwhile, earnings per share – even more important to shareholders than earnings – rise due to debt-fueled share buybacks.
We’d rather base our strategy on something more real. And right now, we guess that earnings, adjusted to normalized interest rates, should put the P/E ratio way over 20 – long past our “sell by” date.
Sure, our STS can be improved. But had you followed the system since 1980, you would have bought the S&P 500 in the early 1980s and enjoyed at least 10 years of that bull market. (The index had started trading above 20 times earnings by 1992.)
You would have made about three times your money by the time you got around to selling out. (At that point, the better move would have been to put a trailing stop-loss on your position. But who knew?)
This would also have put you into gold near its bottom. Let’s say you bought at around $400 an ounce. Stocks have not fallen to a P/E, on last year’s earnings, of less than 10 since. So, you’d still have your gold – now worth about three times what you paid for it.
If you’d started in 1980 with $10,000, now you’d have about $90,000 – with almost no fees or trading costs along the way… and only one tax event (at capital gains rates).
If you’d started with $1 million, you’d now have about $9 million.
Better Than the STS?
Great?
No. But not bad for making a total of two moves… neither of which was very risky.
But of course, you would have missed all the fun of trading in and out… talking to your broker… watching Jim Cramer on CNBC… and reading our newsletters.
And today, you’d be sitting on a pile of gold, cursing us for having kept you out of one of the biggest bull markets in history.
But can you really expect to do better?
Maybe! We developed the STS because we don’t have the temperament to do serious stock research. We enjoy economics… and trying to put the pieces of the big puzzle together. We don’t have a head for the painstaking, detailed work required of a stock analyst.
But we’ve seen that a careful investor who is willing to do his homework can outperform the markets over long periods.
We saw evidence in the track records of our own colleagues Porter Stansberry and Chris Mayer, for example – who have more than doubled the market averages over the last 10 years. Thousands of other investors have done likewise.
You can see the current marketing campaigns for Porter’s service here and Chris’s service here. Our feelings won’t be hurt if you decide to subscribe to their services rather than our own.
Still, you might be better off reading my new letter too.
Besides, the Diary is free. You can’t beat that.
The cost in time… well, we try to make it worth your while.
Regards,
Bill
Further Reading: If you don’t have the stomach for betting on the direction of stock markets, there’s a relatively unknown three-step process you can use to collect hundreds of dollars from an entirely different type of market altogether. According to Barron’s, this is “a simple strategy that can boost your returns without increasing your risk level.” To find out full details, follow this link.
Three Flavors of Risk
Our recommendation to buy beaten down Russian stocks continues to stir controversy among Diary readers. (If you have thoughts on this, please join in the conversation. Just hit “reply” to this email to write to us directly.)
Reader Darin A. takes us to task for our assertion that the high risk in Russia right now (perceived or otherwise) means high future expected returns.
Darin believes it’s the other way around:
Value investing gets you low risk (due to your deliberate choice of a high margin of safety) and high potential reward. You get the best of both worlds.
It all depends on your definition of risk…
Perhaps the simplest definition of risk is that more things can happen than will happen.
But Wall Street likes to measure risk as volatility. The more assets move up and down in price, the “riskier” they are.
By this definition, Russian stocks are certainly risky right now. Since Russia annexed Crimea in March, Russian stocks have been the most volatile since 2009.
As of the end of May, for example, volatility for the Russian benchmark Micex Index was almost three times the level of the MSCI Emerging Markets Index.
It’s easy to poke fun at the Wall Street’s definition of risk as volatility. But keep in mind that during the Great Depression US stocks lost 80% of their value. And in the 1973-74 bear market, stocks lost half their after-inflation value.
Add to that the 1987 crash… the dot-com crash… and the 2008 crash… and it’s not hard to see why investors demand higher compensation for holding stocks over, say, bonds or cash.
And if you were a pension fund manager… and making decisions about retirees’ nest eggs… this kind of volatility really is risk.
For someone who needs to access their funds in the next couple of years, an investment in Russian stocks now could mean those funds aren’t available when they’re needed. The poor retiree could find himself trying to cash out while the Russian market is in a trough.
So, investors demand higher returns on Russian stocks than, say, US or Canadian stocks in exchange for putting up with higher volatility.
But Darin is not wrong, either…
If you define risk a third way – as the potential for a permanent loss of invested capital – low prices can have the effect of damping risk.
That’s because buying low and selling high gets you positive returns. And buying high and selling low gets you negative returns. The lower you buy, the more chance there is of fetching a higher selling price.
The point is that the rewards low prices bring come with a catch: You have to shoulder high levels of perceived risk about a stock or a country – as is the case in Russia today.
Darin’s right: Low prices aren’t risky. But you don’t get low prices without lots of fear… and often the whiff of cordite in the air.
P.S. If investing in Russian stocks is the kind of thing that would give you sleepless nights, you may be interested in a different approach to “investing” altogether. Instead of betting on the direction of stocks, there is a way to pick up extra income by allowing other investors shoulder this kind of risk. You can read all about it in our special investor report.