October is coming. Excess liquidity is disappearing. And with the S&P 500 on a trailing P/E of 19.7, the index is fast approaching “sell territory.”
Watch out.
We finished our series on investment theory last week. Now we turn to practical application.
There are three parts to the investment world. The first part is Aristotelian, Cartesian, Pythagorean. It is a world of logic and calculations. He who calculates best wins.
The second part is Socratic and Emersonian. The investment world, like the rest of the world, follows moral rules. When you do something “wrong” you will pay the consequences.
For example, when you forget to pay a parking fine… you will probably regret it. Leave a rake lying in the yard, turned up the wrong way, and you will almost surely step on it. Buy an expensive “story stock,” recommended to you by a broker you’ve never met, calling from Boca Raton, and you will most likely lose money.
That is true in a larger sense, too. An economy that goes too deeply into debt will have to bear the consequences. No amount of QE or negative real interest rates will make those consequences disappear. They can only distort and displace them.
This is not to say that moral rules will play out the way you expect in every instance. It is wrong to kill. But had you snuffed a certain housepainter in Vienna at the turn of the last century, the world might not necessarily be a worse place.
Likewise, not every foolish bet goes bad. Still, you’re probably better off believing it will.
The third part of the investment world is completely unpredictable and unfathomable. Mr. Market gets up to mischief from time to time; he drives moralists mad and logicians to drink.
US Stocks Are Expensive
The numbers we presented on Friday show that the average investor does not beat the indexes… not even close.
According to data from Dalbar, he consistently lags just about every asset class there is.
This leads the Efficient Market Hypothesis crowd to say: Just buy an index fund. You can’t beat the market.
But our Simplified Trading System (STS) tells us there’s a good time to buy and a bad time.
“Buy low and sell high,” is the basic rule. US stocks are now expensive. The trailing P/E for the S&P 500 is 19.7. The 10-year cyclically adjusted P/E ratio (Shiller P/E of CAPE) for the index is even higher – at 26.3.
What do you do when when US stock valuations are so high?
Well, you need to find markets that aren’t so pricey.
Russian Stocks Are On Sale
Such as the Russian stock market!
There, the trailing P/E is under 6.
You’re thinking: “Hmm… Russian stocks are treacherous. Everybody says so. And with the war in Ukraine and the sanctions regime, they could go much lower.”
One of our own clever readers, Bradley P., warns:
The downside on Russian stocks is still 100% from here. Mathematically that is the maximum loss one can have buying Russian stocks.
Once in the last hundred years that happened; when the Bolsheviks closed the stock market in 1917. […]
Since US stock markets have never lost 100%, while Russian ones have, by a historical perspective US stocks, even at 20 times earnings, are likely a better investment than Russian stocks (never mind whether they use an accounting system you can trust).
Just wait until Russia closes the market to foreign investors, issues capital controls and the ADRs and ETFs go to zero.
Bradley may be right. But we don’t presume to know – neither what is really going on now… nor what it will mean for the future. Neither in Russia nor in the US.
All we know is that our calculations (as primitive as they are) tell us you get more value per dollar in Russia.
And our “moral” rule tells us that you don’t make money speculating on the future. You make money by buying wisely in the present.
Our guess is that Mr. Market aims to make fools of as many investors as possible. And right now, there are far more investors who are short or out of Russian equities than there are those who are long.
Still ahead: how to pick stocks to beat the market… how to get rich… and why it might be better to stay poor.
Regards, 
Bill
The Only Question That Matters for Investors
Russia skeptic Bradley P. is also unhappy with our poking fun at former White House press secretary Jay Carney.
Carney was the guy who, on March 18, advised US citizens not to invest in Russian stocks “unless you’re going short.” Writes Bradley:
Prior to the sanctions one writer on this page recommended the Russian market, then bragged his market timing was better than the dude who talks at USA press releases who joked about shorting Russian stocks.
But so far the press secretary guy is outperforming the investment newsletter.
As I am the guy who pointed out Mr. Carney’s bad timing… and why it was likely a contrarian indicator… a little clarity is necessary.
Since Carney’s warning, the Market Vectors Russia ETF Trust (NYSE:RSX) – which tracks a diversified group of the largest and most liquid Russian stocks – is UP 4.5%.
And that’s despite the worsening situation in Ukraine – including the downing of the Malaysian Airlines passenger jet in July and increasingly tough sanctions regime against Russia.
In fact, as you can see from the chart below, which tracks RSX year to date, Carney almost perfectly timed the recent bottom of the Russian stock market.
That is why stocks offer investors a return: to compensate them for that risk (among others).
Russia’s future is uncertain. And it is arguably even more uncertain now because of the conflict with the Ukraine and the economic fallout of that conflict.
But the question isn’t: Are Russian stocks a “good” investment? The question is: Are Russian stocks a good investment at the price they are selling for today?
This is the only question that really matters for investors.
No asset is so bad that it can’t be a good investment if bought cheap enough. And no asset is so good that it can’t be a bad investment if bought at too high a price.
Remember, your return on any stock – or stock market – is a function not only of its capital appreciation and dividend payments, but also of the price you paid for it in the first place.
And of the two variables only one is knowable: the price you pay.
In other words, although it’s impossible to say what price your stock will command when you sell it, it is a mathematical certainty that the lower the price you pay today the higher your returns will be… and vice versa.
This is what Bill means when he says you don’t make money speculating on the future. You make money by buying wisely in the present.
And because you can’t have low prices without elevated levels of risk (perceived or otherwise)… “buying wisely” is always a scary proposition.
But that’s just how the market works. Superior investors understand that the higher the perceived risk of an investment the higher your expected returns.
When Carney warned investors against going long Russian stocks, the Russian stock market traded on a cyclically adjusted P/E ratio (CAPE or Shiller P/E) of 6.5.
This is an important threshold. Because according to a study by Mebane Faber at Cambria Investment Management – which looked at the CAPE ratios of 44 countries at the end of each year since 1980 – a country’s CAPE dropped below 7 only 28 times out of more than 800 cumulative market years.
But investing in these crisis situations – when perceptions of risk were high – paid off. After its CAPE fell below 7, a country’s stock market on average went on to return 31% over the following year… and 21% annually over the next five years.
This is consistent with the observation that high previous returns indicate low future returns and low past returns indicate high future returns.
Of course, no matter how much investors pay lip service to the “buy low; sell high” advice, most folks will run a mile from the low prices on offer in Russia today.
This is a good thing for anyone who can keep a cool head. After all, were there more bargain hunters willing to snap up Russian stocks, prices wouldn’t be so low… and the expected returns wouldn’t be so high for today’s buyers.