Dear Diary,
Step back. Look at the big picture. Stocks are near record highs. Investor sentiment has never been more bullish. The VIX, which shows the options market’s expectation of 30-day volatility in stocks, is near record lows.
But the US stock market – broadly measured by the S&P 500 – is “above the line” of our Simplified Trading System (STS). It’s trading above 20 times reported earnings.
The index could go much higher. But our simple approach tells us that the safe gains are behind us. It is better to be out than in.
Yesterday, we imagined a man who had lived and invested throughout the entire 20th century. Today, we meet a man, in the flesh, who almost did that… a man 42 years older than we are. He makes 66 seem like childhood…
Irving Kahn is 108, to be exact. Born in 1906, he began investing before the 1929 Crash. He spotted the anomaly… and decided to take advantage of it. He sold US stocks short.
I borrowed money from an in-law who was certain I would lose it but was still kind enough to lend it. He said only a fool would bet against the bull market.
In the event, Kahn doubled his money. But he gave up speculation in favor of long-term value investing. In fact, he practically invented it.
Dollars Selling for 50 Cents
Kahn was Ben Graham’s teaching assistant at Columbia; a Midwesterner named Warren was a student. Said Kahn recently to British newspaper The Telegraph:
In the 1930s Ben Graham and others developed security analysis and the concept of value investing, which has been the focus of my life ever since. Value investing was the blueprint for analytical investing, as opposed to speculation.
During the Great Depression, I could find stocks trading at tremendous discounts. I learnt from Ben Graham that one could study financial statements to find stocks that were a “dollar selling for 50 cents.” He called this the “margin of safety” and it’s still the most important concept related to risk.
Indeed, he uses the same approach today. During the recent crash and in other sell-offs, Tom and I looked for good companies selling at a discount, which do surface if you’re patient. If the market is overpriced, an investor must be willing to wait.
That is the price you pay if you’re going to profit from our STS. You may wait a long time for the stock market to fall below 10 times earnings… and a long time for it to clear 20 times earnings.
Then, like now, you won’t want to sell. Because stocks are still going up! And if you do have the discipline to sell… you may regret it for years… as stock prices continue to rise and you are regarded as a numskull by everyone, including yourself.
Kahn does not believe in market timing. Instead, he looks for underpriced stocks. As the stock market rises, he finds fewer and fewer. At the extremes, a lack of good values forces him out of the market entirely.
That’s what happened to Warren Buffett in 1968, when US stock prices had gotten so high that he couldn’t find any way to use the money he had under management.
What could he do?
He sent the money back to its owners.
Why Is the Market Inefficient?
Our STS is for readers who are not going to do the difficult work of studying company filings to figure out where the value is. You’re just going to get in and out according to a rough measure of value – the stock market’s 12-month trailing P/E ratio – with no consideration of discounted income streams, debt levels, taxes or anything else.
As we saw yesterday, this approach would have greatly outperformed “buy and hold” over the last 114 years.
But we still have an open question: How is it possible that this sort of opportunity exists – even for someone who doesn’t do the hard research?
How come there are still $100 bills lying around, waiting to be picked up, when there are so many smart people who should have picked them up already?
Couldn’t Goldman Sachs hire a few mathematicians, program a few computers, and arbitrage away these gains?
We put the question to our colleague Porter Stansberry at Stansberry & Associates:
So, the question is, why is the market inefficient, given all of the computers and all of the brains on Wall Street? How is it possible that little guys like us are still capable of outsmarting the big guns at Goldman?
Three explanations:
#1. They are conflicted.
Take my prediction that GM would go bankrupt. Here was a car company that hadn’t made a real profit in 20 years, was sitting on $400 billion in debt, and had more retirees on the payroll than workers. Seemed like a pretty simple bet to me.
However, Wall Street was making a lot of money selling GM bonds. There were huge incentives not to rock the boat. Likewise with my prediction about Fannie and Freddie going bust. Everyone on Wall Street was selling those clowns paper that was worth $0.20 for a full $1.00. Going along with the lie was more profitable than shorting the stocks could have ever been.
#2. Far too much opportunity cost.
Trying to arbitrage every minor discrepancy in value would take far too much capital. Firms that have tried to do this (Long-Term Capital Management) end up using far more capital than they can afford to borrow. There are just too many financial instruments to handicap. Likewise, there’s too much knowledge to manage to do so accurately and in a timely fashion.
#3. Far too much risk.
Even when investors possess superior knowledge, getting the timing right and managing all of the other variables is impossible.
Take my short sell of Netscape, for example. Back in 1999, I was shorting Netscape, which produced the first Web browser. Microsoft had begun “bundling” Web browsers inside its operating system, so nobody needed Netscape – which had given its software away and had no revenue model.
The stock was a zero. I was shorting it (personally, with real money) as it sank from $25 per share all the way down to $15. Then, I come into work one day with the news that AOL bought it, using stock, for $90 per share. I got wiped out.
And it wasn’t until about a year later that AOL’s stock collapsed, in large measure because it had been fudging all of its accounting. (They were budgeting marketing expenses on the capital account.)
I’m sure we’ll find that the market is least efficient (and we have the best opportunity to make outsized returns) when:
1. We’re dealing in securities that have little or no following on Wall Street.
2. We’re dealing with stocks that have been heavily promoted by Wall Street.
3. We’re dealing with securities where we have an abundance of firsthand knowledge and experience.
4. We’re dealing in industries where unusual amounts of expertise are required to follow it – insurance or biotech – for example.
5. We focus our portfolios into only a few themes (foxholes) where we have an edge.
Does that answer our question?
It’s as good an answer as we’re going to get. But it doesn’t fully settle the question.
If there are $100 bills lying in the street, there may be a reason – a reason you don’t see – why no one has picked them up.
Maybe no one is looking…
Maybe “The Street” wants you to believe they’re not there…
Maybe they’re too hard to see… or too hard to pick up…
And maybe they’re not really there at all!
More to come tomorrow, when we wrap up our series on how to invest intelligently in an uncertain world…
Regards,
Bill
Further Reading: We’re asking all Hormegeddon readers for a huge favor. We want as many folks as possible to benefit from the insights in Bill’s new book. So, if you’ve already read it – and maybe even sent us your feedback by email – go to Amazon.com and review it.
Already Diary readers are getting the word out. But we want to add as many voices as possible. So if you’ve read Hormegeddon, please go to Amazon.com now and let others know what you got out of it. Here’s that link again.
Yes – Russia Is Still a Bargain
If the US stock market is overvalued, where are there bargains on offer?
Regular readers will know that we like Russia – where the news is nearly all bad and where, as a result, the stock market trades on a trailing P/E of 5.7 and yields 4.8%.
Let’s get the theory out of the way first…
There are all sorts of ways to complicate this, but as Warren Buffett put it:
Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.
Nearly everyone pays lip service to this idea. Almost nobody invests this wa
It’s a lot easier to invest when the crowd is on your side – even if you know that high valuations signal low returns ahead – than it is to invest against the crowd – even if you know that low valuations signal high returns ahead.
Don’t ask me why. It’s just the way things are. And it’s the way things will always be.
The case against Russia is obvious. It is waging a proxy war in Ukraine. Sanctions are hurting its economy. Growth has flatlined. And the central bank has been forced to raise interest rates to 8% to protect the ruble and battle rising inflation.
So why would anyone in his right mind invest in Russian stocks under these conditions?
The answer goes to the fundamental nature of markets. Markets aren’t gambling casinos, as some people claim. They are “discounting mechanisms.” When new developments occur, the market discounts this new information rapidly, reflecting it in prices.
That means the more bad news out of Russia, the more bad news gets priced into Russian stocks. Eventually, a point of maximum pessimism is reached… and a bottom forms. From here a new rally can start. (Remember, the market “pendulum” is always swinging to extremes and back toward the center again.)
That’s why Buffett advises investors to buy when others are fearful. Stocks are the cheapest when the economy is in the dumps and geopolitical tensions are high. Like it or not, when you run away from bad news, you are also running away from bargains.
Likewise, when you buy bargains you must stomach a lot of bad news and negative sentiment.
If you’re like me, you probably hear a lot of folks moaning about missing the bottom in US stocks in 2009. The irony is these same people will turn up their noses at Russian stocks right now – even though, as the chart below shows, on a price-to-book basis the Russian stock market today is at March 2009 lows.
We expect only a handful of readers to follow our advice. But for long-term investors with a tolerance for lots of volatility along the way, Russia is one of the best investment opportunities the world has to offer.
P.S. Don’t forget to review Hormegeddon on Amazon.com. Our aim is to make it another best-seller for Bill. You can review Bill’s book here.