On Thursday, the Dow Jones Industrial Average dropped below 11,000. In the past I have avoided giving investment advice as I am not a registered financial adviser. However, many of my friends and family have asked my opinion on the current market. Thus, in this blog, I will offer my opinion. As always, consult your own adviser for specific advice. Some thoughts:
- The Federal Reserve has made two significant policy mistakes: (1) it has kept interest rates near zero, and (2) it has openly targeted higher stock prices to boost the recovery. This has created enormous distortions.
- Zero interest rates have encouraged speculative market players to utilize cheap leverage (borrowing) to increase investment returns.
- Ordinary investors who were previously happy to invest in relatively safe bank certificates of deposit or money market funds have been convinced to invest in stocks to try to achieve a higher investment return.
- Zero interest rates have also depressed the value of the dollar. Many large multinationals which earn a significant portion of their revenue overseas therefore have received an artificial boost in earnings, inflating their stock prices.
- Targeting higher stock prices has led to the belief that the Federal Reserve has created a floor under the market to protect investors, the so called “Bernanke Put,” This is bogus. The so called Bernanke Put did not stop the market from declining 50% in 2008. Why should it work now?
- Given these distortions reputable market commentators such as John Hussman and Jeremy Grantham believe that the market would be fairly valued at S&P 950 (which would be equal to about 9000 on the DJIA). Thus, based on Thursday’s S&P close of 1140 and DJIA close of 10,990 the market remains significantly overvalued. Other commentators such as Michael Shedlock believe that Hussman and Grantham are too optimistic. My view is that markets go from massive overvaluation to massive undervaluation. I do not think we are at the undervaluation point yet.
- There are a couple of “investment rules of thumb” I have tried to adhere to:
- Never use leverage. When you are borrowing money to buy stock it distorts investment thinking and makes you much more susceptible to emotion.
- If you are leveraged and receive a margin call, do not add additional capital to your position. Accept the loss and sell the stock.
- If you are heavily invested in the market, sell down to your “sleeping point.” That is, hold only as much stock as permits you to sleep at night.
- Remember that short term investing has become more like gambling than investing. Why? Because government intervention and high frequency trading controls the market. Individuals are unlikely to be successful in trying to trade on a short-term basis. Professionals are sometimes successful, but even most professionals have difficulty being successful on a sustained basis trading short term.
- The percentage to hold in equity should be 100 minus your age. Thus, if you are 60 years old, you should not have more than 40 percent of your funds in equity investments. This is my rule of thumb for prudent trading.
- Many of my friends want to recoup their 2008 losses. The market does not care that you may have lost half of your 401k account in 2008. There is no “getting even” in the market. There is only the here and now. The best current strategy is to invest your remaining capital based on the best information you have in 2011.
- Look for value stocks that have good earnings, a dividend, decent earnings prospects and a depressed stock price. The Comstock Partners indicate that we may be a long way from such a favorable environment. They expect stock price earnings ratios will fall to the mid single digits, and dividends to be in excess of 6%.
Investing is an individual pursuit. Crises in Europe, China, the real estate collapse, near recession conditions in the US, are all warning signs for equity investors. You need to seek professional advice and make your own decisions. Again, this is not investment advice, just opinion. But in the words of Sergeant Phil Esterhaus of Hill Street Blues: “Hey, let’s be careful out there.”
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