When to Pull the Trigger

There is a special psychological barrier for those contemplating the purchase of U.S. equities -- long-term investors and traders alike.  The memories of losses in the 2000 era are still fresh.  Those who do not study the fundamentals of market valuation -- forward earnings and interest rates -- see a market reaching the old highs as a sign of danger.

Background

Consider the following key facts:

• In the long run, stocks outperform bonds;
• The current expected yield from stocks is significantly higher than the risk-free bond yield; and
• The overall market, and many of the most attractive growth stocks, have now pulled back significantly from recent highs.  (We see many attractive stocks.)

Paralysis

We talk with many individual investors, nearly all of whom have lagged market averages in their own accounts.  The biggest single mistake is that they can always find reasons not to invest.   One very intelligent person was referred to us in 2004.  He was worried about the outcome of the Presidential election.  That was about 30% ago in the S&P 500, but he was buying condos instead.  He still does not own any stocks.

There are always many things to worry about.  The leading Internet financial sites emphasize the "wall of worry."  Unfortunately, they do not explain it.  A market plagued with many concerns, like this one, is actually the best opportunity.  When the issues are known, market prices reflect the worries.

How NOT to Act

Here is what we often see.

The market makes new highs.  The investor says, "It is is too late.  I missed the best time to get in.  I can't chase this.  I made a mistake earlier, but I cannot buy now."

The market pulls back.  The investor says, " Wow!  I'm glad I did not invest a month ago.  There are plenty of problems.  Look at the selling.  The market is going lower."

Notice that the investor cites the direction of the market when it is moving lower, and the level of prices when it has moved higher..

Using this approach there will NEVER be a correct time to invest.

A Solution

The best approach for investors is to have a disciplined method.  This can be based upon fundamentals or system.

But this is easy to say.  We know that the real problem is getting started.  So here is our best investment advice as 2007 comes to an end:

Do something!  Buy a partial position.

This is what the pros do when in doubt about timing.  Establish a position.  If prices go lower, you can buy more.  If prices go higher, at least you are participating in the gains.  This is much better than following a method that leaves you permanently on the sidelines.

Comments

[oldprof]

Mike - I am perfectly willing to be bearish and raise plenty of cash. Part of my record versus the S&P 500 is based on my defensive posture in 2000-01. The 'Fed Model' approach was pretty useful for that.

One test is how easy it is to find attractive stocks, and I see plenty of them. In many cases the forward earnings already reflect elevated recession fears, as do current stock valuations.

So for me, earnings expectations going (much) lower or interest rates going (much) higher is pretty much what it would take to change my overall market outlook.

Now individual stocks and sectors -- that is another matter. I am always looking for themes. Your energy example is a good one. People miss many good investments through unwillingness to act.

Thanks--once again -- for a good comment and good questions.

Jeff

[Mike C]

Good post, and I'm 95%+ in agreement.

I think the problem is that many investors focus on absolute price levels and the current price level versus the past instead of focusing on VALUATION relative to likely future fundamentals.

For example, my 2nd largest individual stock position is Chesapeake Energy (CHK). Late last week, the stock traded at an all-time high. It has since pulled back about $2.50 (6%). Many investors would be reluctant to buy a stock at an all-time high, and similarly might now be worried after a quick sell-off.

Meanwhile, the stock trades at a P/E of 12, and has produced double-digit EPS growth and is likely to continue to produce double-digit EPS growth. Investors focusing on the all-time high price instead of valuation and fundamentals could be missing out on an opportunity. Just to be clear, I used this as an example, and not to talk my book.

However, I'd like to play devil's advocate and take the inverse of your point with respect to the market. Your preferred valuation metric is forward earnings yield relative to the bond yield for the overall market. Clearly, you have been CORRECTLY bullish for the past couple of years. I don't want to rehash the debate about valuation except to note there are other valuation metrics for the overall market that indicate it is quite richly valued, but let's just put that aside.

You point out in this note that for some investors there will never be a correct time to invest. The question I would pose to you, and I am sincerely interested, is what would it take for you to become cautious or bearish? At what point do you hedge/take defensive measures/raise cash, etc.?

The problem I have with aggregate forward estimates which I'm not sure you have addressed is that there is obviously the potential for downward revisions. Forward estimates are constantly being modified. What if current estimates for 2008 and 2009 are too high? The market is a discounting mechanism, and prices will react both on the upside and downside well before analysts formally change their estimates. If one waits for estimates to come down (resulting in forward earnings yields also coming down) to actually take any defensive measures it will probably be too late at that point. The market will already be down and probably close to bottoming at that point.

Your most recent post indicates you are in the camp of no recession. A recent piece from a well-known fund manager indicates a recession is likely. We are very close to a Dow Theory bearish sell signal. I do not plan to make any extreme moves either way, but I would be very interested to know what data/signals you would consider valid in moving to a more defensive posture.

[oldprof]

David -
Your comment is quite correct. We also take the opposite position when thinking about "trimming" or selling positions.

Thanks for pointing this out.

Jeff

[David Merkel]

Sage advice. Would that more did it.

There is an opposite problem for those that take too much risk, and the initial solution is the same -- start by cutting back positions a little, until you can live with the risk level once again. After that, develop a risk control methodology that fits in with the return generating thesis of the investment method. Few do that, though.