Two Questions to Ask Before You Buy Another Stock

It’s either the best time in the past year to buy stocks…or the worst.

If you take a straw poll of my colleagues you’ll probably get half screaming it’s a buy, and the other half screaming it’s a sell.

By now you’ve probably figured out which side we’re on. We’re banking on continued low interest rates helping to drive stocks higher.

After all, the old theory goes that ‘stocks rise as interest rates fall’. So why should this time be any different?

Well, there’s one indicator to look at that’s either a spanner in the works to our rising stocks stance, or proof that it’s a great time for stock investors. Let’s look at that now…

When you buy any investment you should always have two questions in mind:

  • How much could I make?
  • How much could I lose?

It’s not difficult. In fact, we’d say those two simple questions are at the centre of investing.

It’s something we keep in mind when we publish our monthly issue of Australian Small-Cap Investigator. We always point out that investors could make spectacular gains – because that’s the potential with small-cap stocks.

But we also always point out that if things don’t go right, investors could lose everything they’ve invested in that particular stock – because that’s the potential with small-cap stocks.

Fortunately, in most other types of investing, things aren’t so black and white. It’s not a double or nothing deal.

Even so, you should still ask the same questions. Let’s put it another way. Let’s say you think a stock could rise 2% this year and it won’t pay a dividend.

Even if you think there’s a zero chance the stock will fall (which would be reason enough for your editor to stay away from the stock; if someone claims it’s impossible for it to fall, odds are it will fall), it’s still a bad investment.

Why? Because you can get a better return with less risk just by keeping your money in a savings account.

OK. It’s an extreme example, but we think you get the point. Again, we’re not saying that you should always look for the best returns. What we’re saying is that you should look for the best returns relative to the risk you’re taking.

Trouble is it’s pretty darn hard to anticipate the amount of risk built into a stock price. All you can do is make your best guess.

Stocks at Lowest Volatility Since 2007

For instance, as you’ve seen, stock prices have gone bonkers since last November. So, does that mean investors have factored in all the risks so that if nothing bad happens stock prices will go higher?

Or does it mean that investors have underestimated the risks so if something bad happens, it will take investors unawares and stock prices will fall?

That’s the thing, you can never know for certain. But what you can do is keep an eye on a couple of key indicators. They aren’t a perfect early-warning system, but they’re pretty close to it.

Perhaps you’ve heard of the VIX Index, also known as the S&P 500 Volatility Index. Without going into the nuts and bolts, it’s a measure of the volatility of exchange traded options on the US S&P 500 Index.

In short, when volatility increases, options prices tend to increase too. So it gives you a good chance to compare one timeframe against another.

If we look at the VIX today, you’ll see that volatility is about as low as it was in January 2007:

Source: Yahoo! Finance

That was when volatility started to pick up after remaining subdued for three years. It’s not just in the US where volatility is at all-time lows.

The S&P/ASX 200 Volatility Index is at the lowest point in five years. And has been relatively low since the last half of last year, when stocks started to pick up:

Source: Australian Securities Exchange


Now, do you see the problem? Does low volatility mean that volatility is about to increase…potentially meaning that stocks will fall?

Maybe. But you could have said the same thing in 2005 when the VIX reached a similar level. If you had sold then you would have missed out on two years of extra gains.

We’re Still a Buyer in This Stock Market

So, what use is the VIX? Well, we look at is as an early-warning system. You should use it as an indication for what lies ahead. But you shouldn’t use it as a signal to buy or sell – as we’ve shown, high volatility can sometimes coincide with rising stocks, and sometimes with falling stocks.

That’s because the VIX measures volatility of the index, not the direction of the index. The reason the VIX tends to be higher when the index falls is because stocks tend to fall quicker than they rise (that’s another old saying, ‘stocks go up the stairs but down the elevator’).

All that said, where do we stand? We stand in exactly the same spot. We’re bullish on stocks – especially small-caps – because we believe the market has mostly oversold them.

And we’re bullish on a few blue chips – such as the five we mentioned yesterday – because they’re still beaten-down from previous high points.

But as always, despite our bullish view, we’ve still got one eye on the chance that we’re wrong. That’s why we recommend using an asset allocation model so you can spread your wealth across various asset classes (dividend-paying stocks, small-caps, gold, and cash).

Bottom line: we still like stocks, even at these high prices, and we’ll keep buying them…but with a bit more caution than before. Remember, while the VIX reaching a low point could mean stocks are about to fall…with low interest rates, the current stock rally could have plenty further to run yet.

Cheers,
Kris

From the Port Phillip Publishing Library

Special Report: How to Hunt Down 2013′s Biggest Stock Market Winners

Daily Reckoning: Japan’s Spring Offensive Against the Yen

Money Morning: Are These 5 Blue-Chip Stocks Still a Good Buy?

Pursuit of Happiness: Exchange Traded Options: A Way to Boost Your Retirement Income

Australian Small-Cap Investigator:How to Make Money From Small-Cap Stocks

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