Why You Should Invest in ‘Partial Gloom’

The Aussie market continues to trade nervously. Yesterday it traded down to its lowest level since early June, before recovering slightly.

Today should be a more positive day. But looking at the recent price action, the market is finding it hard to gain upward momentum.

Check out the chart below of the benchmark ASX 200 index. You can see that over the past few months the market has been volatile. Big swings each day, without much to show for it overall.

But it looks like the market wants to head lower. Note prices have spent more and more time below the moving averages (the blue and red lines) recently, indicating momentum is to the downside.

Source: Optuma
[Click to enlarge]

There’s something else I want you to check out. The green horizontal lines show the start and end of the rally.

The start got underway in early November last year with the improbable victory of Donald Trump. (I said yesterday that I wouldn’t mention the bloke, but we can’t avoid the timing on this move.)

The rally peaked out in late April/early May, for a gain of around 15%.

The blue line is the mid-point of that rally. I’m showing you because it is not unusual for bull market rallies to retrace up to 50% of their previous advance, and still be bull markets.

In other words, don’t freak out if we get another leg down. It will just be the market working off some of the rally that occurred in the first half of the year.

When you have your head stuck in the day-to-day, it’s easy to forget that this is how markets work. It goes up, and then gives back some of those gains. It then bottoms again when a sufficient amount of players have decided that they think it will keep going down, and sell out.

When there are few marginal sellers left, the marginal buyers get the upper hand and prices again start to rise again.

I don’t have the numbers with me right now, but did you know that this is how the stock market delivers most of its gains and losses?

That is, not via the power of earnings growth (or lack thereof) but by the sheer force of investor opinion of those earnings.

Let me give you a simple example.

Say the market trades around its long term price-to-earnings (P/E) multiple of 15 times and it has aggregate earnings of $10 per share. It therefore trades at 150 points.

Over the next year, the economy strengthens and earnings increase by 10%. Aggregate earnings are now $11 per share. If investors remained immune to the ‘good news’ of 10% earnings growth and priced the market at a stable 15 times, the market would trade at 165 points. That’s a 10% increase, in line with the 10% rise in earnings.

But because we’re crazy emotional humans and not robots, we get all excited and think the 10% earnings growth will continue for years. We imagine things. This imagining of wonderful things translates into higher prices. So investors price the market at 20 times earnings, rather than 15 times.

As a result, the market moves up to 220 points, which is a 46.67% advance on the old, less ebullient multiple of 15 times pre earnings growth.

As you can see in this example, collective optimism delivered early investors a 36.67% return, while actual earnings growth chipped in with a boring 10%.

That’s why you want to buy in gloom. The gloom has sucked all the returns out of the market. You then simply wait for the optimism to return and boost the market again.

Who cares about actual earnings growth?

Well, actually, you should care. Just a bit. It’s the earnings growth (or otherwise) that is the catalyst for the optimism or pessimism. Except in those rare times, like the dot com boom, when earnings don’t matter.

But it’s not so easy to buy in gloom, for a few reasons. As you may have noticed, central banks around the world have pretty much outlawed gloom from the financial markets over the past few years.

Any time that investors became too gloomy, they handed out a torrent of cash.

They’ve done this so often that investors have become happy. Now markets all around the world trade on a P/E of 20 times, or near it.

The bears say that this is irrational. That it will only be a matter of time before prices come back to normal (15 times) and then onto depressed (10 times).

I say such predictions are too simplistic.

When interest rates are so low, it is actually rational for PE multiples to be ‘high’. The thing is, in finance there is no such thing as an absolute value. Everything is relative.

And for global stock markets, the relative benchmark is the US 10 year treasury yield. Right now, the yield is around 2.25%. That translates to a PE of 44 times. (1/2.25).

In other words, compared to what money managers can get by investing in treasury bonds, buying the S&P 500 doesn’t look as crazy as it seems at first blush.

Sure, interest rates are starting to rise around the world. But central banks don’t want to take the happy pills away too quickly. They will do so VERY slowly. And they will only do so if the economy continues to grow and deliver earnings growth.

What’s my point? I’m not sure exactly, I forgot. I think I’m trying to say that it makes sense to only buy in times of gloom. But when interest rates are so low, you could be waiting a long time for traditional gloom pricing. And who wants to be stuck in cash for years?

Bringing it back to the Aussie market, if you do see another leg down, keep in mind that we might be getting very close to the end of the correction. Rather than sell in a panic, it will be time to look for opportunities.

In this day and age, your only opportunity is partial gloom.


Greg Canavan,
Editor, Money Morning

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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