It’s one of the stupidest things to do. And the mainstream investment media does it all the time.
They’re experts at inflating the importance of price.
Don’t get me wrong, you need to keep price in mind. But the way they bang on about it, you’d think it was the be all and end all.
When stocks reach new highs, they scream, ‘Get out!’ They use subjective measures to inflate fears.
Heading into 2018, it was as if they didn’t know what to do. Stocks, globally, were rising higher, and the short-term view of the economy was getting better.
So what did they tell you?
Sell stocks on their sky high prices and buy them for their potential growth.
What are they saying now as the ASX 200 sits 4% below its 2018 high?
Most are telling you to buy indiscriminately. That’s probably why the market shot back up almost 50 points yesterday.
But here’s what they should have told you…
The most important thing with stocks
Price isn’t terribly important.
It doesn’t matter whether a stock is $10 or $1,000. Similarly, it doesn’t matter if the market is at 5,000 points or 6,000 points.
What matters is value.
And that’s true whether you’re talking about stocks or socks. You want to buy quality at bargain prices.
Now, let me ask you a question. Why did our market drop almost 5% from Monday to Tuesday?
Was it because prices rose to high too quickly? Maybe.
Everyone was saying these new highs weren’t sustainable. Most used price-to-earnings (P/E) ratios to justify that opinion.
Because the market’s P/E was above its long-term average, the market was overvalued, they surmised.
Others believe spikes in volatility caused large investors to recalculate their pricing models, forcing them to selling multiple positions.
But yesterday’s drop had nothing to do with the P/E, volatility or any other metric.
The trade-off every investor looks at
While they might be boring, bonds are incredibly important. Whether you’re in stocks, real estate or bitcoin, you need to know what bonds are doing.
Because AAA government bonds are as close to risk-free as you’ll ever get.
Buying a bond that yields 2.8% (which is the annual payments divided by price), means you’re guaranteed a 2.8% return on your money.
It’s this risk free return that dictates whether it’s worth buying any other alternative. It’s a kind of baseline for the market.
For example, say you wanted to invest in an index fund tracking the ASX 200. Meaning your returns will closely follow the largest 200 Aussie stocks, minus fees.
Over the past 12 months, the market’s yield (what you expect to earn if all thing remain constant) was around 5.4%.
Is this higher yield enough to compensate for the risk you’re taking?
Remember, no one really knows what will happen in the future. The market could shoot up 20%, or fall the same by the amount.
Maybe a 5.4% yield isn’t good enough.
But when bond yields were below 2.5%, it was good enough for many investors, which is why stocks traded so high for so long.
Take a look at the graph below. Since 2012 the All Ordinaries index, the 500 largest Aussie stocks, has traded above its long-term average P/E of 15-times earnings.
Source: Market Index
[Click to enlarge]
Clearly investors are more than happy to buy stocks trading at high multiples.
But what they’re not prepared to do is stay in a low yielding market while bond yields are rising.
This week’s drop has been a great example of that.
To be clear, these ‘investors’ I’m talking about are not individuals like you. They’re institutions. They have hundreds of millions, sometimes billions to put to work.
Because of their size any move causes ripples, which move the market.
So on Saturday, when Aussie and US bond yields spiked, investors had to think hard about whether holding stocks was worth the risk.
A mad rush to get out
Could we see higher bond yields and further stock declines from here?
The simple answer is yes. Bond yields could rise higher from here. But it will all depend upon what central bankers do next.
If they lift interest rates, which means increasing their lending rate to other financial institutions and selling bonds to suck money out of the system, then bond yields could rise higher.
And in the US, higher rates seem like a forgone conclusion…for now.
As reported by Reuters:
‘Stock markets plunged and bond yields soared on Friday after U.S. data showing th strongest annual wage growth since 2009 rattled investors who fear accelerating inflation will usher in more interest rate hikes than expected this year.’
The world’s most successful hedge fund manager, Ray Dalio, is also bullish on US bond yields.
During the World Economic Forum in Davos, Dalio said demand for bonds will fall as central bankers start unloading billions of bonds.
It could encourage some investors to move their money out of Aussie stocks and into higher yielding US bonds.
So what’s an individual investor like you to do?
Finding the gems among the rubble
I’m not going to tell you what the market will do next. No one can.
I’m also not going to tell you to indiscriminately buy.
So what should you do? Focus on individual investments.
High-returning companies like CSL Ltd [ASX:CSL], REA Group Ltd [ASX:REA], Nick Scali Ltd [ASX:NCK], Magellan Financial Group Ltd [ASX:MFG] and Integrated Research Ltd [ASX:IRI] usually perform wonderfully over time.
It’s not only because they earn more dollars on every dollar they invest, but also because investors are willing to pay up for those higher returns.
It’s why most high-returning businesses trade at 30-times earnings or more.
Don’t take this as recommendation to buy the companies above.
But if we continue to see the market pull back further, there’s an opportunity for you to pick up some high returning businesses at extremely attractive prices.
Then, when the market rebounds, you can kick back and watch your positions rise higher for years to come.
Editor, Money Morning
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