A concern I regularly hear about is the future.
People worry that the economy’s best days are in the past and that trouble lies ahead.
And this isn’t just a recent concern…
People have been worrying along these lines for decades. They believe that the economy can’t possibly continue to grow. And this often puts them off the stock market entirely.
Have a read of this:
‘I think Quant Trader is a fantastic service for those who know what they are doing. I’m a 72 years old part pensioner with $250,000 to invest. But if I listen to the market bears, cash is king for now.
‘Reluctantly, I won’t use Quant Trader through lack of confidence in myself. Many will make good money following the signals. But I think the 2nd G.F.C. is looming and I have “wobbly legs”.’
I understand where John is coming from.
I had a similar worldview in the mid-1990s. My thinking was that global debt and speculation were out of control. I was sure that a big deflationary bust was imminent.
Do you know what I did?
I ignored the fact that markets were rising and shifted all my super to cash.
Yes, the 90s had its share of panics — just about every decade does.
But my concerns about an economic dark age were wrong. Life went on, the global economy got a lot bigger, and stocks continued their climb up the wall of worry.
I learnt an important lesson during this period. It’s something I remind myself of whenever uncertainty strikes: Act on the trend — not on my fears.
It’s easy to find an excuse to do nothing. I know, I’ve done it. I also held off buying real estate in the 1990s. Again, I was waiting for a crash that didn’t happen.
Sitting in cash may feel safe. But, historically, it’s a gamble. Most of the time the world moves on without you. All the opportunities go to those who stay in the game.
How to buy stocks in a pricey market
Some say stocks are currently expensive.
And they have a point…
Price-to-earnings (P/E) ratios for US stocks are well over the long-term average. Profit growth is above normal. And as a percentage of gross domestic product, stocks are at high levels.
Does this mean cash should be king?
Well, I don’t believe it does.
An index like the S&P 500 may seem pricey. But this doesn’t mean there aren’t opportunities. Unless you’re an index fund investor, the overall market isn’t all that matters.
For instance, take the three-year stretch from 2000–02. Many people will tell you that this was a dead period for Aussie stocks. The All Ordinaries basically went nowhere.
Have a look at this:
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The All Ords lost 6% between January 2000 and December 2002. There was also a fall in the index’s P/E ratio from an expensive 22.4 to 15.1.
Adding to bleak conditions were three big events: the dotcom crash, the September 11 terrorist attacks, and recessions in Europe and the US.
Many people would say this was a bad time to be in the market.
And if you’d been in an index fund, they’d be right.
But what if you had a strategy for buying individual stocks?
I’ve been doing some research this week. The purpose was to test the belief that all stocks do poorly when a pricey market turns lower. I think you’ll find the results surprising. Here’s what I found:
Between 2000 and 2002, Quant Trader identified 71 trades that made at least 50%. Of these, 22 went on to rise by over 100%. On average, that’s about one every two months.
In some cases, you didn’t even have to wait very long…
FXF Trust (now Challenger Ltd [ASX:CGF]) rose 66% in 70 days in 2000. Mineral sands miner Basin Minerals Ltd (since taken over) put on 162% in under seven months in 2002. And during 2001, the now delisted automotive group Ion Ltd shot up 81%.
Of course, there were many stocks that didn’t kick on. Plenty of signals in this sort of market will result in a loss. Others just grind out a modest gain.
But the point is this: While an index, like the All Ords, can help you identify the general state of the market, it won’t tell you what to expect from individual stocks.
Think smaller stocks…
What made the previous three stocks different?
Well, it turns out they were all small-to-medium-sized companies.
And this was the case for most of the 71 stocks that rose over 50%. There wasn’t a bank or mining giant in sight. The list was mostly comprised of mid-sized companies with lots of room to grow.
You see, larger companies typically have a close link to the economy. They depend on broad-based growth to get bigger. A mega company’s sales rarely surge when the economy is flat. Small- to mid-tier companies also depend on the economy. But due to their smaller scale, some can still get a lot bigger, despite a slowdown in economic activity.
Now, I’m not expecting the global economy to stall anytime soon. Aside from some moderate corrections, I believe markets will generally move higher over the next couple of years.
But I know some people — like John, whose email you saw earlier — are worrying about a big downturn. They believe stocks are expensive and cash is a better option.
Maybe the bears will be right…or maybe they won’t. No one knows what the future holds.
But I can say this from experience: You could miss a lot of opportunities sitting in cash.
My solution is to buy into strength and trade with the trend. This helps maximise upside from trades that are rising. It also keeps you out of stocks that are trending lower.
Another suggestion is to keep an eye on the small- to mid-cap stocks. As you saw during the 2000–02 slump, some big winners came from this category.
Finally, use exit stops…
One of the biggest mistakes people make is to hold on to losing trades. I’ve seen traders lose huge chunks of capital doing this. It’s the greatest wealth destroyer I know.
And remember, even if you think the overall market is pricey, you’re not buying the market. You’re buying individual stocks. Some of these could produce big results in any conditions.
Until next week,
Editor, Quant Trader
PS: If you want to lay down a little money on the hottest corner of the ASX right now…but you don’t know your way around the small-cap sector…this report is for you. Get access now (free).