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Kerry Prazak, CFP
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After working in the nuclear power field for 8 years, I chose to pursue my passion and enter the financial services industry. For the past 10 years, I have been helping clients invest their money at two large investment firms and have now transitioned into providing timely investment ideas in... More
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stockmarketplaybook.com, LLC
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Stockmarketplaybook.com
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How to Pick the Best Dividend Stocks
  • Current Stock Market: Morton's Fork 0 comments
    Aug 18, 2014 5:51 PM

    "The stock market is presently a roulette wheel with dimes on black and dynamite on red." - John P. Hussman, PhD 8/18/14

    This is the first sentence of today's newsletter from John Hussman of the Hussman Funds. You can read it here. He summarizes my feelings well, where all my years of study and research lead to the conclusion that it will be extremely difficult to earn positive returns in the stock market for a buy and hold investor over the next 5-7 years.

    I wish that weren't the case, especially as one who manages money professionally. Clients are counting on me to grow their wealth, and I intend to do just that. But land on black and you get "dimes", land on red and you get "dynamite" type of markets are challenging in two aspects: actually making investment decisions and managing investor emotions.

    The stock market is at all time highs, interest rates are at historic lows, so what's the problem? This is Morton's Fork: Needing to choose between two equally bad options.

    The problem is, valuations matter. They always have. When valuations start getting too high, the only way to justify continuing to invest in the stock market is a) this time its different or b) the way that valuations are calculated are now erroneous.

    I heard this today on CNBC, one person was saying the p/e ratio (Shiller) was 25 (it's actually at 26), which was very high. The other guest said the only valuation that matters is forward p/e which is at 16. One concluded that the market was overvalued and the other said it wasn't, and may even be undervalued.

    So there we have it. Two people in the industry on CNBC, and they can't even agree on what the correct valuations to use are.

    Here's how I do it: Which ones have worked in the past? I like to use those.

    In this case, Shiller P/E has worked well. It has been this high before THREE times: 1929 (Stocks Crashed), Late 1990's (Stocks Crashed), 2006-2007: (Stocks Crashed)

    (click to enlarge)
    Source: Multpl.com

    Is the Shiller P/E ratio not relevant now? A lot of people are saying just that. Because earnings were so low in the 2008-2009 period, it is overstating the current P/E ratio which uses a 10 year rolling period. Once those earnings are replaced with the better earnings we are seeing now, this ratio will go down. That is the thesis to make the Shiller P/E ratio bunk.

    If markets don't severely correct from here, it will be the first time that has happened. (It's not just Shiller P/E by the way. Market Cap to GDP, Price/Sales, Tobin's Q, and others repeat the same story: markets are significantly overvalued.)

    But, earnings now are much higher than historical norms. With the Fed's zero interest rate policy in place, firms have been able to refinance debt at a lower interest rate to increase earnings. The actual revenues are not going up as much, but as it flows to the bottom line, it appears that companies are making more and more money. What else are companies doing? Buying back shares. They have bought back shares in record numbers, many times using very low cost interest debt. Even AAPL did that recently for the first time. Instead of bringing money back from overseas and paying a hefty tax, they just issued debt at record low interest rates and continue to buy back shares. It was a great business move in my opinion, but it doesn't change the fact that earnings are higher than they normally would be because of these policies.

    If that is true, then it could be argued that earnings are actually higher than they should be, and the Shiller P/E ratio should actually be even higher than 26.

    Here's the deal: Maybe the market is overvalued, maybe it isn't. (It is.) Investors don't care right now. They look around and see cash paying zero, bonds yielding nothing, and they would rather take a chance at earning something than have a virtually guaranteed growth of zero. That is the one obvious result of current Fed policy. They have made it so other normal investment options are so unattractive that the stock market looks good on a RELATIVE basis.

    And there it is. Stocks will continue to move higher until this changes. As a professional money manager, I get paid to address these risks and minimize them. As stated above, black is dimes, red is dynamite. Morton's Fork: Choice A: Stay in cash and earn zero and let your money get eaten away by inflation, Choice B: Ignore historical evidence that a severe correction is probable and try to earn money in the stock market at the risk of losing 30-40%.

    Here's what I am doing: Holding more cash than normal, investing in the lowest cost ETFs and index funds to reduce the hurdle rate, and pairing stocks and ETFs using call options (Covered Calls) where I am willing to give up upside in exchange for extra income and some downside protection. As long as the market remains technically strong, I will hold the minimum in equities. As valuations come down (usually after a market correction), I will use the cash to buy more positions.

    The road ahead in the stock market is full of land mines. We can either pull over and wait for them to clear, as others hurdle through them, or proceed carefully ahead, navigating cautiously. I prefer this one. At least with the latter we are making progress, albeit slow. Once the land mines become fewer and fewer, we can increase the speed.


    Disclosure: Kerry Prazak, CFP® is the owner and portfolio manager of East Lake Financial, LLC, a Registered Investment Adviser. Kerry Prazak, East Lake Financial, and/or its clients may hold positions in any ETFs, mutual funds, and/or any investment asset mentioned above. The comments above do not constitute individualized investment advice. The opinions offered here are not personalized recommendations to buy, sell or hold securities.

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