Follow Druckenmiller's Lead - Quit Indexing And Get Selective

by: Superinvestor Bulletin


From the bottom in March 2009 the S&P 500 has tripled.

The valuation of the overall market is now stretched and the easy money tailwind is exhausted.

It is time to adjust investment strategy away from indexing and towards being very selective.

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When making money in the stock market (or any investment class) starts feeling a little too easy it is usually because it is. If you have spent any time in this game you know what we are talking about.

In the late nineties all you had to do was buy a stock with ".com" in its name and you could double your money in the blink of an eye. From 2002 to 2007 you could make $50,000 in the housing market by changing a lightbulb and owning a property for a year. And do you remember the "nifty-fifty" in the early 70s? Maybe you don't but then too things were very easy until they weren't.

We spend all of our time following the very best investors in the world. These are the managers that have compounded money at unusually high rates for decades.

What we have found is that when there is danger in an asset class many of the great investors are simultaneously warning about it. Better still they have often positioned themselves to profit from it. We can avoid danger and increase our returns by following the lead of these great investors.

Today what we are seeing from several of these great managers should make you think that it is time to get out of your S&P index fund (NYSEARCA:SPY). If not that then certainly stop putting new money into it.

It Can't Go On Forever

It has been one of the best runs in the history of the stock market. From that ominous bottom of 666 in March 2009 the S&P 500 now sits at 2,046 more than a triple in seven years.

That isn't a triple in one stock, that is a triple for the entire market. All an investor has had to do over this time is mindlessly pump money into the market and watch that money grow.

Stan Druckenmiller issued a warning last week at the Ira Sohn conference that the party is about to end. We believe his reasoning is sound (no surprise there) and should be paid attention to.

Druckenmiller - The EndGame Presentation

In his Ira Sohn speech Druckenmiller noted that not a week passes now where he doesn't hear someone extolling the virtues of equities on the basis that there is no alternative but equities with interest rates at zero.

He notes that this view is so widely held that it even has its own acronym "TINA" (there is no alternative).

That sounds like people blindly plowing money into equities to us. A bit reminiscent of people blindly plowing money into internet stocks or blindly plowing money into housing.

Everyone justified buying internet and technology stocks with no earnings because the internet would be so huge that these companies would eventually gush so much cash flow that it would dwarf any valuation concerns.

Everyone justified the housing bubble with the argument that housing prices in the United States had never gone down. Flatten maybe, but go down never.

Now everyone justifies the continued buying of equities (index funds in particular) because there is no alternative.

There are always alternatives.

Druckenmiller's favorite alternative is gold, specifically SPDR Gold Trust (NYSEARCA:GLD) where he has the biggest percentage of his family office capital allocated. We think there are other alternatives as well.

We Have Exhausted Our Capacity For Credit Fueled Growth

Druckenmiller - The EndGame Presentation

The end of this bullish stock market run is likely to be caused by the end of unsustainable fiscal actions. Believe it or not, the reality is that the easy money game can't go on forever.

The Federal Reserve policy response to the 2008 Financial Crisis has been so forceful that it not only prevented deleveraging from occurring, it increased it.

How forceful has been the response? During the great recession the Fed expanded its balance sheet by $1.4 trillion which got the economy growing again. Yet despite returning to economic growth the Fed has continued to expand its balance sheet by another $2.2 trillion (quoting Druckenmiller on the numbers).

Interest rates which were low historically heading into the financial crisis have been pushed to levels once though unimaginable and kept there for a sustained period of time.

There is no easy way out of this and the impact of all of this Fed action has seen greatly diminished returns in recent years. With interest rates at historically low levels companies have piled on debt and the sugar high in earnings/cash flows that they are getting from this is waning.

Druckenmiller - The EndGame Presentation

For a while adding low interest debt created cash flow growth, but no longer (see chart above).

Today we are faced with:

- A stock market with a valuation at the high end of what is normal historically

- Record low interest rates which can't go any lower in order to further stimulate earnings growth

- Far too much debt in the system

Put this all together and it isn't hard to see Druckenmiller's point. Where is there room for anything to get pushed further in order to create something positive for equities?

There isn't room for much valuation expansion. We have historically high multiples and a future of slow growth. That is a bad combination.

Interest rates can't go lower and sooner or later something is going to set off a run out of bonds that will push them higher. There is a lot of noise about the U.S. dollar no longer being the world's only reserve currency. Take away some of that forced demand for U.S. Treasuries and things could get interesting.

Then there is deleveraging or at least an end to leveraging. It has to happen.

It Has Never Been More Important To Make Thoughtful Investments

When the game becomes too easy it is because it is. Something is broken, we just don't know it yet.

As investors we have to be flexible and match our strategy with market conditions. Sometimes like March 2009 it is like shooting fish in a barrel. You just buy stocks and you make money. That is the perfect environment for index funds.

Other times we need to be very, very selective. Right before the market crash in 1999 investing in an index fund was the worst thing that you could do with your money. Yet at that very same time buying out of favor, "antiquated" value stocks was exactly the right thing to do.

Today is one of those times to be selective. We think the best way to select the right stocks is to get ideas from the great investors like Stan Druckenmiller or Bruce Berkowitz or Seth Klarman. Investors who have proven themselves to be able to navigate through all market conditions.

If a person were to really get convinced by Druckenmiller's warning, they could also consider betting against the market with an ETF like ProShares Short S&P 500 ETF (NYSEARCA:SH). Shorting isn't our cup of tea normally, but we would suggest not getting long the S&P 500 at this time.

We are going to keep following carefully what all of the top investors are doing with their portfolios. These investors will show us how to continue to make money despite the trick investing environment we are in today.

Click the follow button at the top of this article so you can get our updates and keep track of what is going on too.

Thanks for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.