MarkFord
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“Every step of life shows much caution is required.”
-Johann Wolfgang von Goethe
When I’m Going to Get Back Into Stocks
The Dow has fallen.
A reader asks: Is it time to get back into stocks?
I’m not an investment advisor. I don’t feel comfortable telling others what to do with their money. I prefer to say what I’m doing and why, and then let my readers decide if it makes sense for them.
So: Am I getting back into stocks? Not now. I’ll tell you why.
We just went through one of the longest and largest bull markets in my lifetime. From March 9, 2009 to March 11, 2020, the Dow and S&P 500 rose 351% and 400%, respectively. That was a fun ride – and I’m glad I was on it. But it became clearer and clearer as time passed that the bull I was riding was getting old.
The day the World Health Organization declared the coronavirus a pandemic, the market tumbled 6%. It has fallen since then, and is currently down about 25% from its high. (Erasing more than $8 trillion of the US market capitalization.)
When deciding to buy a stock, there are two simple ways I judge its value. The first, which I’ve been doing forever, is the price-to-earnings ratio (P/E). That is determined by dividing the stock price by the earnings per share. (If the price of stock X is $50, and the earnings per share is 5, the P/E is 10.)
There are other ways to measure share value. A popular one is the price-to-sales ratio. It is determined by dividing a company’s market cap (the total value of outstanding shares) by its revenue. This is a good quick way to compare prices of companies within a given industry, but it doesn’t make sense to value stocks across the board. Another metric is the price-to-book ratio. A business’s book value is determined by subtracting its liabilities from its assets. You take that book value and divide it by the number of outstanding shares, which gives you the book value per share. Then you divide the share price by the book value per share. I don’t use this method because it’s just too much work for my purposes.
What I like about the P/E is that it corresponds to the way I value private businesses. I wouldn’t be interested in buying a company based on sales. And I certainly wouldn’t value it that way. I’m interested in profits. Earnings are profits. The other thing I like about the P/E is that, because it values the shares on profits, it can be used to fairly value large, established businesses in most industries – from manufacturing to agriculture to communications to energy, and so on. In other words, it’s useful for valuing the sort of stocks I want to own: large-cap, dividend-giving, industry-dominating companies that have a long history of profitability and are likely to be here far into the future.
If I traded stocks or invested in growth stocks, I’m sure I’d be interested in getting more sophisticated with my value calculations. But my strategy for stocks is based on my confidence that I do not and will not ever have the interest in or patience for beating long-term market averages. I’m happy to get 8% to 12% on my money over the long haul.
Today, the average P/E for the Dow is 16.4. That’s down two points from a year ago, and it’s getting very close to the historical average of 16. P/E ratios are not reliable predictors of short-term market moves, but over 10 years or more, they work pretty well. Thus, buying stocks with P/E ratios of 15 or less would make sense. And many value investors use that as a buy-in signal.
As an investor in private businesses, I have never paid anywhere near 15 times earnings. For newer, growing businesses, I’ve paid up to 10 times earnings. But for larger, established businesses in my industry, the range is usually a 4 to 6 times multiple of the average earnings over the prior three years.
In other words, for a business that made profits of $80,000, $100,000, and $120,000 over the prior three years (an average of $100,000 per year), I’d be willing to pay up to $600,000.
You can’t do that with larger, stable public companies. Priced at the historic P/E of 16, I’d have to pay $1.5 million for the same company.
The reason for this is supply and demand. In the public sector, there are billions of dollars of buying demand every day. The larger, institutional buyers are happy to pay 16 times earnings for the sort of stocks I prefer to buy. And they usually will. So for me, I’m motivated to buy these stocks in the 12 to 14 P/E range.
Recently, I’ve added a second tool to my valuation kit. I’m not exactly sure how I will use it, but I’m looking at it because I think it makes sense.
It’s called the Dow-to-Gold ratio. I learned about it from Bill Bonner, the founder of Agora, and Tom Dyson, who helped me assemble the core holdings of the stock portfolio I have now.
Here’s how Tom described this tool:
It’s NOT a speculation in gold. It’s a long-term buy-and-hold stock market investment strategy… with a simple market-timing element that helps us buy low and sell high.
Most of the time, we hold the stock of the world’s best dividend-raising companies. We call these “dividend aristocrats” – companies like McDonald’s, Coca-Cola, Hershey’s, P&G, J&J ,and Phillip Morris. [Note: This is basically the same core group that I have in Legacy stocks. No surprise there, since Tom helped design the Legacy Portfolio.]
Some of the time – when these stocks get too overbought and expensive – we go to the sidelines in gold.
We never cash out. And we never hold anything except gold and dividend aristocrats. We just wait for the Dow-to-Gold ratio to reach extremes… and then we rotate between stocks and gold accordingly.
As such, the Dow-to-Gold ratio is the only number that matters to us.
For Bill and Tom, the Dow-to-Gold buy-in ratio is 5. When they can buy all the Dow stocks for five times the value of an ounce of gold, they will be all in.
Right now, the ratio is well above 5. But it’s moving down with stock prices down and gold moving up. It’s likely that gold will move up considerably more if the economy doesn’t drastically improve by mid-summer. If that’s the case, we will see the Dow-to-Gold ratio moving towards 5.
But I’m not going to wait that long. As I said, this is a new metric for me. It makes the most sense in the long view. As individual stocks that I favor move towards a P/E of 12 and the Dow-to-Gold ratio continues to drop, I’ll start buying.
But on an individual basis.
In the meantime, I’ll keep my money in cash and wait to see what happens.
PS: I may put a very small portion of that cash to speculate. If I do, I’ll let you know.
Update on My Investment Portfolio:
Why I’ve Just Sold Most of My Stocks
“Be fearful when others are greedy, and be greedy when others are fearful.” – Warren Buffett
I’ve just sold about 75% of my stock portfolio. I’ll tell you why…
The Economic Outlook Is Scary
At a macro level, our economy is fragile. For one thing, the US has never been in so much debt. The national debt has been growing pretty much non-stop for 20 years, but it accelerated significantly under Obama and Trump. It is currently $26 trillion. That is 107% of our GDP. The last time the debt-to-GDP ratio was that high was in 1948, at the end of WWII.
And then there is our consumer debt: the debt private citizens carry on mortgages, loans, and credit cards. That hit $14 trillion in March, a record high, surpassing by almost $1 trillion the record set at the height of the 2008 financial crisis.
This level of debt is scary. But what’s scarier is that there are only two or three elected officials left that believe in balanced books and sound money.
The business outlook is bleak. Since January, US GDP has dropped nearly $3 trillion, from $21.8 trillion to $19.2 trillion. Thousands of small and medium businesses, employing millions of medium- and low-skill workers, have been shut down. The economists I trust are prognosticating that as many as half of them are closed for good.
By these and many other metrics, the US economy today resembles that of the economy after the real estate bubble collapsed in 2008, except for debt, which is worse. Given that, it seems reasonable to believe that we are looking at an attenuated recession and a feeble recovery.
Longtime readers know that I don’t buy or sell stocks based on macro analysis. But I don’t ignore it either.
The Upcoming Election
This is the main reason I converted 75% of my stock portfolio to cash.
The pollsters and their pundits are predicting that Trump will be ousted in November and the Democrats will sweep the House and perhaps even the Senate. The Democratic agenda is for higher social spending, $500+ billion on infrastructure, and higher taxes for businesses and high-income earners. But I’m even more concerned with the talk about eliminating the cap on the Social Security tax.
Wall Street doesn’t respond well to the threat of higher taxes. So as we approach the November elections, if it looks like Biden will be elected and the Democrats will win both houses of Congress, it’s very likely that we’ll see a big drop in stock prices. A 30% to 50% drop wouldn’t surprise me.
So those are the three reasons I decided to sell most of my stock portfolio: I have a continuing concern about US debt, a suspicion that we have entered into another extended recession, and a strong hunch that if it becomes apparent that the Blues will dominate the November elections, the stock market will take a dive.
Longtime readers will rightly be surprised to know that I’ve sold off 75% of my stock holdings. They will remind me that my investment philosophy has always been to buy world-dominating companies and hold them long-term. They will further remind me that as recently as April 6, I repeated that viewpoint in explaining why I did not sell any of my stocks as the markets were tumbling from the Corona Crisis.
Yes, I’m violating that rule now. Let me take you through my thinking process…
I “lost” millions in March and April. The loss was just on paper, but it still didn’t feel good. Because I didn’t panic and didn’t sell then, I was able to see the market climb back up this “wall of worry.” And now I’ve regained (again, on paper) all that I had lost.
The balance of my stock portfolio is at an all-time high. But there is a fair chance that the market will take a dive sometime between now and November. And if it does, it could be, as I said, a steep dive – 30% to 50%.
So I did what I sometimes do when I’m in a confusing situation like this. I interviewed the three parts of my brain.
First, I asked my limbic brain, the part that’s in charge of my emotions: “How would you feel if that happened?”
And Limbic Brain answered: “Like horse shit. Like a fool. But I would blame-hate you for keeping our money in the market.”
Then I asked my reptilian brain, the part that’s in charge of my instincts: “What would you do if Limbic Brain felt like that?”
And Reptilian Brain answered: “I would definitely panic. I would be afraid the market would drop even further. I would take flight. I would tell Limbic Brain to sell everything – all of our stocks – immediately and eat the loss.”
And finally I asked my rational brain: “What do you think of all this?”
And Rational Brain said: “Normally, I’d tell you to ignore Limbic Brain. I’d say that Reptilian Brain is bluffing. But in this case, why take the chance?”
“What do you mean?” I asked.
Turning to Limbic Brain and Reptilian Brain, Rational Brain said: You have told us how badly you would react if our portfolio dropped again by 30% to 50%. How good would you feel if we held on to our stocks till November and they went up in value?”
“Like by how much?” they asked.
“Say, 10% to 15%,” Rational Brain said. “Which, I might remind you, would be an unprecedented three-month climb, considering where they are now.”
Limbic Brain and Reptilian Brain went into the corner, as they always do when confronted by Rational Brain, and conferred. After a few minutes, they emerged.
“So how would you feel about our making another 10% to 15% on top of our current gains?” Rational Brain asked.
Limbic Brain shrugged. Reptilian Brain, lacking shoulders, said, “Meh.”
Rational Brain turned back to me. “As you can see,” he said, “my less intelligent but immensely muscle-bound siblings don’t really care if our stock portfolio goes up. But they really, really are going to go nuts if it goes down again.”
“Yes, I can see that,” I said.
Rational Brain leaned forward and stared into my eyes. “You know what you should do,” he intoned. “Sell all or most of your stocks right now and wait until November. You will be giving up the unlikely possibility of getting modestly richer over the next three months. But you will be safe from the more likely possibility of becoming considerably poorer.”
“That makes sense,” I said to Rational Brain.
He winked. “That’s what I’m here for.”
And that’s why I sold 75% of my stock holdings. If you are having some of the same concerns regarding your investments, conduct an interview. Your brain parts are yours, formed by your own knowledge and experience. See what they have to say. And then do what your Rational Brain advises.
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