-- Published: Friday, 29 May 2015 | Print | Disqus
The great endeavor of investing can be distilled down into four simple words, buy low sell high. They are so basic, so resoundingly clear, that even a child can understand this principle. Yet still the great majority of investors never achieve significant success. Even while full-well knowing the core idea of investing, they end up buying high and selling low. That treacherous struggle of investing must be overcome.
It’s funny, as life is full of simple ideas that are incredibly challenging to put into practice. Investing is certainly not unique in this regard. Americans’ expanding waistlines are a great example. The only way to lean up is some combination of eating less and exercising more. We all know this basic truth, we all know what we ought to be doing on both fronts, yet it’s still really hard to execute. Emotions are the reason.
The hard laws of physics dictate that losing weight requires running a calorie deficit, which inescapably means being hungry. And no one likes the ongoing sacrifice of being hungry, as it’s psychologically grating. Exercise is a serious sacrifice too. Not only is there a time opportunity cost of foregoing doing something else more enjoyable, but it’s physically taxing. That old saying “no pain no gain” is certainly true.
Investing is very similar, a simple idea actively confounded by emotions. And that’s not surprising, as so many emotionally-charged elements feed into this endeavor. Investing first requires surplus capital, which only comes from spending less than income earned. This necessary sacrifice leads to money being highly coveted and valued, fraught with emotional attachment. And then dreams come into play.
People invest because they want a better standard of living for their families in the future, a cherished dream for all. With so much riding on their hard-earned surplus capital, they are naturally very careful about casting it into the unforgiving markets. So they wait to invest until they feel really optimistic and comfortable about the investments they’re making. But paradoxically that is the very point of failure.
The core mission of investing requires first buying low before later selling high. The problem is buying low never feels good. The only time investments are cheap and underpriced is when they are deeply out of favor and unpopular. And no one wants to invest in something that hasn’t performed well and therefore isn’t expected to fare well in the future. So buying low is an emotionally-unpleasant experience.
Buying low requires investors to fight the crowd, to go out on a limb and buck conventional wisdom. It requires investors to forgo acceptance from their peers and operate as a lonely rebel. Given the extreme emotional attachments inherent in money and social standing, merely being hungry from running a calorie deficit is trivial in comparison. Buying low is an exceedingly-great challenge that few overcome.
Instead of making the serious sacrifices necessary to forge the emotional fortitude required to buy low, most investors instead revert to following the herd. They only invest in assets that have already rallied much, and are therefore universally expected to keep on climbing indefinitely. This results in buying high, the polar opposite of investing’s mission. This approach is commonly known as momentum investing.
Market prices are naturally determined by supply and demand, so assets that have powered higher for a long time have enjoyed strong demand. So investors assume that will continue, which is often true for a season. But markets are forever cyclical, they perpetually flow and ebb. Eventually buying exhaustion arrives, everyone who wants to invest in a popular asset is already in so new demand gradually withers.
And once that happens, the price soon starts on a long selloff to far-lower levels. Investors who got caught up in the emotional hype to buy high often end up selling much lower later, which leads to big losses and capital destruction. That’s why momentum investing depends on the classic greater-fool theory. The only justification for buying high is the hope that a greater fool will come along later to buy even higher!
Since momentum investing is so fraught with peril, the alternative is far more prudent and wise. It is of course contrarian investing. The dictionary definition of contrarian sums this up perfectly. It is “one who takes a contrary view or action, especially an investor who makes decisions that contradict prevailing wisdom, as in buying securities that are unpopular at the time.” Contrarianism demands opposing the herd.
While underlying supply-and-demand fundamentals ultimately determine asset price levels, they are utterly dominated by popular emotions over the short term. These are collectively known as sentiment in the financial markets. It exists on a continuum between fear and greed. This can be visualized as a great pendulum, swinging from extreme fear at one end of its arc to extreme greed on the opposite end.
Both sentiment extremes encompass an array of emotions. Fear also includes despair, antipathy, and apathy. Extreme fear only arises after long sustained periods of price declines, which cause popular consensus to wax exceptionally bearish. On the other end, greed also includes euphoria and complacency. That only grows extreme after large uplegs, when investors universally become very bullish.
As we humans are inherently-emotional creatures who crave acceptance, we easily get caught up in these intense prevailing market emotions at extremes. When an asset is high and adored so everyone is bullish on it, we want to rush to buy it. When an asset is down and out so everyone is bearish on it, we want nothing to do with it. Our natural inclination is to buy popular greed and sell popular fear, which is dead wrong.
Following these warm-and-fuzzy comfortable impulses with everyone else leads to buying high and selling low. That’s obviously not the recipe for investing success, even though it feels really good and accepted at the time. Contrarian investors do just the opposite. They force themselves to buy low when popular fear reigns and it feels terrible, and to later sell high when greed runs rampant and it’s hard to exit.
Most investors buy high and sell low because they fail to understand that markets are forever cyclical, all extremes are self-correcting. Extreme fear and greed can never last for long, they soon burn themselves out. Eventually fear is so great at bottomings that everyone susceptible to being scared into selling has already sold. And greed at toppings is so universal that everyone who wants to buy has already bought.
Once these peak herd emotions are reached, the markets inevitably reverse. Widespread fear is followed by major new uplegs and bull markets, while widespread greed leads to major new corrections and bear markets. Investors who expect universal emotional extremes to persist indefinitely are making linear assumptions in a nonlinear world. That’s a consequence of not having enough knowledge of market cycles.
Market cycles are as inevitable as the calendar-year seasons, which we all understand simply by virtue of experiencing them every year throughout our lives. But since the great market cycles take decades to unfold, most investors don’t perceive them. They are only evident through concerted historical studies, something that takes a lot of effort. It’s far easier for investors to simply succumb to their own emotions.
Contrarian investors acknowledge market cyclicality, and realize that exceptional greed and fear never last as the great sentiment pendulum soon starts swinging back the other way. They understand one of the most important truths about investing. It is always price levels that drive prevailing sentiment, never the other way around. This causality is really important, since its direction greatly affects investing decisions.
Prices that have fallen long and far breed exceptional fear and bearishness, while prices that have rallied long and far create universal greed and bullishness. Since neither extreme is sustainable, the smart investment to make in both cases is the counter-trend one. So contrarians buy low when assets are deeply out of favor and underpriced, to later sell high when they mean revert back into favor and get too expensive.
This is investing’s great struggle, its vexing core paradox. The only ideal time to buy low is after a major price decline when fear and bearishness are ubiquitous. This is very uncomfortable to do, requiring a serious emotional sacrifice. Investors have to fight the crowd to buy assets when they are the most unpopular and therefore underpriced, risking ridicule from their peers. No pain no gain applies here too!
Contrarian investing is exceedingly difficult because it requires us to fight our own inherent emotions. We have to train ourselves to do the exact opposite of what feels good, which is no easier in investing than it is in eating and exercise. Investing success depends on forging ourselves to bet against the crowd, to take the opposite side of popular consensus. That requires suppressing our own greed and fear.
This is really hard to do, a constant ongoing struggle even for hardened contrarian investors with decades of experience. Like being hungry, it never quite feels right or natural. It requires great effort to have our logical brains overrule our emotional hearts. There is often a sense of deep doubt or even dread when investing in deeply-out-of-favor stocks, it’s really a surprisingly-unpleasant experience.
But that’s the sacrifice required to multiply wealth in the stock markets, as the most out-of-favor stocks have the best potential for the greatest gains. They have vast room to run higher as they eventually return to favor and investor demand improves. This is a stark contrast to stocks that are already high, which don’t have much more upside since the great majority of capital inflows they’ll attract are already invested.
So are you a prudent contrarian investor, or a momentum investor hoping for a greater fool? If you are investing in popular stocks that are universally loved after long rallies, you are absolutely buying high. Maybe you can sell higher still in the future to a greater fool, but the odds are really against you. If you feel great when you invest in adored stocks with universally-bullish outlooks, you are not buying low.
The problem today is virtually everything is high thanks to the US Federal Reserve’s extraordinarily-anomalous stock-market levitation since early 2013. Back then the Fed embarked on an unprecedented open-ended quantitative-easing campaign, creating money out of thin air to buy bonds. This forced interest rates to artificial lows, fueling mammoth stock buybacks funded by corporations borrowing aggressively.
Ever since then, the US flagship S&P 500 stock index (SPX) has perfectly mirrored the Fed’s epically-bloated balance sheet. Its growth fueled one of the most extreme bull markets in US history, with the SPX up 215% over 6.2 years as of this month. That dwarfs the average bull market at this stage in stock-market cycles, just a doubling in less than 3 years! This is all thanks to the Fed’s extreme market distortions.
Even more damning, it’s been an astounding 3.7 years since the end of the last 10%+ correction in the SPX! Typically such necessary selloffs to rebalance sentiment unfold about once a year in normal healthy bull markets. The US stock markets are now almost as overextended as they’ve ever been, which suggests they are in the process of topping before a serious selloff. It will likely become a full-blown bear market.
And even worse than these technicals is the sorry fundamental state of the US stock markets. The 500 elite companies of the SPX currently have an average trailing-twelve-month price-to-earnings ratio of 26.0x! The century-plus historical average is 14x, which is fair value. And twice that at 28x is bubble territory, which the stock markets are dangerously close to today. These are extremely expensive stocks!
Another core tenet of contrarian investing as important as markets are forever cyclical is valuations really matter. Stock prices ultimately gravitate to some reasonable multiple of long-term corporate earnings power. And the higher their price-to-earnings ratio, the longer it takes investors to “break even”, or for companies to fully earn back the capital initially invested in that stock. At 14x fair value, this process takes 14 years.
But investors today love many market-darling companies trading above 30x, 50x, and even 100x trailing earnings! It is the height of folly to buy large companies trading at such stellar valuations, as they have virtually no chance of earning back their purchase prices before today’s investors retire. And once companies are already large, the odds of them growing earnings enough to justify high multiples is almost zero.
So today’s euphoric, complacent, Fed-inflated stock markets are a veritable minefield for contrarian investors. There are very few if any opportunities left to buy low after such a long bull market artificially extended by the Federal Reserve’s actions. It’s hard to abstain, because popular consensus assumes this bull still has years left to run. But that’s just the greed talking, these markets look exceedingly toppy here.
Buying low before later selling high demands finding deeply-out-of-favor assets, a herculean task after such a big and anomalous bull market. In order to be cheap, they have to be overlooked, unpopular, and even despised. That can only happen after a major, sustained price decline. That leads to extreme and unsustainable bearishness, to investors assuming these assets are going to keep spiraling lower forever.
As a full-time contrarian speculator and investor, and student of the markets, I search for such unloved opportunities every day. And given the extreme Fed-fueled euphoria that has taken root in these lofty stock markets, the only major overlooked area is the precious metals. Gold, silver, and the stocks of the companies that mine them remain universally despised. Without much investment demand, prices are very low.
But like stock markets, gold is forever cyclical. Its price perpetually flows and ebbs as it regains and loses favor among investors. And today the great sentiment pendulum remains pegged on the fear side, only just starting to swing back towards the opposite end of its arc. Adding to gold’s upside potential is the fact it is one of the very few assets that move contrary to general stock markets. It’s the ultimate hedge.
So as these greedy toppy stock markets inevitably roll over into their next selling cycle, investors are going to start migrating back into gold since it tends to rally when stocks are weak. Investment demand for it rises as a counterbalancing portfolio diversifier. And as gold rallies, so will silver and their miners’ stocks. The whole precious-metals complex is ultimately just a leveraged play on gold’s own fortunes.
The mining stocks in particular have recently been as far out of favor as they’ve ever been, trading at truly fundamentally-absurd levels relative to prevailing gold prices. Some are now trading at P/E ratios under 10x, far cheaper than the broader markets even at today’s low gold prices. As gold recovers, their profits will soar and greatly amplify its gains. That will help catapult gold-stock prices a heck of a lot higher.
It’s never easy buying deeply-out-of-favor stocks, but that’s the inherent struggle in investing that buying low before selling high demands. Don’t buy high-flying popular stocks that feel good, as they’ve already enjoyed the vast majority of their gains. Instead concentrate on what’s left for dead, the ultra-cheap and abandoned opportunities with great potential to literally multiply in the coming years. That’s the key to success!
Unfortunately since it’s so emotionally-hard fighting the crowd, great sources of contrarian information are hard to come by. That’s why I founded Zeal many years ago. We’ve long published acclaimed weekly and monthly newsletters for contrarian speculators and investors. They draw on our exceptional market experience, knowledge, and wisdom forged over decades. They explain what’s going on in the markets, why, and how to trade them with specific stocks. Cultivating a studied contrarian perspective has rarely been more important. Subscribe today, we’re running a 33%-off sale!
The bottom line is becoming a successful investor and multiplying your wealth in the markets requires a great ongoing struggle. In order to buy low then sell high, you have to fight your own emotions to do just the opposite of what you want to do. Buying low is only possible in deeply-out-of-favor assets suffering in universal bearishness. And selling high means fighting greed-filled periods of seductive exuberance.
Since today’s stock markets are near such extreme highs thanks to the Fed’s gross manipulations, there aren’t many buy-low opportunities left. The one major asset class still deeply out of favor with fantastic potential to multiply in the coming years is the precious metals. Fear reigns and they are despised, with most assuming they are doomed to spiral lower forever. But that is exactly the time to buy low, before cycles shift.
Adam Hamilton, CPA
May 29, 2015
So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm
Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
Copyright 2000 - 2015 Zeal LLC (www.ZealLLC.com)
| Digg This Article
-- Published: Friday, 29 May 2015 | E-Mail | Print | Source: GoldSeek.com
