Posts Tagged ‘colorado springs’

Lost in the froth of the recent market is the fundamental truth of why anyone buys stocks in the first place. In investing, you are buying a future stream of earnings. So, if you buy a one year CD at the bank that pays 2% interest, you are investing in an extremely low risk choice that has a 2% future stream of earnings. The reason stocks historically have higher returns on investment is that they involve more risk (i.e. you expect a larger future stream of earnings from stocks because you are accepting a far greater degree of risk than in a CD, a US Treasury Bond, or a corporate bond). So, you make a rational decision to invest in a stock because you believe the risk you are taking is justified by the higher expected return.

At the turn of the new millennium, stocks were priced extremely high compared to historic norms. The return, not surprisingly, has been pathetic so far this decade. We have had a secular bear market and investors would have been better off choosing almost any other investment vehicle for the past 9 years. Commodities and gold have led the way, offering an excellent return on investment during this period. The low return on equities makes perfect sense by fundamental standards.

We believe that this fundamental truth has been lost on investors and that we are at a crossroads. The highest quality stocks are priced near historic norms and we believe you can make the case that owning them going forward is a rational decision. You stand to receive a larger income stream on your investment than in safer instruments. According to the Wall Street Journal, the Russell 2000 stocks (an unmanaged index of smaller companies) has an expected Price to Earnings ratio of 55 as of this morning. So, if everything goes well (no small feat in this economy), an investor should reap an earnings stream of less than 2% for the next year from investments in the Russell 2000 stocks. Why would an investor make the choice to buy these stocks at this time with a lower stream of income than in any other investment? We believe another wave of punishment will arrive for those who choose to ignore the fundamental fact that these companies are not currently a prudent investment. Perhaps then investors will come to grips with the fact that buying stocks is a rational decision based on the choices that exist when you make an investment choice.

We enter another week beginning with a stupendous market rise. With more and more experts sounding words of caution on this market, the bulls seem to respond ever more resolutely by moving the market to new highs. We have seen this movie before. We don’t know when it will end, but we know it is not a happy ending. We need the financial equivalent of the term “post 9/11”. Have we really learned nothing? Isn’t the value of a stock determined by what the return on your investment is likely to be? Once again, the riskiest stocks seem to have the lowest return on your investment going forward, but are the stocks that are rising the fastest.

I understand taking risks when they make sense. For instance, investing in emerging markets makes sense because these economies are likely to have much faster growth over the coming years. So, the risk you take may be rewarded by larger returns than safer investments. Small, financially less stable U.S. companies do not fit this profile. As a group, they are more likely to be losers moving forward than their higher quality counterparts (who have cash to fund operations and growth) and there is no proof that they are about to enter a period of strong growth.

Investors should approach this market with great caution. They should let their gains ride, but with a very short chain from here. Capture profits and limit losses as we move forward in an overheated market. Live to fight another day by remembering we are in a “post 2000” market.