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Fear of a False Factor is Favourable – I (Short Answer)

“More important than predicting the future is understanding what the market thinks will happen.” – Eric Bushell

Have you noticed that almost every day recently the news is about a fear of something new that will not happen?

We have actually had more concerned calls than in 2008. The constant negative news makes it hard for most people to sort out the actual seriousness of the situation.

Here is a short answer and a long answer (part 2 of 2)  to our opinion of what is really going on.

Recent Market Fears

  • U.S. debt ceiling. First there was the issue of increasing the US debt ceiling, the issues in negotiating it, the downgrade of their credit rating, whether the US is able to pay all its debts and the list of deficits (budget, trade, employment, social security, etc.).
  • European debt. Then we went through a series of European countries (Greece, then Spain, then Italy, then France), whether they could pay their debts and whether the European Union will survive. Then came the fear of the “double-dip recession”.
  • Perma-bears. Now the permanent pessimists think they are finally right. There are the permanent gold bugs (“The US dollar will lose its value. The only safe investment is gold or silver.”), people that dislike Americans (saying with glee “The US is finished!”), and the permanently pessimistic “perma-bears” (“It is mathematically impossible for the US to pay its debt”, we will get deflation or hyper-inflation or both, there are government conspiracies, we have run out of oil, etc.).

Oh my God, are we all doomed???

Specifically, is it safe to be invested?

Our opinion: NONE of these things will actually happen.

We have been meeting with a series of our fund managers and pouring over their commentary to help us understand what is really going on. Some have connections to the top finance and government decision-makers and all are very knowledgeable and experienced about the markets. Based on insights from our fund managers and a lot of other reading, here is our opinion about what is really happening.

The Short Answer

1. This is nothing like 2008. The underlying fundamentals are sound. The US has a huge economy with huge powers to collect tax and is easily able to pay its bills. Europeans have a deep drive to maintain the Euro. They are very creative and will support all the countries in the European Union.

The markets are only down roughly 10% year-to-date. Two weeks ago, we had a 4+% drop on Monday and Wednesday, but a 4+% gain on Tuesday and Thursday. The market is confused.

2. The issues in the US and Europe are primarily political issues, not financial issues. The markets have been irrational, fed by rumours and fears, NONE of which we think will happen.

3. The companies in the stock market are in great shape. Everyone seems to have forgotten that we are not investing in the economy or the government – we are investing in companies. Companies have not been this financially sound in decades. Profits of the largest companies are at an all-time high ($100.07/share). Stocks are very cheap (11.52 P/E) and they have tons of cash.

4. Buying opportunity. For long term investors, this is what great buying opportunities look like – overly pessimistic markets combined with very strong company fundamentals. “Be fearful when others are greedy and greedy when others are fearful.”

The current price of stocks is based on what most investors think will happen. There is a buying opportunity when the market is too fearful of things we are confident will not happen.

The long term growth of the stock market will continue to reward those that have faith and patience.

Remember the 4 Fs: Fear of a False Factor is Favourable.  Stay tuned for the long answer.

About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.







19 Comments, Comment or Ping

  1. 1. Steve

    My opinions on Ed’s topics:

    1. Yup, this is definitely not 2008. That market collapse was justified since an enormous amount of monetary momentum was riding on some very risky assets that were bound to deflate eventually.

    This market collapse is based (IMHO) on the slow realization by investors that we are sitting at or near the true intrinsic value of the economy. It will have to grow organically, rather than through the expansion of credit. I expect earning stability and very very slow growth for about 8-10 years. Expect the market to be volatile until investors come to terms with this.

    2. US issues are purely political. They can easily afford to pay their bills now. However they are going downhill, this will become a really serious problem in a couple decades.

    European issues are not purely political (very high unemployment, unsustainable borrowing costs). Several EU countries truly have unsupportable debts and default is eventually inevitable. This slow growth period will probably kill off a few over the next decade.

    3. The companies in the market are in fact in great shape. I wouldn’t recommend buy and hold but dividend investors can own some great companies at prices we haven’t seen for quite a while.

    4. Once again, dividends and the like look great. Buy and hold capital stocks not so good as we enter a stagnant decade.

  2. 2. Connie

    Thanks Ed, for starting the discussion, but I happen to agree with Steve. I don’t see why Germany would want to be a HAVE country and carry all the HAVE-NOTs around.

  3. These are some of the reasons I am sticking with my asset allocation. I will review the allocation in December like I always do.

  4. 4. Samuel

    I agree, although prices may dip a bit lower – a great buying opportunity.

  5. 5. SST

    With respect, I’ll disagree on all points.

  6. SST, can you elaborate a little? I’m interested in hearing your thoughts.

  7. 7. Ivan

    Fundamentals are strong?
    - US unemployment is still above 9%
    - First time unemployment insurance claims are holding stable above 400,000 (and growing since 2008)
    - All time high the length of time required for average unemployed person to find a job (40 weeks or something)
    - US debt is all time high and growing fast (so much for US “able to pay it’s bills”)
    - All time high percent of population on food stamps in US
    - Baby boomers retiring -> falling percent of people in work force

    US economy is weak, never recovered from 2008, QE1 and QE2 gave only an illusion of recovery. Once US economy tanks, Canada will also feel the pain, nobody will buy our stuff. The only solution for US now is to create more and more money to pay it’s debt basically devaluing the dollar and causing inflation. This is why gold is in all time high -> people and countries are trying to protect their purchasing power.

  8. 8. Ed Rempel

    Hi Steve,

    Stay tuned for the Long Answer article on Monday. It will have a lot more explanations.

    Regarding your specific comments, here are a few thoughts you may want to consider.

    First, what do you mean by “the true intrinsic value of the economy”? I’m curious how you calculate that.

    “Intrinsic value” normally refers to investments. Believe it or not, the economy and the stock market are not correlated – either short term or long term. In fact, they are slightly negatively correlated. So, even if the economy grows at 2% for the next 8-10 years, as you are predicting, that might be positive for the stock market. Germany has grown about 2%/year for the last 50 years vs. about 4% for the US, but Germany’s stock market has done better. China has both the fastest growing economy and the worst stock market of all industrialized countries in the last century.

    8-10 years for an economy is a very long time. That sounds more like the last decade than the next decade.

    We expect there to be a normal recovery for the US, although a bit slower (perhaps another year or 2). Our view is that the US went through a normal recession combined with a few bubbles popping. There is some deleveraging happening that is mostly done, but otherwise there should be a normal recovery. Unemployment normally takes 1-2 years to get back to normal, but this time there the construction industry is slow as well, so it will take a bit longer to recover.

    The US is going through an interesting time. They may be in trouble in 20 years – if they do nothing. However, we don’t think their politicians will take that long to stop posturing.

    We don’t share the same pessimism about the US. Predicting the future involves much more than just projecting the present. Many things will change. The leading economy of the next decade will likely depend on new innovations. The US is still the most innovative country in the world, so the next economy-leading technology might be discovered by them.

    We think Europe might well end up with a Eurobond, which would solve the “crisis”. They could, for example, allow each country to issue Eurobonds equal to 60% of the GDP. These bonds would have a high rating just because of Germany. Germany is claiming they are against a Eurobond now as part of their negotiation with weaker countries. They want other countries to agree to limit the spending of their governments permanently, as was the intent of the European Union. Of course the governments of the weaker countries oppose this because it would reduce the power of their governments.

    That is part of the political negotiation going on. Hopefully, eventually Europe will have to go with full economic union, which would solve not only the debt issues, but the other economic issues in Europe. Much of the employment problems relate to ridiculous laws making it extremely difficult to fire bad employees. A full union would likely result in these laws being cancelled. Also, if unemployed people in Greece or Portugal would easily move to the available jobs in Germany or France, then unemployment would also immediately be reduced.

    Your comments about growth and dividend companies are probably true, but future growth may be the opposite of what you think. The most important factor in evaluating stocks is to understand what the market expects to happen.

    Right now, dividend stocks are talked about everywhere as being the best long term investments (generally true) and defensive because of the dividend. How much of this is built into current prices of dividend stocks? In general, dividend stocks do better after strong bull markets, when they tend to underperform and tend to be undervalued. And they tend to be overvalued after bear markets when they tend to protect value.

    In general, dividend stocks outperform long term because they are out of favour and cheap most of the time. About 75% of the time, stock markets are in bull markets, and dividend stocks generally underperform in bull markets.

    In other words, you are probably right about dividend stocks, except that the market is really over-hyped in all types of income investments, especially dividend stocks, so the positive qualities of dividend stocks may be more than 100% built into current prices – which would mean they could underperform going forward.

    Our fund managers are telling us that growth stocks in general, especially many tech stocks, are hugely undervalued. Expectation for them are very low and investors have been shying away from them for a decade. As the current bull market (which started in March 2009) continues, growth stocks may well be the best place to be.

    Ed

  9. 9. Ed Rempel

    Hi Connie,

    There will be more info in Monday’s “Long Answer” article, but in short, on this side of the Atlantic, we do not understand the deep, 60-year commitment of Europeans to the EU. The extreme nationalism that cause the 2 World Wars taught them they need to work together. They also know that all the borders have been a massive drag on growth and living standards in Europe.

    Germany has benefited hugely by the Eurozone. Usually strong manufacturing results in your currency going up, which cuts into your manufacturing. That is the normal, self-balancing process. However, with the Euro, their manufacturing has been staying strong as the Euro falls.

    In short, there is no way that they will let the EU fall apart.

    Germany could solve Europe’s problems by writing one big cheque for about $1 trillion now or by agreeing to be part of Eurobonds. The Eurobond is probably what they will end up with. It would solve the problem and be the next step in full union, which is where we think Europe will eventually realize it must go.

    Germany will likely not agree to Eurobonds until the weaker countries agree to strict limitations on their spending. This is the political issue that needs to be solved to fix Europe’s “financial” problems.

    Ed

  10. 10. Steve

    Hi Ed,

    Thanks for the detailed response. Looking forward to Monday.

    1) To answer your question on what I meant by “intrinsic value of the economy”, it’s one of my armchair investor terms.

    Specifically, the spending in the economy that is driven by after tax, non-leveraged earnings by both individuals and companies is what I consider the intrinsic core. Many people (and companies) supplement their spending with credit, and if leveraging investments that produce income, you have leveraged income to further supplement spending and economic activity.

    2) Regarding the stock market and the economy being negatively correlated, this only applies to your stock holdings if you buy the market. So the correlation between the investments someone buys, and the economy can be very different than the market.

    In my example, I mostly invest in large cap companies with healthy dividends who’s prices moves primarily with earnings.

    So in my particular case, the market value of my investments is nearly 100% correlated with the economies (sectors) which my investments operate in.

    3) In summary, it is my opinion that the overall market is entering a period where intrinsic value is the driver, not growth or speculalion. I’m not saying it does this all the time (see how I dodged those 80 year studies there?) When it is unclear where new growth will come from in an already weak environment, then prices can fall back to intrinsics.

  11. 11. Jungle

    Ed, I’m not sure if you could say 100% that “dividend stocks” have priced in the fact that they COULD be all the flavor right now.

    We’ve seen some great deals and on some big companies trading at discount prices that do not really reflect the companies true price. In other words, there is some value because the stock market is being irrational for two reasons: Investors over reacting to the latest news and alithogram computer programs selling huge amounts of shares, causing great volatile (swings) in the markets. When the whole index plummets up and down 5% due to volume, great companies are dragged down creating some buying opportunities: i.e. large cap dividend stocks with great balance sheets.

  12. 12. Ed Rempel

    Hi Jungle,

    Are you saying you were able to successfully take advantage of the 4% daily up and down moves 2 weeks ago? Good for you if you were!

    Dividend stocks, in general, are relatively cheap today, but the entire stock market is very cheap.

    Our thinking is that dividends are just one of many important things to consider in evaluating stocks. Even more important factors include earnings growth, growth potential, quality of management, insider ownership and purchases/sales of shares, being underpriced by the market, having assets the market is not aware of, and knowing important things about the company that nobody else knows.

    If you focus just on dividend-paying stocks, you can miss most of the best opportunities. Right now, a few of our fund managers are telling us of companies around the world that are growing their profits by more than 30%/year, are priced at a P/E of 8%, have zero debt and very strong management. No dividend – but amazing fundamentals!

    We are told there are lots of companies around the world with exceptional fundamentals like these selling at great prices.

    Ed

  13. 13. Jean

    In regards to the 3rd point, thats what I love. I am big on sticking to the basics when investing. I am all about looking at each individual company, and looking at their balance sheet, future cash flow projections, and just good old fashioned fundamentals of any company. Sure there is alot of fear out there and uncertainty but nothing gives a better financial picture than a balance sheet of the individual companies, and not the government like you are saying.

    -Jean

  14. 14. Jungle

    Unless the market keeps dropping then yes, we took advantage of buying some great companies. It was a little gut wrenching putting 20k in the stock market. If the market drops further, we’ll just add to positions.

  15. 15. Ed Rempel

    Hi Jean,

    Great comment. Very insightful.

    The issues in the economy and politics come and go. But sit down and analyze company balance sheets and income statements. Lots of companies are in amazing shape – profits growing strongly, low debt, lots of cash, their sales forecasts are strong and you can buy them at very low prices.

    P/Es of 11.7% while interest rates are so low? Flip P/E over and you get E/P, which is known as “earning yield”. It is about 8%, which means companies on average are earning profits after tax of 8% of their total shares. Investors can generally expect to make this return over time from a combination of share price growth, dividends or share buybacks. This 8% is average (so many companies are far higher), after corporate tax, and growing – so investors’ returns should include projections of growing profits.

    On average, bond yields are 2-3% (and not growing), while stock market yields are 8% and growing strongly. This difference is huge by historical standards!

    This high earnings yield results from low stock prices that result from all the overdone pessimism and fear out there.

    That is what will eventually drive higher stock prices – regardless of what happens in the economy or politics.

    Ed

  16. 16. Jean

    Yup Thanks Ed! And you are exactly spot on with your P/E analysis I am a recent finance graduate, in fact I graduated May of this year. I still have not yet gotten into the real job market yet. Gonna be going through some more schooling as I feel I need to learn more before I enter the job market. Anyways, what boggles my mind is how sound financial analysts allow themselves to be driven by fear and emotions. With all the proof out there, with companies with solid balance sheets, its kind of mind boggling that alot of stocks would tank over other market fears. I guess I haven’t fully learned the ropes yet on how exactly Wall Street works.

    Going to read your long version next.

    -Jean

  17. I’ve been backing up the truck a bit over the past month and making positions – particularly in dividend-paying stocks.

    I’ve been on the hunt for bargains, and despite recent events that have sparked fear into the markets (debt ceiling, issues in Europe, and slow US growth), I am cautiously optimistic with the state of affairs in the markets.

    If you look at the TSX, we are nowhere near the levels from 2008-09, let alone the low of 7,590 we witnessed in 2009.

    As long as I take a diversified approach with my overall portfolio, I’m never overly worried about the markets.

    Nice post!

  18. 18. Ed Rempel

    Hi Jean,

    Great comment. I understand your confusion over how many investors and even sound financial analysts can get carried away by the fear in the markets today.

    Let me put some perspective on it. There is nothing wrong with what you learned in your finance courses. The part of real life investing you need to understand is marketing.

    Most of the investment industry is about selling products. There are some parts that are focused on effective investing, but they take some looking around to find.

    Most fund managers are more motivated by keeping their job and growing their fund, then investing excellence. They try to own large, well-known popular companies in their top 10 that is published and tend to have allocations similar to the market. We call them “closet indexers”. The risk is underperforming. It is generally okay to lose money when everyone else is. The saying among fund managers is: “It is better to fail conventionally, then to succeed unconventionally.”

    The news media is focused on selling their news, which is why they over-emphasize stories. This starts the public focusing on these stories.

    Most of what you read on the internet and the investment industry marketing to DIYers is mostly focused on getting business or promoting more transactions. Therefore, they talk mostly about popular stocks, create computer over-simplified tools and encourage changing portfolios based on the news. Again there is hardly any real analysis anywhere.

    Analysts usually work for a fund company or a bank. They do in-depth analysis, but can often get promoted more easily if they promote stocks that their bosses will want to promote. Again, these would be popular stocks, stocks in the news, or large “safe” stocks.

    Most of the industry doesn’t look at real analysis and is just focused on marketing investments to the public, but the analysis you do is what drives the market long term and is what helps make quality investments.

    In your courses, you assume that everyone is looking for quality research and the best possible investments. To understand real life, you need learn to tell the difference between those that are focused on marketing and the quality investors.

    We call it the difference between the business of investing and the profession of investing.

    We need more people in the industry committed to excellence in investing. So don’t be discouraged and keep studying.

    Another suggestion is to read “There is always something to do” by Peter Cundill. He was clearly one of Canada’s best ever investors. His book is quite inspiring and shows the huge difference that quality analysis can make.

    Ed

  19. 19. Jean

    Thanks Ed! For that really insightful and thorough reply back. Thats the thing, we mainly learn to work by the ‘books’, more of what you would expect from college. I guess I still need a little bit of ‘green’ so to speak in me. I do wish they prepared us more for the real world instead of just doing the books and learning from the theoretical standpoint. Thank you for the book recommendation, will have to check it out for sure!

    -Jean

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