The stock market wakes up to global risk

Surprisingly–to me, at least–the market has finally woken up to global economic risks.

The signs were there before: commodity prices tanking, emerging markets in heavy decline, state interventions in Greece and China, accusations of broad corruption in places like Brazil.

The question investors will be asking themselves over the weekend is: is this the beginning of a bear market or just a brief pullback to be bought into?

I’ll spoil the suspense: no one knows. Only in hindsight is it clear when bear markets begin versus temporary pullbacks.

What I do know is that a significant pullback or a bigger bear market are both opportunities for investors. During such times, psychology takes over as some people panic, and that means something is being sold too cheaply.

To benefit from such situations, the goal is not to pick the absolute bottom in the stock market or a particular stock, but to know what specific securities are worth–after arduous research–and then to buy accordingly.

When people ask me if such pullbacks scare me, I always say “No!”  Such times are great opportunities to benefit from the panic of others.

In other words, I’m excited to go shopping.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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The stock market wakes up to global risk

China and Greece: sound and fury signifying nothing?

Just a couple of weeks ago, you couldn’t look at the news without seeing dire predictions about Greece leaving the European Union or China’s stock market tanking. Now, it seems like these perils have passed and there’s nothing to worry about. That’s unlikely the case.

I’m an optimist by nature, and I tend to think things will work out in the long run. That does not, however, make me a Pollyanna. I don’t think that problems in Greece or China are the end of the world. But, I also think it’s naive to think that such issues were insubstantial and likely to fade with so little hardship.

Greece still can’t pay back its loans, and they are still demonstrating little desire to reform. European lenders still want their loans repaid, and seem unlikely to grant Greece forgiveness for large amounts of debt. In other words, the situation hasn’t really changed, and therefore still requires careful observation.

China’s stock market did not tank because of some bizarre conspiracy. Like all markets that have been artificially pumped up, it must necessarily deflate. Any attempts to defy that natural process are doomed to fail one way or the other. The underlying issue of China’s economy slowing down has not changed. The political and economic consequences are non-trivial and demand watching.

Markets have a natural ebb and flow, just like nature. And, just like nature, those ebbs and flows are largely unpredictable over the short term. That doesn’t mean you can’t see broader themes evolving. It was easy to see that the tech bubble of the late 1990’s would pop, but impossible to predict when. It was easy to see that the housing market of the mid 2000’s would burst, but impossible to predict precisely when.

Greece and China have real problems that will eventually reverberate throughout the global economy. I don’t know precisely when these issues will loom large, but I do know they haven’t been resolved. This is not a good time to ignore those risks.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

China and Greece: sound and fury signifying nothing?

China: more important than Greece

While most of the world was overly focused on Greece, bigger things were afoot in China.

First, the Chinese economy is the 2nd largest in the world. What happens in China matters for the world economy. In contrast, Greece’s economy is but 2% of the European economy. Although Greece’s problems are likely to become broader problems in Portugal, Spain, Italy and France, by itself Greece doesn’t have a big impact on the world economy.

Second, China’s economy is still essentially run by a communist central planning authority. They are giving some free market principles a try, but they have maintained a firm grip on the most important things. How they react to the inevitable ups and downs any economy faces is important for understanding how the world economy will do in coming years and decades.

Over the last year, the Chinese government has been showing they aren’t ready for prime time. First, they have reacted to economic slowing–inevitable in any economic system, whether capitalistic, communistic, socialistic, etc.–with attempts to prop things up. As usual, such attempts look good in the short term but fail over time. Governments just aren’t any good at allocating capital.

Second, they are misreading market reactions and have basically lost their cool. After trying to use free markets to boost their economy, they are now trying to prevent markets from clearing by forcing large stockholders to hold instead of selling. There is nothing that spooks markets more than a government’s attempts to force the outcome they want instead of the natural equilibrium that would otherwise exist.

This a classic reversal of cause and effect. Stock markets, like all markets, react to news by adjusting prices to make supply and demand match at market clearing prices. Any attempt to prevent that mechanism from operating in the short term leads to disastrous effects in the long run. Markets are effects, not causes, contrary to how many politicians and historians like to interpret the facts.

The more the Chinese government continues to overreact and try controlling outcomes, the more world markets will overreact as a result. Such impacts will be much worse than letting markets find equilibrium. Just witness commodity price swings in reaction to Chinese intervention and you can get a flavor for how nasty things can get. 

I think what is going on in China should be watched much more closely than what is happening in Greece. The stakes and consequences are much greater.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

China: more important than Greece

The stock market could jump up or tank this summer, be prepared

Will the market drop this summer? Does it matter? Yes, and no.

The hardest thing about investing is dealing with emotional swings. People really want the market to go up and never go down, but wishing won’t make it so.

These emotional swings lead people to make big mistakes. Many sold in 2008-2009 and haven’t gotten re-invested. The opportunity cost of that is HUGE.

It’s better just to start with the premise that the market can go up 100% and down 50% (as Benjamin Graham suggested decades ago). Just accept that now because it has throughout recorded history.

If you are rattled by that prospect, then you don’t belong in the game (and you’ll have to save roughly three times more money per year to reach the same goal as someone who is investing in stocks).

If you invest, you must be prepared for such swings, even though that is tough to do.

Could the market tank this summer? Yes. Will it? No one knows. If it does, you need to be emotionally prepared to handle a drop.

Could the market continue marching up and double over the next 7 years? Sure. Will it? No one knows, so just be prepared.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The stock market could jump up or tank this summer, be prepared

What do you do when price goes down?

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When you buy a new car and drive it off the lot, the price others would pay for it goes down that instant. In fact, on average, the market price of a new car declines 20% in the first year. How do you react to that?

Did you make a mistake in buying? Did you think about that price drop ahead of time? Would you feel better or worse if you had daily, monthly, quarterly or annual price quotes on  your purchase?

These questions are not idle chatter, because any investment you make will decline in market price at some point in time. If you respond rationally to that decline, you’ll get very satisfactory results over time. If you don’t, you’ll be your own worst enemy.

Every investment rises and falls in price over time. Go ahead and accept that right now. Cash fluctuates with inflation and deflation; bonds fluctuate with interest rates; commodities fluctuate with supply and demand; stocks fluctuate with all the above and more. It’s a fact of life.

If you expect fluctuations to occur, you can react prudently to market price–benefiting from volatility. If you hope your investments will only go up in price, you’ll panic and sell at the wrong time. That will lead to lousy results.

Acknowledge it right now: whatever you buy will fall in price at some point in time. You should be prepared, specifically, to see any stock you buy both drop by half and double over time. How can you possibly sleep at night or react prudently to such an acknowledgement? By clearly understanding the difference between market price and underlying value.

As Warren Buffett put it, price is what you pay and value is what you get. Let me modify that statement a little: market price is the amount you’d pay or receive if you had to buy or sell RIGHT NOW! If you don’t have to buy or sell right now, market price should not be your main focus.

Market price is the intersection of the price a seller is willing to sell and the price a buyer is willing to buy. If the seller is panicking, they are likely to take a lower price. If the seller is euphoric, they’re likely to want a higher price. When sellers and buyers agree to make a transaction, that’s market price.

But, what if particular buyers and sellers aren’t knowledgeable or rational. What if they are panicking like they did in early 2009, or overly euphoric about technology stocks like they were in early 2000? In those cases, market price may not be a very good indication of underlying value.

Market price tends to depend on who is doing the selling and buying at any point in time. If the people you are selling to or buying from are sober-minded, intelligent, knowledgeable, then market price and value are likely very similar. If not, then not.

Underlying value is the value to someone sober-minded, intelligent, knowledgeable. Think about someone who has been in an industry for 30 years, who knows and understands suppliers and buyers, who grasps the full context of where the industry has been and is going, who knows growth rates, input prices, distributors, shipping costs, financing rates, the competition, etc.

When that expert looks at a business, they don’t think about market price, they think about dividends, returns on investment, cash needs, industry dynamics, and they think about it over the long term. When an expert comes up with what a business is worth, that assessment is based all the relevant information available at the time, and will much more accurately reflect the long range value of the business. Unlike Wall Street analysts and most investors, an expert isn’t thinking about market price in 6 months or 6 seconds, they are thinking about customers, buildings, factories, raw materials, long term contracts.

To successfully invest, you need to focus on underlying value instead of market price. Market price then becomes your servant instead of your master. If buyers and sellers are scared, you may want to buy from them. If they are euphoric, you may want to sell to them. At all other times, you look at their price quotes like a disinterested shopper. You aren’t forced to buy or sell and aren’t swayed by the crowd’s frequent price quotes and dramatically shifting opinions.

This is the key to successful investing. If you need to buy and sell right away, market price is your guide, and you’re likely get a poor deal. If you don’t need to buy and sell, then you should feel free to focus on underlying value first and market price second.

In this way, you benefit from swings in the market. If you focus on what the expert does: long term cash flows, industry dynamics, underlying asset values, etc., you can easily take or leave market prices. Then you can buy assets cheap and sell them expensive, and you’ll get very nice returns.

But, if you focus primarily on market prices, you’ll panic when price drops and sell at the bottom, or become euphoric as prices climb and buy at the top. That’s what most people do in the stock market, and that’s why they get lousy results.

Next time the price of something you own drops, ask yourself if you are focused on market price or underlying value. If the truth is that you don’t know anything about the underlying value of what you own, you shouldn’t be investing your own money. If you are focused on underlying value, ask yourself if you would be panicking if you owned the whole business. It is, after all, a portion of the business that you own. 

Yes, the future may not look as good as the past. Yes, competitors or the economic cycle may be making things difficult, but did the value of your buildings, factories, inventory, cash and future cash flows really drop by 30% just because reported earnings missed Wall Street’s forecast by 5%? 

If no, then it’s probably time to buy more of the business. If yes, then take a week or month to think about and review all the relevant data, and wait until your emotions have simmered down. In the cold light of full analysis, you may decide the business isn’t as bad off as others think. Or, you may decide it really is doomed and you should sell. Wait until you’re sober-minded to do so.

Make market price your servant, not your master. Focus on underlying value. Your net worth will reflect this choice over time.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What do you do when price goes down?

Unsurprising drop

The stock market was down 2.5% on its first trading day of June. This follows a decline of 6.8% in May, leaving stocks down 10.2% since its high of April this year, and down 18.9% since the high of October 2007. This seems to have surprised, and even shocked, many investors.

When asked what the stock market would do, J.P. Morgan famously said, “It will fluctuate.” Benjamin Graham told investors (in his book The Intelligent Investor) to resign themselves in advance “to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent of one-third or more from their high point at various periods.”

In other words, the stock market is a roller coaster, and investors should anticipate and even expect frequent stomach-churning drops and thrilling climbs along the way. These drops are not a sign of something unusual and dreaded, but something expected and even eagerly anticipated. Why? Because drops lead to opportunity as merchandise that cost $100 a few days ago is now on sale for less (sometimes, much less).

As I pointed out in my posts, Better than zero and “Where’s the market going next year?”, the math underlying expected future returns should have warned investors to anticipate drops. And, as I expressed in my post, All eyes on China, news of slowing growth from China would likely lead markets lower, and it has.

I think investors were surprised because they don’t think of the stock market as a roller coaster, or they try too hard to relish the climbs and forget the inevitable drops. Perhaps they also suffer from myopia, attending to recent company reports and economic news instead of thinking about longer term data. 

Nevertheless, drops will happen, and they should be exploited instead of feared. Lower prices mean higher future returns–clearly a good thing. Panicky investors that sell as the market drops benefit longer term investors that buy from them. I’m not saying the drops won’t pull at your stomach–they will. What I’m saying is drops are to be expected and wise investors will have the courage to act as the market drops to exploit short-term oriented investors.

I’m not panicking as my portfolio drops, but lining up my buy list and making purchases as the market sinks. The more it sinks, the more I’ll buy. Just like riding a roller coaster, I look forward to the plunges and climbs, because that’s the nature of the beast.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Unsurprising drop

Growing potential energy

They say patience is a virtue.  That doesn’t mean it’s a whole lot of fun.

Sometimes, I feel like Bill Murray in Groundhog Day, waking up to the same day each and every day and wishing the cycle would end.  Each day, I research individual companies with a focus on businesses with competitive advantages and good management selling at low prices.  On rare days, when prices deviate enough from fundamentals to merit action, I do some buying and selling.  And yet, the cheap companies keep getting cheaper and the expensive ones just get more expensive.  I’m waiting patiently for this cycle to end, but it’s not much fun. 

Unlike Bill in the movie, I’m not trying anything radical to break out of the cycle.  As Bill eventually discovers, the cycle ends not from bold or wild action, but from doing the right things.  The cycle of the cheap getting cheaper and expensive getting more expensive will end, too.  I just need to stay true to my purpose.

So, what allows me to maintain patience?  Just like I know virtue leads to happiness and diet and exercise lead to weight loss, I know that buying cheap and selling expensive works over time.  Added to this, I understand the concept of growing potential energy. 

Potential energy is the result of a force acting on an object over time.  When a spring is compressed, it has a lot of potential energy.  That potential energy is eventually turned into kinetic energy when the spring is released. 

The force, in this case, is crowd momentum causing the expensive to get more expensive.  That force, applied over time, is compressing a metaphorical spring, conversely making the cheap become cheaper.  That very process, though, leads to its own resolution.  Because the system is not in equilibrium, the longer and further the spring is compressed, the more dramatic the eventual release of kinetic energy when the spring’s potential energy is transformed.

I have to be patient because no one knows how long crowd momentum will compress the spring (6 years and running, so far).  But, knowing that the spring is just getting more and more compressed, creating a growing reserve of potential energy, makes it easier to be patient.  I know that the longer the spring is compressed, the greater the reward–the release of kinetic energy–once momentum runs its course.

Or, as 17th century philosopher Spinoza put it, all things excellent are as difficult as they are rare.  I’m feeling keenly the difficult and rare part, in time I will gain the excellence as well.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Growing potential energy