AN INCONVENIENT TRUTH: EXPENSIVE PRICES + POOR FUNDAMENTALS = DISASTER

When we made the decision to use ETF’s instead of value stocks in our October 25 Value Alert newsletter, it was a decision based on practicalities. Value stocks have simply stopped working as the bull market has matured. However, we now feel that the entire market is reaching valuations that may be closing in on obscene. Here’s why…

When the October 25, 2015 newsletter (in which we lamented the overvalued conditions) was published, we commented that the S&P 500 P/E ratio was at 18.23 and the Russell 2000 P/E ratio was at 71.7. The average P/E ratio for the S&P 500 since the 1870′s has been about 15.5, so the S&P 500 was slightly elevated two weeks ago. Data for the Russell 2000 is not as readily available, but according to Russell Investments, which introduced the indices in 1984: “The average P/E of the Russell 2000 since 1998 has been approximately 17.0, vs. 13.5 during the period (from 1984 to) 1998.” Therefore, the Russell was extremely overvalued two weeks ago. But now, it has a valuation that is jaw-dropping.

In writing today’s article, I just checked in with the Wall Street Journal Market Data Center to get an update. The S&P 500 P/E ratio is now significantly higher at 23.41, and the Russell 2000 P/E ratio is at a mind-boggling 188.46. Check for yourself.

EARNINGS AND REVENUE RECESSION CONTINUES

Those incredibly high prices are accompanying declining revenues and profits, a trend that we have discussed several times in previous newsletters.

In the current earnings reporting period, nearly one-third of S&P 500 corporations have reported earnings and revenue from the third quarter. With 147 companies reporting so far, profits are down -0.6% and sales are down -2.7% from a year earlier.

151108_declining_revenues_and_earnings_smIt seems logical that several quarters of contraction in earnings and revenue would have weakened stocks. After all, if robust sales and healthy profits are the primary drivers behind price appreciation for publicly traded companies, shouldn’t diminishing sales and dwindling profits lead to price drops for publicly traded corporations?

Welcome to the bizarre world of central-bank planning, worldwide stimulus, and currency wars in a race to the bottom. Despite the plummetting fundamentals, the S&P 500 is within 2% of its all-time high and the Nasdaq 100 set a new all-time high last week. And, of course, the Russell 2000 has the highest PE ratio ever recorded!

22 Biases That Will Cause You To Lose Money When Investing

Seventy-five years ago, Benjamin Graham identified the value approach to investing in the books Security Analysis and The Intelligent Investor.  In that time, the value approach created many billionaires and one mega-billionaire (Warren Buffett). However, even with its widespread adoption, the ubiquitous growth of computing power and plethora of freely available financial data, value investing continues to show significant outperformance of the market.

What could cause this advantage to persist when the value approach seems so established and well-worn?  The advantage persists for the same reason that existed when Graham first identified the opportunity: human beings behave irrationally.  While the tools to identify value have progressed dramatically, the human mind has not.  We are all prone to the classic (and very expensive) human biases that have been with us since our predecessors emerged from the caves.

Here are the top 22 biases that can destroy your portfolio (see how many you can personally check off):

1) Denial:  Once locked in, irrational investors hate admitting they’ve made a wrong decision. It’s an ego thing.   So they hang on to losers, even refuse to sell losers. Alternatively, it means you are not as smart as you thought.  Regardless of what it means to you, it is a losing proposition.

2) Attachment:  You fall in love with “special” stocks. You exaggerate virtues, downplay problems and then hold on too long.

3) Extremism bias:  Irrational investors have trouble assessing risk, often bet big, and lose big.  Probable events become inevitable. Unlikely events become impossible. So you are likely to miscalculate your risks.

4) Anchors:  In your mind you tend lock in price targets, like a $100 stock or Dow 18,000, then minimize any data that suggests you’re wrong.

5) Ownership bias:  Once purchased, you value what’s yours even higher, like overvaluing your home.  That blinds you to the real value, adds to your losses.

6) Herd mentality:  For all the talk about macho individuality, the truth is most investors do not think for themselves and tend to follow the crowd, or blindly track some trend.

7) Getting-even bias: You lose, then you try to break even taking extra risk, doubling-down. You get overanxious, overreact, and you lose more.

8) Small-numbers bias:  Making decisions on limited data that’s incomplete and likely exaggerated.

9) Loss aversion:  Many cautious people tend to avoid losses more than seek gains.  That fear keeps investors out of the market too long and in “safe” investments such as Treasury bonds or money market accounts.

10) Pride:  You hate selling losers, hate admitting error.

11) Risk averse:  You take too little risk after a big loss or a losing streak, get too conservative, don’t trust yourself and miss opportunities for higher returns.

12) Myopic bias:  You think recent data is more important than older information. So you may pull back after a losing streak, or ride a winning streak till you lose it.

13) Cognitive dissonance:  You filter out bad news and tend to ignore and discard new information that conflicts with your biases, preconceptions, and belief system.

14) Bandwagon:  You disregard fundamentals.  You think you understand “momentum.”  You conclude that “so many” followers cannot possibly be wrong.

15) Confirmation:  You’re not only critical of any news that contradicts your beliefs, you blindly accept any data that confirms expectations.

16) Rationalization:  You are super-logical and can marshal lots of evidence to back up whatever you first decide to buy, even if it’s based on limited logic and data.

17) Anchoring bias:  You rely too much on readily available data, just because it’s available, even when you know it could be faulty.

18) House money:  You treat winnings as if they belong to the house or casino.  Then you take bigger risks, giving it all back, and then some.

19) Disposition effect:   You tend to lock in gains and hang onto losses, selling shares in an upward-trending market, hanging onto losers too long, similar to loss aversion.

20) Outcome bias:  You judge your decisions on results rather than the context when you made the decision.   That’ll result in misleading you the next time.

21) Sunk-costs bias: You treat money already invested in a stock as more valuable than future opportunities, so you often hang on rather than sell and reinvest.

22) Perfect behavioral storm:  Separately, each bias is bad enough.  Combined, they become bubbles, set you up and wipe you out.  Either way, financial ‘experts’ can easily manipulate you into what they want, blowing bubbles and popping them without you ever knowing what’s happening … manipulating you like a mindless puppet.

OK, you probably have a rough idea of how many of these biases with which you identify.   For example, let’s say you estimate that out of this list of 22 known investors biases, you’ve irrationally made investment decisions based on just five of these bad habits and biases.  That is far more than enough to explain the times when you lost significant money while investing.  The point is that there are many, many ways in which the subconscious, emotional aspect of your human brain can trick you into making mistakes in your investment approach that cause you to lose money.

What’s the solution?  In the words of Warren Buffet, America’s value investor extraordinaire, “An investor will succeed by coupling good business judgement with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.”

IntelligentValue.com provides you with business judgment based on 30+ years of equity analysis and portfolio management, insulating you from mistakes rooted in the biases listed above.   We’ll provide detailed stock selection based on quantitative analysis that identifies the best investment opportunities and combine that with rules-based market-risk analysis to avoid the worst return-destroying drawdowns.

Get a Free15-day Trial and a 100% Satisfaction Guarantee at IntellgientValue.com/subscribe.htm (please check to see if memberships are currently available).