Over the last couple of months I have been increasingly interested in the stock market and I have also thus far been quite vocally bullish of it. Before you judge me, I would like to remind that back when the S&P 500 was @ 1300 we were calling for S&P above 2k and we were getting laughed at. Now, I will admit that I am fairly sure that we are in the very last phase of this bull market but I think we need one more push higher. We are seeing a lot of reports from stock brokers on the record amount of accounts being opened, the record low amount of cash being held into accounts and this for me is a sign of the last phase of the bull market, not that it is ending here and now.
Last couple of days I have been re-reading “The Intelligent Investor” by Graham and while I most certainly don’t agree with his views on Technical Analysis and Trading, the book is in my opinion by far the best on Investing. I remember first reading the book when I was around 21 and being completely entrenched by the desire to become an investor a desire that holds true up to this day. I have always enjoyed the idea of owning portions of business I love, especially because I have always had interest in such a vast amount of different industries. I also remember the vigor with which I went through the book trying to absorb every single paragraph of it into my memory. I definitely have not succeed in the last, however, there are few very important wisdom that I want share from Mr. Graham that are forever engraved in me:
- All bull markets must end badly
- All bear markets will push stock values too low, below their par value
- “The Intelligent Investor dreads a bull markets, since it makes stocks more costly to buy. And conversely, you should welcome a bear market, since it puts stocks back on sale.”
The reason I am sharing this specifically is that myself being quite bullish the stock market I do hope for a larger correction. One of the reasons I did my first blog post was to outline my hope for a larger correction in the stock market. As things stand the S&P 500 P/E ratio is around 24, historically above the Post WW2 20 P/E ratio. I would love to go around and buy stocks trading under 20 P/E, hopefully closer to 10.
Bear markets are really nothing that one should worry about, they are something to get excited about, about the opportunity to buy stocks cheap. That is assuming you don’t believe the financial system will crumble and go down to zero. However, regardless of how bearish one can get, I find it difficult to find such predictions come to life. Why one might ask ? Let us examine the role of the stock market, something often forgotten in the rage against banks & the financial system.
The stock market unlike derivatives, FX and other sorts of financial instruments CREATES wealth. It is not a zero sum game. This is crucial to understand, as it ultimately is aimed at creating value rather than re-distributing wealth. It is one of the reasons QE was such a big success, all those 401k’s look a lot better with all the wealth created from a raising stock market.
Without the stock market companies like Microsoft, Apple and Tesla wouldn’t exist or at least wouldn’t be what they are today. Elon Musk wouldn’t be sending Cars in Open Space with a message “Made on Earth by humans”, you wouldn’t have the privilege to enjoy an iPhone in your pocket and if you did it would cost 4 times what it does.
As we all know the Modigliani-Miller theorem states that there is hardly any difference in the cost between financing a company with equity or with debt, however, equity financing is the best type of financing to encourage innovation in my opinion. Selling stocks buys ownership in the company and unlike debt instruments it gives a sort of a lee-way for companies to experiment and go outside of the pragmatic box of what is known to work. Think of Amazon, think of how far share prices have went on a company that just starting making profit. Why is that?
Because the share price discounts the future value of the company and when a company has great innovations in the line, things that people see true value in – in the future, the stock market will support such endeavors.
It is often forgotten how important the stock market is for innovation. It has truly enabled great companies to achieve even greater things. It has been the playground for a number of businesses to push the boundaries in their industries.
So why is it then that we often forget this important role of the stock market? Why do we often forget that stocks aren’t just some numbers on a screen. It is because something so enabling has peaked the interest of many fraudulent activities and unfortunately has primarily benefited people that are driven only by greed.
However, it is wise to not forget the many corporations around the world providing employment to thousands of people that have given shares to their own employees. Let us not forget that these people have received a huge bonus from their companies as a result of the stock market advances. The stock market is not evil, the stock market is if anything, one of the really great things in finance. The real problem lies in the enormous disparity in the distribution of wealth. It seems to me that we need more people like Graham that were interested in the underlying assets they were buying and the real value behind them and less speculators. The enormous growth of speculators unfortunately drives an enormous growth of greed and at some point fundamentals become irrelevant and we start to forget the importance and the role of the stock market.
We should never forget that the real purpose of the stock market is to finance good companies and push them to become even better at what they are doing, in return if the management of the company is good and does well with the financing it has acquired the stock will create wealth for its owners. Stocks have never been meant to be a get rich quick scheme and when you look at the moves of stock indecies one should always remember that.
Now to the other point of discussion I wanted to address in this blog post, hedging market downside. The thing is, in my own opinion, you can never predict what a stock will do. What you can predict is risk to reward ratios and make them statistically work in your favour in the long run do. However, trying to predict when the stock market turns with accuracy seems like a dream out of some financial broker fantasy that wants to sell you something. Thus, my point is personally to just be r4eady for such an event at any time and know how to protect yourself.
I recently came across something that Ray Dalio advised as his “perfect passive portofolio”, while I doubt there is such a thing I found it quite interest and for some part quite accurate. I will admit I found this from a Tony Robbins video and I still can’t quite decide if I think the guy is genuine or a fraud, but considering the fact Paul Tudor Jones and Oraph never went against him, I assume he has some credibility to it. Link to video:
Here are the key points that “reportedly” Dalio made that I actually agree with:
- No leverage here
- 50-50 bonds/stocks portfolio doesn’t make much sense from a risk perspective for a passive investor. The reason being is that Equities are inherently around 2-3 times riskier than bonds thus a 50-50 portfolio actually doesn’t mitigate exposure to Risk by 50% rather closer to 16-17%.
- In a really “not risky” passive portfolio you will want bonds to be ~ 65-70% and Equities ~ 20-25%. I completely agree with that and I know that there will be a point in time when bonds, despite all the CB intervention over the years, will adjust to normality and yield on Bonds will be higher than yields in Stocks.
- You want some exposure in FX and Commodities.
I shared that video mostly because it is very sensible and isn’t the sort of bullshit going around promoting the “perfect” portfolio.
Now, I probably wouldn’t do it the way Dalio has suggested, but I agree with most of it. So I will just share how I plan to hedge my stock positions in a case of a market crash
- I will go long USD, CHF & JPY to the amount that my stock portfolio next value adds up. So assume I have 50k invested in stocks, I would go 20k long USD, 20k long CHF and 10k long JPY, I underweight the JPY because of BoJ intervention probability.
- I would certainly put ~ 5-10% of my overall portfolio value into Gold. I dislike Gold, that is no lie and I have been vocal about it, however, in times of a market crash Gold has proved to do remarkably well over and over.
- I will definitely look to get into some Treasuries. I can’t specify a significant % because it will likely depend on just how bad the bear market is and how bonds do, but in a bear market some sort of a fixed income will be more than welcome.
- I will probably also look to get some puts on the stock market that are in the tails, to hedge myself in the event of catastrophic failure. My main aim will be to look at things that are deep out of the money to try to negate tail risk of a event like 2008 or the great depression.
- Lastly, and perhaps most importantly, I will be not panic. Companies whose stock has been killed on momentum but the underlying fundamentals remains solid, in terms of revenue and profitability, won’t be touched. In the end of the day it is good to remember the words I shared from Graham, the market will always over-react in a bear market and will always undervalue companies, even the most solid ones, which honestly is going to be a buying opportunity. On the other hand if some of the businesses I have invested in did significantly deteriorate and had to resort to getting into to debt, I will probably sell.
This basically sums up where I stand on stocks, why I am not afraid of any downside and how I plan to handle any more significant downside. In the end of the day, never forget that stocks are aimed to create wealth and that there will always be companies to make money from and buy stocks of as long as there is a stock market. Lastly, I hope you found this post interesting and I didn’t bore you to death.