We have had quite a bull market over the last several years. One that I don’t ever remember lasting so long. When the market just goes straight up, we also can get a false sense of skills. As Buffett once said, “A rising tide lifts all ships”. So, we may have made money on a company we had no business investing in, simply because EVERYTHING has been going up. As of today, July 26, 2017, the Dow Jones hit a record high and yesterday the S&P 500 hit a record high.
This isn’t going to last forever, so be prepared to see the market take a hit eventually. I don’t know when this will happen. Based on the S&P 500 PE Ratio, as seen below, the current level is at a 24.73 PE. The average level going back to the 1800’s is 15.66. (Source: www.multpl.com). That’s incredibly overvalued based on the S&P’s historical valuations.
The Buffett Indicator (Market Cap to GDP Ratio), shows a similar picture:
A Fairly Valued market is when the reading is between 75-90. A reading over 115 is considered “Significantly Overvalued”. Right now the indicator has a reading of 128.9. We are at scary high levels. Levels that we have only seen a few times before in the history of our stock market. However, I read an article yesterday on the Brooklyn Investor blog that makes a great point about how much higher this market can go without reaching Bubble territory based on interest rates. If you want to read that article, here is the link: http://brooklyninvestor.blogspot.com/2017/05/bubble-watch.html. So, we don’t know exactly when the market will have a correction, so be prepared.
How do you prepare for that? Invest on facts, not emotions. Don’t hold on to a company too long just because you THINK it can go even higher. Greed is good sometimes, but it can also hurt you if you don’t know what you are doing. Only hold onto something if you KNOW, based on valuations, that it can go higher. In our Value Investing Course, we teach 13 Valuation Calculations (for more information on that course, click here: http://www.wallstreetvalue.com/learn-to-trade-like-the-pros/value-investing/). Use your valuations on every holding you own. If a stock you own is overvalued, take some money off the table or sell the position entirely and build up a cash position until you find a better place for that money. Stocks don’t go up forever. Most of the time a stock will revert back to its mean. So, if a stock is insanely cheap, it will go back up to where it should be valued, but if a stock is very overvalued, it will come back down to where it should be properly valued. Remember, Mr. Market is rational MOST of the time, but not all the time. There are times when he misplaces stock prices too far on the low end and too far on the high end. If a company you own is priced too far on the high end, then take some profits before it goes back down to a more appropriate valuation.
What do you do if you own a stock that is going down in value? It is only natural to get nervous when we see a stock that we just purchased start to drop in value. First of all, it’s a bummer to lose money, but it also creates doubt in our analytical ability. We ask ourselves, “did I make a mistake” or “am I not cut out for this” etc. Unfortunately, many people succumb to these conclusions and they sell at the bottom. They sell on emotions instead of investing with facts.
Warren Buffett has said many times that he hopes his holdings drop in value after he makes an initial investment. WHAT?!?! That makes no sense? Why does the wealthiest investor in the world want to see his holdings fall? Here’s why: If you do your analysis properly (I will take this opportunity for another cheap plug…. take our Value Investing Course and use our 50 Point Investment Checklist to make sure you are doing your analysis correctly), you will identify a great company with excellent growth rates, a durable competitive advantage, etc. and then you will determine an approximate value for that business. Let’s say that you have determined the business should be valued at $50/share and you were able to purchase it at $35 a share. You bought some shares and then it fell to $30. Well, if you loved the company at $35, wouldn’t you love it even more at $30? You did your analysis, based on facts and numbers, not emotions, you read the risks associated with it and determined that the company is as solid as it gets. The drop in value could be a result of the whole market declining, the sector declining, or a minor issue within the company itself, but it’s a MINOR issue. If that is the case, we want to buy MORE at a lower price. That gets us more shares of a great company AND it lowers our cost basis. If our analysis is done correctly, then we just need to wait for Mr. Market to get back to feeling rational and price that stock correctly at $50. This goes against conventional wisdom that we were taught and psychologically, it’s harder to buy something that is going down, but this is how you create wealth.
This is a strategy that Warren Buffett uses, so does my mentor, Phil Town. He actually wrote a book that talks about this in detail. “Payback Time” was a NY Times Bestseller and he mentions that when he buys a stock and it goes down in value (which is what he wants to happen) he takes that as an opportunity to buy more shares and lower his cost basis. We need to fully understand the business to make sure the drop in value is an opportunity and not a value trap where were are “catching a falling knife” each time it goes down in value. If you do your analysis and you understand the business, you will be able to differentiate the two.
In conclusion, do your analysis and trust in it. If you own stocks that are overvalued, take some profits. You will never go broke taking a profit. Don’t be greedy. If you own some stocks that are down in value, take a correction as an opportunity to buy more shares if you really understand the business. Don’t let a drop in value scare you into selling. If you are in cash positions, use a market correction to load up the truck. A lot of wealth was created in 2008 and early 2009. That is when Apple was trading at $85 (pre-split) and rose to $700 before they split. Priceline was trading at $45 in October 2008 and is now over $2,000. Under Armour is trading under $2 and is now around $20. I can go on and on with more examples, but you get the point.
A correction is an opportunity to create a lot of wealth if you are prepared for it. Don’t fear a declining market. If you invest on emotions, you will get crushed, but investing on facts will create wealth.