I was asked to do a post on how to buy equities even though I currently recommend refraining from owning stocks because I’m bearish. Assuming someone really insisted on equities then I would suggest they use the following criteria:
- Invest conservatively seeking to reduce risk rather than chase after gains
- Buy large cap stocks with corporate moats
- Buy stocks with low debt loads
- Buy stocks with consistently growing P&L items such as earnings, sales
- Use bank loan skills in evaluating P&L’s to decide what to pay for earnings based on quality of earnings such as durability, stability, longevity of earnings, throw out one-time income items
- Use PE10 advocated by Ben Grahman and Robert Shiller. Don’t trust short term earnings results or forecasts of future earnings
- Don’t look at assets to estimate value because they can be distorted by bubbles, look at long term earnings and all P&L items because they rarely are significantly warped by bubbles.
- Buy stocks that are in the top quartile for the above criteria
- Limit purchase to stocks with reasonable PE’s.
- Avoid financial stocks due to the opaque nature of the credit quality of their assets and their extreme leverage
- Avoid industries that will be hurt by consumer reducing their expenses such as expensive non-staple retailers
- Avoid tech stocks because the risk of permanent drop in income is greater than the reward. The Nasdaq never recovered from its high of the year 2000.
- Avoid the “Value trap” of buying stocks that have dropped in price; in some cases a price drop with low PE’s is a tip off to an imminent failure and is not a bargain
- Find a mutual fund that believes in this post's philosophy as evidenced with a below average standard deviation and above average Sharpe and Information ratios.
- Use an actively managed mutual fund that follows the above criteria and which is an “I” class fund.
Timing the market: when to buy equitiesNo one can time the market, but it may be possible to obtain alpha by “boycotting” the market and refusing to buy when it is too high and then buy when stocks “go on sale” during a crash. The buying opportunities are during a capitulation phase when PE’s are at 8, or 10 or 12 and the public is very negative about stocks. These opportunities may only occur once in a generation.
Today the stock market's PE10 is about 23, which implies equities are 70% overpriced over a fair value of a 15 PE ratio. Ironically if you like equities you should boycott the market so that you can preserve your capital and buy stocks when the price is right. I love equities and hate bonds, but because this current era is a bad time to buy stocks and thus a good time to hide out in the safety of bonds I advocate a 100% allocation to quality bonds. The bond allocation recommendation is temporary, just like the 1929-1941 Great Depression was temporary. Eventually the cycle will change and it will be time to own stocks.
The hidden risk equity investors encounter is being brainwashed by the “high water mark” and being brainwashed by repeated Fed bailouts and by Shadow Banking financed bubbles. Like Pavlov’s dog, some investors are conditioned to think that the Fed will bail them out and that the market will return to the high water mark and then go higher. But history shows that the equity risk premium (ERP) stays negative or flat for long, irregular periods during which time (especially when adjusting for risk) it is better to be in bonds than stocks. The best clue about when the ERP will flip in the opposite direction is if stocks reach capitulation phase pricing.