Investing in Times of Hysteria

NOTE: I wrote this piece prior to the Federal Reserve announcing their plans for withdrawing bond purchases and liquidity on June 19, 2013. I’ve tried to update certain sections to reflect this.

This is a crappy time to be investing in stocks. There I said it.

I have been investing in stocks since 1996 and in those 17 years I can say that I have never seen a worst period to be a stock investor than where we are right now. The impact is this type of period we’re in can lead us to panic or freeze-up when it comes to making sound investment decisions.

When you look at the performance of the equity markets, you would think my statement is crazy. Look at the results so far this year especially in the US. The S&P 500 is up 15 percent year to date and the blue chip Dow Jones Industrials are up almost 16 percent year-to-date. Even embattled and burning Europe where half the population is unemployed are seeing indexes with positive returns. These are golden times, no? Indeed they are considering almost 5 years ago the world economy almost fell over a cliff. Now most of if not all those losses have been made up if you had the stomach to stand pat and ride it out.

That being said, this is still a crappy time to be investing in stocks. I’m not saying it out of sour grapes as most of the stocks I own have been have been treading water this year. They haven’t tanked but they haven’t gone like gang busters like the overall market. I’m OK with that because I know I have no capability in beating the market consistently.

It is amazing that these levels of equity returns have been generated under a backdrop of anemic economic growth. Job creation and GDP growth in the US and Europe has been a start and stop. China has been showing signs of a meaningful slowdown (if you count 7 percent GDP as slow). Businesses have been reluctant to hire because they are not seeing meaningful sustainable demand pickup. Banks have limited their lending to Triple-A companies and only until recently been lending money to small to medium sized companies. They have been essentially hoarding money and parking it, licking their wounds from their financial heart attack. These types of events should not be translating into surging stock prices because stocks should be reflecting underlying future profit growth and fundamental future prospects for the business.

Instead, we have been witnessing a case study in Jedi mind trickery, where other “forces” have been guiding investors to stocks. In this case the Jedi master at the hear of this has been Central Banks led by the Federal Reserve in the US, who over the past 3 years have been embarking on a policy of pumping liquidity into the economy to stimulate economic growth, at least that’s what they set out to do. The result of the low interest rate policy has left investors or savers with very few options. You can buy GIC’s that pay next to nothing and when factoring inflation, you’re actually losing money. You can go up the Investment Onion to bonds which have been a great investment as rates have trended lower, but there’s only so far you can go. What’s left for most investors who are searching for anything resembling yield is to go for stocks. You can get yield simply by getting dividends which pay more on an after-tax basis than bonds. Also if demand goes up, then price appreciation is not far behind. So investors have been nudged and guided into equities because the Central Banks have made it the only game in town. UPDATE:Since I first wrote this, the Federal Reserve has signalled they will be willing to scale back their money printing and bond purchases if there was tangible, meaningful, economic improvements. The stock market has since taken a hissy fit, because they are so used to cheap money and have since been selling off stocks.

The problem has been investors are piling into anything resembling a stock and not taking into regard the risks associated with the companies they are investing. Right up until now, all stocks have been treated equally in terms of risk profile which is…there is no risk! Investors have been ignoring risk and it is reflected in the Volatility index (VIX) which has been treading in the low teens for the longest time now. (NOTE: since the Fed signal, it has begun to track up).

Up until now, you can analyze any company and stock and it doesn’t matter because stocks are not being valued and traded based on its fundamentals. That’s dangerous and frustrating for investors.

Investing right now is a game of musical chairs. As long as you can walk around the chairs and the Federal Reserve keeps the music playing and prints money, you’re golden. At some point, the Fed will stop pumping money and the music will stop. At that point, things will get ugly. As I’m linking investing and music, we can say investing is truly an art these days.

When will the music stop? Ben Bernanke has indicated the Fed could start easing their bond purchases as early as late 2013. It seems though more and more that it will be sometime in 2014. What will happen when the music stops? People may realize these stocks don’t support their valuations and may bail out hard core.

We are living in hysterical times for investing. Up is down and down is up. Under this backdrop you’re sitting there looking at your portfolio and are asking yourself, “What do I do”. How do you deal with these disconnects? Should I just throw caution to the wind and just buy up a bunch of stocks like everyone else seems to be doing?

That’s why this is a crappy time to be investing in stocks. Many fundamental principles that hold true to investing are being completely ignored. For those who have adhered to a specific strategy like buy and hold, or technical analysis, those ideologies are being tested and many are questioning if they are doing the right thing. As investors, we are extremely vulnerable during these periods of hysteria to going off our playbook or to change our investment strategy to make sure we don’t get left behind. We’re fighting our discipline and it is very easy to go off the wagon.

As I’ve been dealing with these feelings, I’ve tried really hard to keep a few principles in mind when I’ve working through these challenges personally. Here are a few key ones for investing in times of hysteria.

Step 1: Avoid the Hysteria. Take a Breath

Hysteria (good and bad) breeds emotion and when you act on emotion, you’re screwed. You will make a crappy decision. Hysteria comes from watching news, hearing the pundits sound off and more so now from social media. Upon the Fed decision on their roadmap, stocks sold off everywhere. The emotional response is to sell because everything around you is selling. You don’t want to hold the bag. What happens usually is we throw the baby out with the bathwater. The reality is the bag likely has some good stocks of companies that will do fine and perform brilliantly in the long run. Will McDonalds stop selling Big Macs? Will Intel stop selling computer chips. Will IBM’s marketing strategy materially change because some analyst or economist on Wall Street who’s never run a business or risked their own capital preaches doom and gloom? Probably not.

The easy response is to turn it off and ignore. The reality is we’re overrun with information on our laptops, tablet, TV’s, radios, and phones. You can’t escape it so hear it out, BUT DON’T ACT ON IT! Take a breadth. Go out. Do something else.

Step 2: Regain Focus. Review Your Investing 1st Principles.
If you have been working with me, you will know the drill. We will review the core principles what drives wealth creation and stock prices. The hysteria and noise of the markets will cloud our thinking and most likely will naturally and systematically force us to drift away from our investing values and strategies. It is important to re-anchor ourselves to regain clarity on what our investment goals, our tolerance for risk, as well our reaffirming the criteria we seek out for identifying solid investments.

Step 3: Analyze and Apply
With our principles re-established, we should set out and do the number crunching or seek references that will answer the fundamental questions: Is this company creating tangible wealth? What is the quality of their balance sheet? What are the future prospects for their business model? Is the stock selling at a discount? We need to return and continue applying the rigour to answering these questions. We also need to gauge the market sentiment and market psychology. Are investors gloomy or optimistic on stocks? What does the consensus think? These will provide clues and aid us in terms of the next step, execution.

Step 4: Execute
We’ve done the legwork and number crunching and we’ve found companies that we feel are solid investments. We’ve scanned the market to make sense of market psychology and it is telling us that sentiment is negative so the time to buy stocks is here or vice versa. It is time to put our money where our mouth is and follow through. The problem is that pesky emotion. It is really easy to freeze, especially when you see the market going down. It can at times be very difficult to fight through this barrier, yet it is at this most critical time where you must be confident in your due diligence and trust that you are doing the right thing. You should be able to sleep with your analysis and the actions you have taken. Doubt is not an option because if it is, don’t do it.

Step 5: Repeat and Stay Disciplined
Keeping the rigour and discipline to staying true and consistent to your investment principles and strategy is very hard as emotions and hysteria are always nearby to knock you off your game. It takes work. It takes a bit of time and experience because you have to go through several iterations of buying and selling stocks and especially buying and selling stocks successfully to gain the confidence. I found over time as I’ve been doing this that eventually it becomes second nature and instinctual, but in the early days, it helps to have kind of an outlet, whether it be documenting your actions, or bouncing ideas off an independent 3rd party like an investment coach to keep you on the proper track and stream.

So yes it is a crappy time to be investing in stocks, but if one is armed with some core principles and investing values and one learns to maintain discipline and filter out the hysteria around us, one can leverage them to improve their odds of successfully navigating the hysteria.

UPDATE: July 11, 2013
Today the markets surged upward on recent comments by the Fed Chairman, Ben Bernanke. Mr. Bernanke clarified the Fed position stating that the central bank won't begin to reduce purchases of bond (i.e. print money) until the economy is strong enough. Essentially this means the trend for stocks is to resume its upward ascent, economic fundamentals be damned. The recent comments indicate that it is likely we will not see any movement on interest rates until 2014. So the hysteria continues. Within this context, I decided to pare back my short position in the S&P 500 by half. There is just no sense fighting the Fed now, eventhough the diagnostics look crappy.