Beware of Overpriced Stocks

Today Netflix crashed 13% after lower than expected subscribers were reported for the second quarter. It now trades at $85.63 after falling $13.13. If you had invested in this stock just yesterday you would have lost over 13%. The first thing I do when I see stock headlines like this is pull up the stock and look at it’s P/E ratio. This is currently at an outstanding 266! That’s more than 20 times that of Apple, meaning people have much higher expectations of growth with this stock.

That being said, 266 is better than a P/E of 0 (sometimes denoted ‘-‘), which means that the company does not turn a profit at all. One big example of such a company is Tesla. People are so adamant that Tesla will be the wave of the future that they’ve heavily invested in this stock, which means that Tesla will probably have a high beta. When fluctuations happen you will see these high beta stocks swing much more violently than stable low risk stocks such as Proctor and Gamble, Johnson and Johnson, and utilities. That being said, certain events can still cause ‘stable’ companies to flop or gain/lose an incredible amount of value – buyouts, disasters, shortages are some of these types of events.

In my opinion, I would not consider buying any company with a P/E ratio higher than 100, and would discourage investing in an unprofitable company. If I had to use a stock screener to automatically buy stocks I suppose I would filter by P/E ratio between 10 and 22 with a dividend of between 1 and 3.5% and a return on equity of at least 10%. Return on equity means how much percentage profit each stock generates. For example Apple has in the first quarter had a return on average equity of over 30%, meaning if each dollar of stock generated 30 cents in profits. Not bad! A low return on equity means the profitability of the company based on its equity is low, so more money put into the company might not yield much profit so the incentive for price growth or dividend payouts is probably lower.

 

You Are Forced To Invest in Risky Assets

Mortgage rates history

Bank CD Rates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Take a good hard look at the charts above. While mortgage and CD rates were over 10% in the mid 1980’s, mortgage rates have dropped to between 3 and 4 % starting in the 2010’s and the bank interest rates have fallen to around 0.1%. The problem with the current investment environment today is that there really is no where to get a great return except for higher risk assets. Stocks and bonds both carry risks, and have been heavily pumped up due to the lack of alternatives such as existed in the past. Central banks have been pushing people with assets to invest in the stock market for quite some time now, as such investments ostensibly drive economic growth and also people’s retirement accounts.

Retirement accounts in the US are not the same as they were  in the past – in 1980 the 401k accounts were started by private companies take take advantage of section 135(a) of the Revenue Act of 1978. This became a trend among companies across the US and is now the standard. Companies would much rather have individuals put money into their 401k than be obligated to support them after retirement. The 401k is a type of defined contribution plan rather than a defined benefit plan. Federal law does not require employers to offer or to continue to offer a plan, but most white collar jobs do come with this benefit.

The IRS dictates that 401k beneficiaries being distributions at a certain age. The rules are a bit different for designated beneficiaries, but they should be closely followed otherwise penalties will be imposed. If an employee decides not to invest in a 401k, he or she does not receive any taxable benefits offered by the 401k which could either be:

  1. Untaxed deferrals to the 401k plan
  2. Untaxed gains for the Roth 401k plan

In short, money that goes into the normal 401k plan is not taxed up front but instead when removed from the account. Money that goes into the Roth 401k is already taxed but doesn’t get taxed when removed. Entire industries are supported on fees and administration costs related to people’s 401k accounts – if you haven’t yet, you should check out how much money you are charged for keeping money invested in each mutual fund, bond, ETF, etc. you are holding. Deciding to put your 401k money in fixed income will yield you close to nothing, but having money invested in international funds generally is more risky.

Unfortunately for the saver of today, the best investments tend to be stocks or real estate. Gone are the days of investing in bank CDs, at least in the US. If you’re looking overseas many countries still have double digit interest rates you can get on savings, but those countries tend to have higher inflation too.  Keep in mind holding a foreign bank account you will need to report your assets with the IRS using the FBAR form.

cd rate

 

 

Strategic De-Vesting

My last post noted how investing during a stock market trough is a wise decision. Many financial advisers will never advise their clients to reduce exposure to the stock market, but given the current price valuations I suggest selling off some stocks to hold gold, silver, or practical real estate. The reason for this is clear – the stock market has had a great ride, but that ride is based on a handicap of low interest rates and valuations which exceed standard price/earning ratios of the past. Amazon has a P/E ratio of 300, Tesla has a P/E ratio of nothing because they don’t even turn a profit! Apple holds a pretty low P/E ratio of around 11 because of doubts on future profitability.

The point is, there is a frothiness to the US stock market which is alarming. In my opinion it would be best to sell of around 30% of your portfolio now and ensure your investments are in stable asset classes. I’ve mentioned investing in water almost almost one year ago, and here are the results (using 1 year return from today):

GE : up 22% (Current price $32.21)

ECL : up 6% ($119.10)

AWK: up 62.95% ($82.76)

WTS: up 21.47% ($61.05)

I would keep these water stocks except for ECL and sell high risk assets such as Tesla, Amazon, etc. to ride out the upcoming correction.

If you check out my post on how investing in the stock market is like a chess game you should note that my recommendation on gold/silver stocks has also paid off.

The particular company I linked in that post has gone up 151% and is now trading at 6.05. I suggest selling this stock at this time to retain the profits.

 

So in summary my suggestion:

Hold on to the water stocks

Cash out and perhaps put money into modest real estate

 

Capitalizing on People’s Fears

The stock market has lost about 10% of it’s value in 2016 so far. Consider this a 10% discount from what it was before 2016, however timing the discount is nearly impossible. One thing’s for certain, buying a stock now would be better than buying that same stock 19 days ago. One way to ensure you’re getting a discount regardless of how low the market goes is to dollar-cost-average. If you’ve already lost a it in the stock market this year, then most likely your instinct is telling you to sell before it reaches 2008 crash levels. If it does recede further this might be a correct strategy, however very few major news organizations will tell you this. The 2008 crash erased about 50% of stock market value between late 2007 and early 2009, so we still have 40% to go if the crash gets that bad.

One commodity that almost always seems to prosper when stock markets crash is gold. Gold and treasuries. One investment that often gets hit after the stock market is real estate. However, real estate value decline isn’t usually permanent unless you’re talking about a city which becomes deserted like Detroit. You can also make money off of real estate by renting it out – assuming there are renters interested in your location. Other alternatives for the timid include putting the money in a CD, which unless you are holding it for 10 years will give you a measly return less than inflation in many cases. Other uses for money include education, donations, or simply burning to keep the house warm.

My suggestion is to dollar cost average a return to the market, and keep an eye out for severely undervalued investments in the next few weeks or months as the market crashes. If you have investments in relatively unharmed stocks, it might not hurt to sell those and use the money and buy the stocks which will recover the most.

Investing in Water

One aspect of investing that some people consider when they decide where they put there money is helping mankind. That could be in the form of a simple donation or investing with companies that help mankind develop. One area that needs investment that will forever be necessary is water transportation and desalination. Water scarcity is one of the largest risks to economies around the world, as populations continue to grow and glaciers and fresh water sources continue to diminish. I visited Lake mead less than two months ago and it currently sits at the lowest level since Hoover dam filled up this artificial lake in the 1930’s, its clear to me that civilizations across the world cannot continue to rely on traditional reservoirs and a certain amount of precipitation to divert emergency. As we have done with oil infrastructure, the same will eventually have to be done with water – desalination and purification of ocean water and pumping that water across lands to irrigate and placate populations.

The biggest players in that type of game can definitely change if the need escalates, but currently we have a list of the following companies who are related to supplying water infrastructure or desalination services:

  • General Electric (GE)
  • Ecolab (ECL)
  • American Water Works (AWK)
  • Watts Water Technologies (WTS)

This is a short list, but in summary General Electric has worked on desalination plants and will definitely be a player to come in this field. Ecolab is involved in water purification technologies. America Water Works is more of a utility company that provides water service and waste water treatment (another vital component of sustainable water infrastructure). Watts Water technology helps provide water quality solutions – in layman’s terms it creates plumbing pieces that help buildings smoothly move water around. Feel free to view each company’s website for more details.

These types of investments can be a form of macro trend investing – investing in technology which is up and coming and required for a sustainable future. As folks have witnessed in recent history investments into coal and dirty energy have proved very unprofitable, and that is based on standards governments have been setting which have resulted in fewer coal powerplants and slower growth in the demand for crude oil as car efficiency goes up and electric car sales increase. Water is a resource that everyone needs – which can be conserved but will need more supply soon!

 

The Stock Market Vs a Chess Game

The stock market is in some ways much like a chess game – prices of stocks usually are priced based on future expectations. In other words the folks at multi-billion dollar hedge funds have done the math, and have tried to play a long ways into the future. This can be said about the price of stocks, and the price of stock derivatives. The biggest reason why the stock market has been falling in recent weeks is due to the expectation that the Federal Reserve is going to raise interest rates – a low jobless claim rate cause stocks to sink faster because it increases the chances that the Federal Reserve will in fact raise rates to stave off inflation. By doing so, stocks are no longer as good of an investment relatively speaking compared to cash – stocks have risk and cash has little risk, so to increase interest rates means you can get more return for a no risk investment.

However, since the stock market looks to the future there is a very real possibility that stocks will have taken into account a Federal Reserve interest rate increase before the increase happens – and if the increase is lower than expected you should see the stock market start to jump back up due to its factoring error.

That being said, investors should still reassess the forward price earnings ratios of their stocks to make sure they aren’t holding on to something that is too expensive. Speculators will still hold onto company stocks which they see as having lots of potential even though they are priced very high. You can see that in companies like Tesla, where a company that doesn’t have a P/E ratio because it isn’t profitable yet still boasts a good stock price. On the other hand, a company like AFLAC has a very low P/E ratio of 10 because I suppose investors don’t see AFLAC coming up with the new invention of the century. Apple is priced at a moderately cheap price of around 15, as investors are weary that Apple may have had its day in the sun and won’t come out with any new revolutionary products since legend Steve Jobs has left.

My suggestion then is to sell off your expensive stocks and as the market drops incrementally buy back in as prices because attractive. As an insurance policy against the Federal Reserve deciding not to raise interest rates I suggest buying some precious metal company stock, and companies that will do well under higher interest rates include banks such as Bank of America. I want you to be the one who yells Checkmate before your portfolio yells it to you!

Please make sure to read my disclaimer below before taking any action.

How Does Greece Affect the US Economy?

Greece in and of itself does not directly do much business with the United States. Greece does not have manufacturers that compete with the US, such as S. Korea, China, and Germany have. Greece does, however, greatly impact the European Union not only because of the size of its economy but more importantly due to the thought of a collapsing EU. The EU (European Union) was created in 1993 and has 28 member states. If Greece exits, it will raise the spectre of other economically weak countries like Italy and Spain leaving – this will shatter the Euro and send investors running for the hills. It will make the US dollar much stronger which will hurt US exports, which in turn will affect US international companies negatively. It will also hurt US tourism as it will be much more expensive for Europeans to visit the United States.

The thought of a collapsing economy and certainly the fact that Greece has stopped people from withdrawing their money from their own bank accounts may have a ripple effect across other countries in Europe and possibly the world. The 2% drop in the Dow Jones on Monday and the 2.5% drop in the Nasdaq does not bode well for an actual Grexit (The new term used to describe Greece’s exit from the Eurozone). Stock markets that are already priced too high in terms of price earnings ratio will feel more pressure to correct themselves. A falling stock market means less market capitalization in companies which is used to fund their operations, which may in turn lead to job losses. The stock crash of 1929 led the way for the Great Depression in the United States, which is an extreme example of what happens when a stock market crashes.

If a stock market crashes then confidence is lost, and the likelihood of new jobs is dampened.

 

Reading the above you might think it’s time to head for the hills, but I think that a more important and less pronounced threat is the United States debt and trade deficit which will not be helped by a European crisis. Ways to protect yourself include but are not limited to:

  • Shifting out of stocks and into cash, whose value will most likely increase relative to the rest of the world unless the Federal Reserve doesn’t increase interest rates and comes out with another stimulus package
  • Making sure that your portfolio does not include European investments

Of course, these protective measures may limit your upside potential, but will most definitely defend you against a downside. If you’re courageous enough, you can always short individual stocks. Please read my disclaimer below and have a nice day.

Ignore Most Market News

The average stock investor should avoid most news stories related to stocks. The reason I say this is that many times people have emotional ties to gains and losses and tend to make far too many transactions for what is necessary based on reading a barrage of market news, which is a entire industry unto itself. I recently commented on how inconceivable it was for the price of oil to hit $10 per barrel, but that kind of news made headlines. While people were heading for the hills, I decided to and taught readers how to invest in oil using ultra ETFs. Now Brent crude is trading at $63.31 and those who had shorted oil when it was less than $50 per barrel would be feeling the pain.

Now the key word here is ‘most’. Many folks try to make a name for themselves and their product by claiming outrageous things trying to build publicity for their name and if the off-chance they’re right it was all worth it! Well, if they’re wrong then they’ll just stay quiet for a few months. There are, on the other hand, reasonable financial advisers who will make thoughtful suggestions about the state of affairs.

My suggestion is this:

The stock market is overpriced, a historically good bet but given current P/E ratios it’s just a matter of time before the market falls. The timing on that fall is between now and 1 year from now. The correction should be between 10 to 20%. Many people should be looking forward to this correction in order to bolster their portfolios at a discount.

Oil has taken a hit but is on a comeback. We will probably see the price of oil rise in a few months – possibly due to global conflict.

To act on this would be to simply sell stocks and buy oil.

Make sure to read my disclaimer below.

6% Chinese Stock Market Drop

On October 28th, 1929 the Dow Jones Industrial Average fell 12.8%.

On May 28th, 2015 the Shanghai Composite Index dropped 6.5% – the largest fall since 2008.

The Wall Street crash took place after a period of speculative buying where many Americans were borrowing money to invest in stocks. The same can be said about Chinese investors, and to a lesser extent American investors as of late. As P/E ratios drift higher and higher, or non-profitable company stocks start to rise, it’s only a matter of time before the market gets overheated. Considering many of these investors are using borrowed money, the risk of sudden downturn is higher – Margin loans must be called if account balances get too low, and burned investors will not be able to get back in the market.

Whether the 6% drop is a prelude to something bigger is yet to be seen – but keep in mind the market in China does not allow single shares to go down more than 10% in a single day, which means we may see a further drop tomorrow. This will in turn put stress on Chinese investment banks and will have a trickle down effect on the Chinese economy. If mom and pop investors are all putting their life savings in the stock market do you think they will spend as much on the street as they used to?

Anyways, this is all speculation, but I think it’s safe to say we are going to be seeing some pretty interesting financial news come out in the next few months.

The Most Powerful Force in the Universe

E = mc²

E = mc²

Albert Einstein

Mass energy equivalence paved the way for our most powerful weapon and energy source. Nuclear force was not, however, the most powerful force in the universe according to this man. Instead, it was compound interest.

Einstein was a man of relativity, and while it is true that nuclear is the strongest type of force taught in the classroom, in the real world his statement makes a lot of sense. The top 1% of income earners will make much of their income off of investments, and these investments typically yield a certain percent of profit per year which is then applied back upon itself the next year. This is one way in which income inequality grows – because the lower wage earners do not put their money in compounding investments.

It is important for anyone looking to get the highest return on their investment to understand the basics of compound interest.

Rule of 72

For those that don’t want to pull out a calculator to find out how long their investments will double in size there is a helpful and speedy way of figuring out roughly how long it will take to double their money. Divide 72 by the interest rate and that will be the number of years a annually compounding investment will take to double. See examples below:

9% interest – 72/9 = 8 years

5% interest – 72/9 = 14.4 years

3% interest – 72/3 = 24 years

If you use outrageously small or large interest rates the rule of 72 starts to break. Obviously a 100% interest rate will double your money in just 1 year, not eight and a half months!

Compound Interest Formula

The mathematical formula for annually compounded interest is

FV = PV * (1 + i)ᵗ

Where FV is future value, PV is present value, i is the interest rate, and t is the number of years. As most readers know, this is an exponential function of time (See Figure Below).

Solid line is exponential function with lower constant value.

Solid line is exponential function with lower constant value.

As you can see, exponential values can quickly get out of hand. Other real world examples of exponential growth include population growth in developing countries, inflations affect on currency (exponential decrease in value as seen below).

How inflation eats away

How inflation eats away

The phenomenon known as the rising income gap comes largely from these two graphs. The top graph represents invested wealth and the bottom represents buying power of a single unit of a depreciating currency.

What do I do?

If you’ve read to this point then you’ve already taken a good first step – you’re searching for knowledge and exponentially growing your financial acuity rather then let your mind exponentially waste away. I suggest creating a financial plan which takes into account your age (time till retirement), risk tolerance, and net worth and allocate uninvested funds into investment accounts. Investments can range from stocks, bonds, real estate, and even high interest savings accounts. Keep in mind that these days interest rates are amongst the lowest in mankind’s history, in the United States in particular. Most of all, don’t panic!