Some Lessons From The Recent Market Volatility

Carl Williams was your average Broadmeadows boy.

OK, maybe he was a little below average.

He flunked Year 11. Tried his hand at a few trades.

But the slow grind of rising to wealth wasn’t his bag. It’s why he became a semi-professional gambler. He poured everything he had into his new profession, dreaming of quick riches.

When the bouncers cut him off, Carl needed another outlet. Another way to feel a rush.

He turned to the drug trade.

And its then, that his life took a turn for the worst. Consumed by greed, Carl worked his way to become a crime kingpin.

You can probably guess what the dirty entailed.

And business was good, for a while.

That was until drug-related murders increased. Carl’s greed soon turned to fear as he himself was staring down the barrel of a gun.

He took a bullet to the stomach. A short time later he was in court and convicted of four murders.

Carl Williams’ story is unique. Very few of us hustle our way to the top through underground crime. But the similarities between Carl’s rise and fall and that of investors is almost comedic.

Just like Carl, investors have had it good for a long time. But as we come to the end of 2018, all that greed shifts to fear.

And I’m going to show you how could profit from it all.

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Stocks are down, again…

Stocks are down, again. You know that.

The S&P 500 (largest 500 US stocks) is now in the red for 2018. The All Ordinaries (largest 500 Aussie stocks) even more so.

But it’s not just stocks.

Bond yields are on their way down too.

Investors don’t think interest rates will go much higher, which said something about inflation expectations. When interest rates are low it usually means inflation is also low.

And with low inflation on the horizon, investors are piling back into bonds that have terrible yields.

MoneyMorning 30-11-18

Source: CNBC

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It may have something to do with trade tensions.

You heard the US arrested Meng Wanzhou of Huawei Technologies?

I’ll let The Washington Post fill you in…

Meng was arrested on a U.S. extradition warrant because Huawei is suspected of evading American sanctions on Iran, according to multiple news reports. U.S. prosecutors have been investigating since 2016 whether Huawei violated U.S. export and sanctions laws by shipping U.S.-origin products to Iran.

The arrest, on the same day President Trump and China’s President Xi Jinping met for dinner in Buenos Aires for trade and national security talks, is being viewed in China as politically motivated.

‘…In the past, China has retaliated swiftly against similar kinds of actions. The question now is whether Beijing will risk derailing talks that may offer the best chance of de-escalating a deepening trade conflict.

So, now that a trade truce might be off the table, investors are running to a safe place — US government bonds.

That’s my thinking anyway.

But wait a minute…

We all knew this already. The arrest is new. But we already knew about interest rates and the trade war heading into 2018.

And during the start of the year stocks were doing just fine.

From mid-2017 to January 2018, US stocks were up almost 16%. And Aussie stocks climbed more than half of that.

February rolls around and investors want nothing to do with stocks. They do a complete 180. And what they thought was going to be another year of growth became the opposite for most asset classes.

Charlie Bilello, over at Pension Partners echoed the same feeling…

At the start of the year, investors were unequivocally greedy. And who could blame them? The S&P 500 had just completed its 9th straight up year and it did so without a pullback greater than 3%. In the AAII Sentiment Poll, Bulls outnumbered Bears by 44%. This was in the top 5% of all readings dating back to 1987.

Fast forward to today and sentiment has shifted 180 degrees. Volatility has increased as the S&P 500 has experienced a pair of 10% corrections. In the same AAII Poll, Bears now outnumber Bulls by 22%, which is in the bottom 5% of all readings. Investors are now fearful.

It’s why I think the connection to Carl Williams can explain the point. For a long time, everything was going Carl’s way.

He had power, money and status.

But like investors, Carl got greedy. He overstepped his power. He thought he was invincible, much like investors throwing money into the market and watching it go up.

Sooner or later, that greed goes too far. You start taking on more risk (buying stocks at higher prices). And you assume everything will work out fine, just as they have for years.

But it isn’t until you meet a road block — for Carl that was a disgruntled drug dealer, for investors it was interest rates and a trade war — that greed turns to fear.

And it’s when others are fearful that opportunities pop up. 

Where should you look when prices fall lower?

It’s one thing to say there are opportunities all over the place. It’s another to actually find and buy them.

And while investors are fearful now, I suspect, with a bit more time, fear will kick up a notch. At least I hope it will.

Fearful investors have pushed market prices down, pushing up potential returns.

If you buy a stock that could rise to $10 a share for $2 rather than $5, then your potential return triples from 100% to 400%.

Problem is, prices aren’t at bargain levels this year. Not the ones in the All Ordinaries anyway.

Australia’s 500 largest stocks are trading on a forward PE (price to next year’s expected earnings) of about 14.5-times.

The average for those same 500 stocks, during the lows of 2008 and the climb there after, is also about 14.5-times.

That means the market is generating a forward return of about 6.9%, which is one over 14.5 (that also assumes earnings remain constant).

It’s not exactly exciting. But look under the hood and I’ll bet you find some stocks worth a first pass. If prices go any lower, then you’ll see more and more of these 500 stocks go on sale. Just in time for Christmas.

So, where should you look when prices do fall lower?

Perhaps you could look at the unloved, the disgusting. Too often investors shun terrible businesses, and then some.

Their overly pessimistic view of these bad businesses creates opportunities. Of course, in a perfect world you’d like to buy good businesses for cheap.

But in reality, it’s not always easy to find such opportunities. It tends to be much easier finding the terrible…which actually isn’t as bad as everyone thinks.

Lucky for you, the market is in a pretty bad mood right now.

Let’s hope some salt gets chucked in the wound so we can pick up great investments heading into 2019.

Your jolly investment pal,

Harje Ronngard,

Editor, Money Morning

PS: If you want to lay down a little money on the hottest corner of the ASX right now…but you don’t know your way around the small-cap sector…this report is for you. Get access now (free).

Source : https://www.moneymorning.com.au/20181210/stock-market-lessons-from-melbournes-gangland.html

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