Another Stock Market Indicator Flashing Red
“Our models tell us the market will go up 16% in 2018.”
That was a Wall St. analyst talking today on CNBC.
OK, so the market could go higher from here. The problem, is that a 16% gain is not worth a 20-30% loss.
According to CNBC, “Since the prior bear market ended in March 2009, this advance in equities is now the second-oldest on record without at least a 20 percent drop in the S&P 500.”
Think of it like this… Let’s say you had $100 dollars. You’d risk losing $20-30 for a $16 gain.
I don’t know about you but I would demand a higher return for the risk. I realize everyone’s risk tolerance is different.
But I would need at least a chance at earning $60-90 on that kind of risk. (If it’s a speculative opportunity, a speculator might be fine risking $100 to gain $800.)
Would you take an offer where you could gain 16% with a chance to lose 20-30%?
I don’t think so. The risk is too high.
Remember, the price you pay for an asset is the single biggest driver of future returns. You want to buy using a margin of safety.
Buying the market with a chance of only a 16% gain isn’t buying with a margin of safety. It’s a sign that you’re buying what everyone else is buying.
Go against the crowd.
I talked about the extreme sentiment levels of the herd earlier this week. There’s another useful indicator out there to use as a stock market gauge.
It’s an indicator that one of my favorite investors uses… Warren Buffett.
He says, “it is probably the best single measure of where valuations stand at any given moment in time.”
The indicator is market capitalization to GDP. It’s a long-term valuation metric.
Source: Advisor Perspectives and dshort.com
As you can see, it’s at nose-bleed levels. Buying at these levels is not buying with a margin of safety.
But look… This indicator or the sentiment index I wrote about earlier this week isn’t a doom and gloom story.
You don’t need to go load up on guns, ammo, build a bunker or anything else.
It’s just this is the kind of thing that happens in markets. Markets go up and get expensive. Markets go down and get cheap.
Every few decades something like The Great Depression or the global financial crisis happens. (There are ways to prepare your portfolio for that.)
When markets go on extended runs like the one we’re in now, you need to be selective about what you buy.
Yesterday, I talked about coffee.
It’s cheap and investors hate it. Cheap and hated are two great places to start when looking for investment opportunities.
The bottom line is that there are always opportunities to make money. It doesn’t matter if we’re in a bull market or a bear market.
But you don’t want to buy assets just because they might go up. The lesson here is to think about the risk versus reward.
In other words, think about how much money is at risk and the potential reward for putting that money at risk.