Broker Check

Buy LO Sell HI

March 23, 2015
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Buying LO means not buying HI but it also carries with it the expectation that low priced stocks will rise in value.

It may also be that a stock that has already risen may rise further in value.

In both cases we are reminded of our economics texts and JM Keynes who described the stock market as a beauty contest where value is judged by a panel which is the investing public.

“It is not a case of choosing those faces that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence’s to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

This means that people price the markets not on fundamental value such as earnings or dividends, but rather on what they think everyone else thinks the value is, or what everybody else would predict the average value to be.

A public test conducted on Planet Money tested the Keynesian theory by having its listeners select the cutest of three animal videos. The listeners were broken into two groups.

The first group selected the animal they thought was cutest.

The second group selected the one they thought most people would think was the cutest.

Fifty percent of the first group selected a video with a kitten. Seventy-six percent of the second group selected the same video.

This result is entirely consistent with Keynes’s theory.

And in terms of the stock market it means that investors are likely to pay far more for a cute kitten video than it is really worth because they believe that others will pay more.

How Does Investor Opinion Work in Practice ?

Everyone loves Apples because everyone thinks everyone else loves Apples. The market thinks interest rates will rise because it thinks everyone else thinks interest rates will rise.

No one likes gold because the market thinks that everyone thinks the US Dollar will keep rising. And so on. It is always comfortable to be with the crowd.

Sentiment is reflected by technicians in the relationship between the 50 day and 200 day moving averages. When sentiment starts rising the 50 day crosses the 200 day upwards. When sentiment declines the 50 day crosses below the 200 day moving average downwards.

In a way it is a bit like falling in love and the sorry realisation later that expectations have not been met. That is called buying HI and selling LO.

We believe that in the long run sentiment will ALWAYS prove to be fickle and that the most certain way to ensure success in the markets is to practice “value at a fair price”.

That is to only own investments that are specific to our individual needs that fit with out asset allocation and what we need in our portfolio.

In other words ignore what others think is pretty and stick with what is suitable. This may include expectations about future earnings but make sure they are our own expectations not what we think others may think.

So What is Cheap Now?

Having recently watched the new movie “ The Reluctant Fundamentalist” ( about a very bright Muslim who remains reluctant to accept fundamental valuations in his career on Wall St and equally reluctant to accept Muslim Fundamentalism) we understand that financial assets that appear cheap right now may remain cheap for a lot longer. There is no guarantee that a cheap asset will increase in value. However we can be much more certain that it will not decline in value further than an asset which is very expensive.

Commodities

The Commodities Research Bureau Index is at its lowest since the GFC.

All agricultural commodities, as measured by the Powershares DB Agriculture Fund DBA, are at their lowest since the GFC . There are two ETFs which we think are cheap based on a recovery in agricultural prices, VEGI and MOO, both of which have large holdings in Monsanto which is well down from its recent highs.

Oil

We think it is the Saudis and the Pentagon ( the quickest way to crush Russia and ISIS is to starve them of money for oil) who are behind the massive drop in oil prices which are now at their lowest level, inflation adjusted, for many many years. We would not be surprised to learn that it is actually the Saudis who are behind the massive increase in oil storage in the US. Low oil prices benefit the refiners which is why we have seen stocks like Tesoro, and Valero, up sharply in price since oil prices started dropping. The best ETF which is well undervalued on forward earnings is Powershares Dynamic Oil and Energy, ticker symbol PXE. It has a large holding in Valero, and although it holds many of the producers, is trading on a 50 pct lower multiple on consensus forward earnings.

Neither food nor oil are on the radar for most investors just yet which means they are not being judged in the current beauty contest.

John Kimber