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To The Moon, Alice, To The Moon

MarketClick on any image for a full sized view

Well, we had a huge day in the market today and I thought that it deserved a bit of discussion.  As everyone who reads the blog knows, I am very cautious on the markets right now given their level of extreme excitement, extreme greed, extreme overvaluation, and negligible expected forward returns.

Take a look at the graph above – in the RSI indicator at the top of this S&P 500 Index graph, you can see the huge turquoise area above the top line.  This indicator is telling us that there is extreme excitement and buying interest in the markets and that they are due for either a pullback or a rest with some weeks of sideways movement.

greedCheck out the Fear and Greed Index above – this is one of the highest readings I can remember seeing on this indicator.  Contrary to what you are hearing on tv, market do not go in a straight line like a rocket to the moon.

Fair ValueAbove is a spreadsheet I’ve posted on this blog in the past – it is one I use to gauge where the market is valued compared to its historical valuation levels.  It uses four  different valuation measures and comes up with a weighted average valuation.  Right now, it shows that the market is 13%+ overvalued.

Expected ReturnsThis is another spreadsheet that you have seen in the past here.  It is one that I use to calculate the expected forward returns for the S&P 500 Index over the next decade.  Based upon today’s valuation for the market, we should expect a forward average annual return of 3.86%.

I know it is fun to watch your portfolio value go up when the market is on fire like it is now.  However, it is equally as gut wrenching to watch the value of your portfolio go down when the market takes a major tumble.  That is why it is imperative that investors employ risk management techniques to make sure they keep the gains in their portfolio when the market goes down.

We are employing those risk management techniques, booking gains on certain holdings, keeping cash and short term bonds on hand to protect the portfolio from the inevitable downdraft that will take the valuation down toward or below its fair value.

Our strategy will be one we have used over the decades I’ve been managing money – use that cash and those short term bonds to buy shares of companies we want to own that have superior investment characteristics at liquidation prices from investors that did not manage their risk and are panicking during the inevitable correction.

Warren Buffet has said that “You pay a very high price in the stock market for a cheery consensus.”  And that “the time to buy is when there’s blood in the streets” (I believe he was paraphrasing one of the Rothchilds in the last half).

This is in essence what we are doing – employing the greater fool theory of investing:  we sell appreciated shares of stock to someone and book our gains, then buy it back from them later at a significant discount.

The market does not go in a straight line like a rocket heading to the moon – there will be a day of reckoning  when fear “trumps” greed.  But until then our strategy will be to continue to make money off the investments we have in the market, book profits when the fundamentals so dictate, and manage our risk so that we can take advantage of any corrections and the people who did not manage their risk.

–Mark