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Don't Forget to Look Down

By Dan Ferris, editor, Extreme Value
Thursday, August 27, 2009

Psychologists call it "recency bias."

It's when you assume what just happened recently will continue to happen indefinitely. In the stock market, when "up" is happening all around you, it's normal to abandon any thought of "down."

But I strongly caution you, especially when taking new positions: Don't forget to look down. Don't buy because stocks have gone up. Buy only what is cheap and safe.

The stock market has few investors looking down now. The American Association of Independent Investors (AAII) sentiment index says only 40% of investors are bearish. It was 70% bearish back in March.

Everyone was looking down then. Now, they're all looking up. They don't want to miss the fireworks.

Looking down right now isn't easy. Some of the world's most famous and successful investors are having trouble doing it. Author, hedge-fund manager, and former Morgan Stanley analyst Barton Biggs isn't looking down. He says it's a new bull market. George Soros isn't looking down. He says the economic stimulus worked and the bottom is in.

But I'm listening to the godfather of all hedge-fund managers, Michael Steinhardt. He got it right, I believe, in a recent interview when he said, "I'm not saying we're in a zone of reasonable valuation... [I'm saying] you can't talk about valuation so readily."

It's really difficult to know if stocks are overvalued or undervalued right now. The solution to this is simple, but almost impossible for most investors to execute... 

Famed value investor Jeremy Grantham says it best. From decades of experience and research, he's learned "the best long-term predictor of future stock market gains is the current value of the market."

Since the current value of the market is difficult to fathom, you need to be careful about the current value of any stocks you buy. In other words, don't worry about the overall market. Worry about how much you're getting paid for the risk you're taking.

When a stock gets cheap, its dividend yield rises. A stock's dividend yield has to be high enough or it's not cheap enough, no matter how you measure it. 

That doesn't mean you should go out a buy a pile of risky commodity companies yielding double digits. I'd much rather buy Procter & Gamble, which is yielding 3.3%... or Microsoft, which yields 2.1%... or Wal-Mart, which yields 2.1%. These yields don't sound like much to the novice investor. But Treasury yields aren't much better at 4% for the longest-dated bonds. And unlike Treasuries these yields will grow over time

Procter & Gamble has raised its dividend every year for 55 years. Microsoft has increased its dividend an average 40% every year since 2003. And if you bought Wal-Mart 12 years ago, you're now earning 10% a year on your original cost. (Imagine owning a business like Wal-Mart and getting a 10% yield!) 

Jeremy Grantham is bearish on the overall stock market. Unlike most investors, he hasn't forgotten to look down. But he's still bullish on these high-quality businesses, which are trading near multiyear historical lows.

No matter what you think, what we've seen recently in the market can't continue indefinitely. The best way to keep an eye on both the upside and the downside is to buy what's safe and cheap.

Good investing,

Dan Ferris

P.S. One of the world's greatest "safe and cheap" assets is a rarely talked about asset I call "gold-backed" annuities. They allow you to capture the enormous potential upside in precious metals right now... while offering a large amount of safety. You can access my full report on these assets with a trial subscription to Extreme ValueClick here to learn more.

Market Notes


Like a husband who stayed out too late, the bull market in small resource stocks is quietly "walking up the stairs."

Our chart today displays the past year's trading in the S&P/TSX Venture Index. You can consider this index the "Dow Industrials of small resource stocks"... the speculative companies involved in energy and mining.

Last year brought devastation to this index. As folks fled anything related to risk and commodities, the Venture lost 75% of its value in just months. But as you can see, it's slowly and surely creeping higher. The companies in the Venture have enormous potential to rise if commodity prices stay high... and the early money is starting to flow into the sector.

When you're "long-term long" an asset, this is exactly the kind of action you like to see. You don't want too many people figuring out what you already know. You like slow and steady gains that aren't reported in the headlines. But we recommend taking your positions here soon. If gold passes $1,000 an ounce, this quiet rise will turn into a loud one.

In The Daily Crux

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