Monday, February 07, 2011

Lack of Imagination or Too Much Imagination?

The continued full steam ahead bull market in stocks has caught many (including myself) by surprise. Its not that I didn't believe this meteoric rise couldn't happen, just that I thought perhaps the market had learned something from a decade of multiple 50% crashes and bubbles.

At these market levels stocks are priced for perfection and any hiccup could present a large downside. Currently, the market pendulum has swung to an "Imagination" of future, ongoing prosperity for all and has forgotten what happen just a few short year ago. But is this a good thing? For those who invest in stocks I think you must have a different "Imagination" - what can go wrong and what are the downside consequences.

There are so many things that can go wrong and there is no or little Margin of Safety left in the market. Just a few things:

Terrorist attack
Oil disruption
Internet attack that cripples communications as we currently know them
American Austerity
Steve Jobs take another leave of absence (wait, that happened! Please come back Steve, get better).

My point is not that you shouldn't invest when bad things can happen - bad things can and DO always happen (too use a way overused term - Black Swans). The threat of bad and unexpected events shouldn't keep one from investing in stocks, however when you do decide to invest there needs to be a margin built into your purchase that accounts for the possibility of bad things happening (an expectation if you will). That way, you know you still have value in your purchase when/if things do go bad and you won't have to panic sell (thus feeding the beast).

For example, when Reagan took office unemployment was sky high, inflation was rampant, the economy was just in big trouble. Yet stocks were trading at only 8 times prior cyclically-adjusted earning. The market suffered from a lack of "Imagination" as to what could go right. But those people who invested in stocks had a huge margin of safety - things didn't have to go very right for them to receive a reasonable return on stocks. This is not the case today - in an economy that is much more difficult than 1980/81 we have stocks bid up to levels that were only seen prior to major stock market tops. The stock market suffers from a lack of imagination of what could go wrong and has priced in perfection and almost zero Margin of Safety.

History has taught us that these exuberant times can continue and for much longer than any of us ever imagine (NASDAQ, Housing, etc).

There is little margin for error, very little imagination and we should be cautious at this juncture.

Scott Dauenhauer CFP, MSFP, AIF