Benjamin Graham, the father of fundamental stock analysis, likened the stock market to a bi-polar person. Is Mr. Market now too manic?
Benjamin Graham wrote the investment classic Security Analysis in 1934. He advocated systematically examining stocks to find undervalued and overvalued stocks. This made him the father of fundamental stock analysis. Today, computerized systems have reduced the value of traditional stock analysis. It makes it easy to analyze large databases of stocks. Back in Mr. Graham’s time, such stock analysis required arduous work.
Bur Mr. Graham grasped an important insight in these years. He noted that he was criticized by his peers for being too conservative during the stock market boom of the ‘roaring 20s’. Then he was criticized by his peers for being so reckless as to buy stocks after the market crash of 1929 and during the ‘dirty 30s’. But in Security Analysis, he says that he never changed his approach to stock investing.
Although he never said so, we believe that this criticism may have given Mr. Graham his insight that the bi-polar stock market is swept by tides of excessive pessimism and optimism. In his 1949 book, The Intelligent Investor, Mr. Graham calls the stock market ‘Mr. Market’.
Mr. Market tells you what he thinks
Mr. Graham wrote that each day, Mr. Market tells you what he thinks your stakes in companies are worth. Furthermore, Mr. Market offers to buy you out at this price or to sell you his stake at the same price. Sometimes, Mr. Market’s offer seems justified by business conditions as you see them. But other times, Mr. Market’s offer strikes you as silly. When Mr. Market offers you a ridiculously high price for your shares, you should sell to him. When Mr. Market offers to buy you out at too low a price, you should buy shares from him.
In February and March, 2020, the COVID-19 pandemic burst onto the world’s stage. For most people, this was the worst pandemic since the Spanish flu killed 20 million people a century earlier. COVID-19 has also killed people, destroyed businesses and crippled economies. Not surprisingly many investors panicked and sold in droves. Stocks became cheap. Mr. Market was in one of his depressive phases.
What few seemed to notice was that central banks slashed their benchmark lending rates. And many governments pursued very loose fiscal policies. Bond yields fell far below the dividend yields of most stocks. And expansionary fiscal and monetary policies worldwide fortified the global economy. In response, investors returned to stocks en masse. Stocks have climbed ever since.
Are stocks now ridiculously expensive?
The question is whether Mr. Market’s manic phase has gone too far. Are stocks now ridiculously expensive? We don’t think so as long as stocks offer so much more than bonds. Even so, we know that at some point Mr. Market will change his mind and become gloomy. This could happen if interest rates climb further and faster.
Another risk is COVID-19 ongoing mutations. What will happen if vaccines become ineffective against new varieties of COVID-19? How long will it take to vaccinate most of the world’s people. India, for instance, has an enormous problem. Until the developing world is vaccinated, no one will be entirely safe.
Take these three steps to protect yourself
We don’t know when Mr. Market will change his mind and by how much. But there are steps that you can take to protect yourself. First, pay down or eliminate your debt. Be sure to pay off margin debt that you borrowed to buy stocks.
Second, gradually buy stocks over time. That way you’ll avoid the problem of buying most of your stocks at a cyclical peak. Always keep some cash handy.
Third, move up the quality scale. Sell small speculative stocks and reinvest the proceeds into larger stocks that we rate ‘Very Conservative’ or ‘Conservative’.
Buy stocks with stable earnings and cash flow. For instance, we recently reviewed electricity producers that profit from stable demand.
Focus on ‘Dividend Aristocrats’ that raise your dividends every year. This will give you a growing stream of dividends. It will also convince income-seeking investors to pay more for your shares.
These steps will stand you in good stead when Mr. Market changes his mind and falls into a depressive phase.
This is an edited version of an article that was originally published for subscribers in the May 7, 2021, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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