Sunday, November 9, 2008

Sentiment - tying it all together

Fundamentals are now and will be quite bad for the next few years, but just as importantly, sentiment has turned. This is a long-term (i.e. greater than 5 years) secular shift that promises to make the ultimate lows in stocks lower than they would be if sentiment was positive and fundamentals were poor.

If you doubt this, think about headlines used to explain daily or weekly movements in stocks or other investment assets. There always seems to be an "explanation." Think of this past summer when everyone was talking about oil:

"Stocks rise due to energy strength."
"Stocks fall due to expensive oil."
"Stocks fall due to weakness in the energy and commodities sector."
"Stocks rise due to cheaper oil."

Huh? No wonder retail investors who watch CNBC are confused. "Show me the price action and I'll give you the headline," to paraphrase an old saying. Some of the so called maxims of stock investing are based on fallacies that can be easily disproven, yet they persist. The perfect example: when the Fed cuts rates, stocks go higher. If you want to do a little of your own research on this, all you have to do is look at the last year or so to know this is complete garbage. Yet everyone hangs on the Fed's every word as if their magic fairy wand controlled the economy and/or stock prices. Just like the Wizard of Oz, pay no attention to the man behind the curtain.

Sentiment, or emotion/mood, is a big part of what drives stock prices. The price to earnings ratio is a good way to assess sentiment. In certain periods of history, people are willing to pay more money per dollar of corporate earnings than others. In other periods, stocks are shunned even when a good long-term buy. Look at the chart below, which I copied/stole from another site a while back and can't give proper credit for:

People who say P/E ratios make stocks "cheap" right now are not accurate and are not taking sentiment into account. The price people are willing to pay for a dollar of earnings has peaked and is heading down. The chart above is almost a perfect sine wave and our down slope for this cycle is ahead of us, not behind us. History tells us the P/E ratio will drop for general stocks until it is less than 10 before a new long-term (i.e. decade or more) bull market is born. Prices of stocks are falling right now, but earnings are falling just as fast or faster and we have a LONG WAY TO GO before a P/E ratio of less than 10 signals that it may be time to dip your toe back into general equities.

But why is this true? Why was someone willing to pay $100/share for a stock with no earnings in 2000 and why isn't someone willing to pay $1/share for a similar company now? The answer is simple: sentiment. The social mood has turned against stocks. We are at the beginning to middle stages of this social mood turn. The first glimpse came in the 2000-2003 bear market, but now the fast, furious and devastating turn comes that will destroy your investment portfolio if you don't change to match the times. Buy and hold will work only if you're willing to wait 20 or more years just to get back to even.

Once the P/E ratio for stocks gets below 10 and one ounce of gold can buy the entire Dow Jones Industrial Average, I will change my bearish tune and become a wild general stock bull. You will no longer hear me talking about gold and gold stocks, unless it is as a shorting opportunity. Until that time, however, general stocks are a short-term trade or a shorting opportunity only. Gold and gold stocks on the other hand are currently a long term, dream-come-true opportunity to protect and enhance your wealth.

Wikinvest Wire