In yesterday’s Digest, we began a new series from global investment strategist Eric Fry. In it, Eric highlighted how recessions and bear markets can blindside many investors. He exposed several “leaks” in the $31 trillion U.S. stock market which are troubling. In this second and final part of that series, Eric illustrates how, time and again, the so-called experts have missed these “leaks” right before they broke big and caused major financial storms. More importantly, he offers up specific ways to protect yourself against — and even profit from such storms. Keep in mind, Eric was one of the few analysts who predicted the last big market crash, in 2007-’08. He showed his readers how to profit off of companies that eventually went bust. In fact, his readers could have walked away with gains like 1,415% on Countrywide Financial, 4,408% on Fannie Mae, and even 6,425% on Freddie Mac. To me, there’s no one better to show you how to gain a huge advantage during market turbulence. I’ll let Eric take it from here. Jeff Remsburg

Take Off Your Bear Market Blinders and Focus on These Propositions
By Eric Fry, Fry’s Investment Report

A few days before the epic stock market crash of 1929, the renowned economist Irving Fisher declared, “Stock prices have reached what looks like a permanently high plateau … I expect to see the stock market a good deal higher within a few months.”

Seven decades after Fisher’s infamous faux pas, another esteemed economist issued an equally misguided forecast. That economist was Federal Reserve Chairman Alan Greenspan.

On March 6, 2000, Greenspan assured a Boston College conference on the “New Economy” that the internet-based economy would continue to foster productivity, technology innovation, and enduring wealth creation.

“I see nothing to suggest that these opportunities will peter out anytime soon,” Greenspan predicted. “Indeed, many argue that the pace of innovation will continue to quicken in the next few years as companies exploit the still largely untapped potential for e-commerce.”

Alas, the tech-heavy Nasdaq Composite index topped out almost immediately after Greenspan stepped away from the podium.

 

 

But at the birth of the new millennium, Greenspan was not the only learned individual to predict a “new era” of permanent prosperity. So did Washington Post columnist James Glassman and economist Kevin Hassett. In late 1999, the duo published the first edition of Dow 36,000, in which they predicted the Dow Jones Industrial Average would hit 36,000 within a few years.

It was not to be. This forecast was as inaccurate as it was audacious.

Within two years of Dow 36,000‘s arrival in bookstores, the Dow had slumped to less than 9,000. Even now, nearly 20 years later, the blue-chip average is trading for less than 27,000 — well below the 36,000 target.

Just a few years after the 2000-’02 bear market took many investors by surprise, the stock market started fooling investors again. The housing boom of the mid-2000s was so intoxicating that many investors failed to recognize the ensuing bust until it was too late.

During the run-up to the epic stock market collapse of 2008, professional Wall Street prognosticators were firing off errant forecasts like July 4 fireworks.

In November 2006, for example, Greenspan confidently declared, “Most of the negatives in housing are probably behind us … A lot of people are going to lose their homes. It’s a family tragedy. It’s not an economic — or macroeconomic — tragedy.”

Five months later, Greenspan’s successor, Ben Bernanke, doubled down on his predecessor’s errant forecast by declaring, “At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

By the end of 2007, signs of the coming housing bust were sprouting like red caps at a Donald Trump rally. But that troubling reality did not seem to trouble Abby Joseph Cohen, Goldman Sachs’ chief investment strategist.

Despite the fact that the housing market and the banking sector were both displaying advanced signs of serious distress, Cohen issued a forecast in late 2007 that the S&P 500 would climb 14% in 2008 to reach a new all-time high. Instead, the blue-chip index tumbled more than 50% to hit a 13-year low.

But Cohen’s misguided prognostication was hardly an outlier. In early 2008, lots of supposedly savvy professional investors believed the credit crisis was nearly over … even though it had just barely begun.

• On April 8, 2008, for example, Morgan Stanley CEO John J. Mack declared that the collapse of the subprime mortgage market in the United States had reached its eighth inning, or “maybe top of the ninth.”

• Two days after that, Goldman Sachs CEO Lloyd Blankfein pronounced, “We’re closer to the end [of the credit crisis] than the beginning,” and “we’re getting to that point where people are seeing the light at the end of the tunnel.”

• Five days after that, Lehman Brothers CEO Richard Fuld said, “The worst is behind us.”

• Fifteen days after that, Treasury Secretary Henry Paulson declared, “I think we’re closer to the end of the [credit crisis] than we are to the beginning.”

Every single one of those big-wig investment professionals was catastrophically wrong about the health and trajectory of American finance. Their myopic forecasts reminded me of one of my father’s favorite phrases: “Better to remain silent and be thought a fool than to speak and remove all doubt.”

Clearly, the predictions business isn’t easy. As the investing legend Peter Lynch once observed, “I don’t remember anybody predicting the market right more than once.”

Most of us struggle to imagine adverse outcomes because we expect today’s good news to resemble tomorrow’s. When stock prices are flying high, we tend to believe they’ll fly even higher. Over and over again, we fail to see serious risks, even when they’re standing right in front of us.

The “accepted wisdom” of any particular era is rarely as wise as it purports to be. It almost always fails to recognize major turning points — whether from extreme highs or extreme lows.

Today’s accepted wisdom embraces the belief that stock prices are likely to keep moving higher. Investors might not be wildly in love with stocks, but they certainly like-like them … a whole bunch.

And generally speaking, they harbor little fear of a major selloff. After all, the stock market has been rising for the last 10 years.

So, what’s to fear?

 

When Cash Is King

 

The chart below provides a partial answer. Based on price-to-EBITDA (that is, gross earnings), the S&P 500 is trading close to a record-high level. That’s not a good sign, as richly valued stocks tend to produce subpar investment results.

 

 

For example, if the S&P 500 merely dipped from its current valuation to its average price-to-EBITDA valuation of the last three decades, it would fall more than 30%.

But once a stock market begins a major decline, it rarely stops falling at the “average” level. Instead, it continues to fall and overshoots on the downside.

In other words, when stocks become this pricey, good things rarely happen. Conversely, good things often happen to lowly valued stocks. The chart below illustrates this inverse relationship.

For example, in 1994, the blue line shows that U.S. stocks were selling for only 5.2 times EBITDA — or less than half today’s valuation. From that low starting point, the orange line shows that the S&P 500 delivered a total return of 247% during the ensuing five years (from 1994 to 1999).

 

But as U.S. stocks soared toward their 1999 highs, they reached a rich valuation of 11.2 times EBITDA. That was the record-high reading on this indicator … until recently.

Not surprisingly, from that lofty starting point, the next five years in the stock market were a complete bust. The S&P 500 produced a loss of 11%. In fact, even 10 years after that high-valuation reading of 1999, the S&P 500 was still 9% underwater.

In other words, after one entire decade of investment, the stock market turned $100 into $91.

Clearly, the starting price matters when making an investment. That’s why buying U.S. stocks at their current lofty valuations could be a risky bet. Today’s high price-to-EBITDA reading is certainly a warning sign — a sign to lighten up on stocks and build up your cash holdings.

Cash is the only asset that truly protects your capital during a market selloff.

As I pointed out in Bear Market 2020: The Survival Blueprint, cash occupies a unique place in the world of investing.

Here’s an excerpt from the book:

There’s nothing like it. Cash is both the repository of accumulated wealth and the seed of future wealth creation. Almost every success story begins with cash. If you don’t have any, you won’t ever achieve investment success. That’s a cold, hard fact … It is what enables savvy investors to pounce on excellent opportunities, and to gobble up the tasty investments that can turn modest investments into millions, if not billions, of dollars. Without cash, every investment opportunity is a nonstarter.

That’s why I suggest raising modest amounts of cash at moments like these, when warning signs are multiplying and valuations are hovering near historically high levels.

I also suggest adding to your investments in the precious metals sector. That’s why I have recommended buying three plays on precious metals to Fry’s Investment Report members. The two I recommended in June are up 12% and 20%, respectively. The third, which I added to the portfolio only two weeks ago is up modestly. (To find out how to get those recommendations for yourself, click here.)

That said, I do not suggest panicking or going “whole hog” into gold and silver. Just add a bit more.

But even as you raise some cash and boost your exposure to precious metals, you should not abandon your core long-term investments.

Reducing exposure to stocks doesn’t mean eliminating exposure to them. As we guard against bear market losses, we must remain focused on our long-term investment objectives.

Even in a challenging environment, some stocks will perform well. We’ve gotten a taste of that dynamic already, as most of the stocks in our portfolio have performed well, even though the overall market has been drifting lower. The solar sector provides one very welcome example. In the July issue of the Investment Report, I recommended buying the shares of two solar companies. Since then, one has gained 17% and the other has popped 27%… even as the S&P 500 is up just a few percent.

This short-term outperformance is likely to blossom into strong long-term outperformance.

That’s why, in addition to following the six tactics I lay out in Bear Market 2020: The Survival Blueprint, it is critical to focus on stocks and sectors that offer uniquely promising long-term prospects … and never settle for mediocre investment propositions.

No one ever walks into a restaurant and asks for a glass of “fairly clean water” or a serving of “almost fresh fish.” Sure, you might not get sick, but that is not the objective. We must always seek to thrive, not just survive.

Our investments should advance that same objective.

To find out more about how we do that at Fry’s Investment Report, click here.

Regards,

Eric Fry