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Market Is Skating on Thin Ice

You need to start thinking differently if you want to survive the next downturn.

Since Donald Trump’s victory on Nov. 8, the stock market has signaled its approval by racking up a year’s worth of gains of 9.8% for the S&P 500. At the same time, its mid-cap cousin, the S&P 400 index, has increased by 14.6% while the small-cap Russell 2000 index is up 16.6%. Life has been good for stock market investors of all stripes, but that may soon change.

This week’s inflation report from the Bureau of Labor Statistics was hailed as good news, with the Consumer Price Index growing at its fastest rate in three years. That suggests the economy is picking up steam, reinforced by encouraging retail sales in January, also released this week. Combined with Trump’s promises to cut corporate taxes and increase spending on massive infrastructure projects, all signs seem to be pointing towards a high-growth stock market.

I’m skeptical. And I think there’s a strong possibility that the stock market is overreacting to a lot of pie very high in the sky. The unbridled optimism that has pushed all the major stock indexes to record highs can just as quickly be replaced by daunting pessimism if Trump fails to deliver on the “phenomenal” changes to the tax code he alluded to last week, or backs off on his promise to rebuild American’s roads, bridges and airports.

So I believe we will soon reach an inflection point in the stock market, when unsustainable expectations learn a lesson from empirical facts. To avoid a shellacking you’ll need to become a contrarian and ignore Wall Street groupthink.

That’s one reason why I constantly refer back to my IDEAL Stock Rating System in Personal Finance when making portfolio decisions. By scoring every stock according to three time-tested valuation metrics, it helps me avoid overpriced momentum stocks that will dive when reality hits the road. Right now an astounding 40 stocks in the S&P 500 earn the lowest possible IDEAL score of 0, and another 51 companies get the next lowest score of 1.

At the same time, only two stocks earn the highest IDEAL score of 10, and another seven get the second highest score of 9. That means that while a total of 91 stocks are considered severely overvalued, only 9 are equally undervalued. That asymmetry is greater than it has ever been since I introduced this system over two years ago, suggesting many stock prices must fall to restore some semblance of.

That’s why investors need to start thinking like contrarians. Some of the stocks you feel most comfortable owning will be the same ones that will perform the worst when the market tumbles. Conversely, other stocks that have been abandoned by the herd could end up leading the market higher as their unrealized value becomes apparent.

For example, fourteen months ago I added IBM to the Personal Finance growth portfolio when most analysts were saying that its best days were behind it; today, its share price is up 40%. Last May I bought Harley-Davidson after it was pronounced dead by many industry experts, but I’m pleased with the 30% gain realized on HOG since then.

Everyone loves making money in the stock market, and many financial journalists turn into permabulls to pander to readers who only want good news. They are often taken to task for not tipping off readers that a major change is on the way. We are not permabulls, we call them as we see them. So I’m telling you now: you need to start thinking like a contrarian to make smart investment decisions.

At Personal Finance we’ve already started to stack our portfolios for when reality strikes.

 

 


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