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Price and Value: How to Profit From The Imbalance

By John Persinos on March 30, 2017

The father of value investing, Benjamin Graham, famously said: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

The voting machine favors popular companies. But over time, the weighing machine objectively gauges corporate fundamentals. And right now, the weighing machine is about to render a merciless verdict.

Standard earnings multiples suggest stocks are the priciest they’ve been since the dot-com run-up. Below, I pinpoint a simple and easy way to profit from the imbalance. Compelling growth opportunities still exist, even in this perilous market, but you need to apply astute investment picking stills (and that’s where we can help).

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio promulgated by Yale professor Robert Shiller suggests stocks are the third-most expensive they’ve ever been, behind 1929 and 2000 levels. The forward 12-month price-to-earnings ratio for the S&P 500 is 17.9, compared to the 10-year average of 14.4.

Distorting valuations for the past 8-9 years have been ultra-low interest rates and trillions of dollars’ worth of quantitative easing in the U.S. and Europe. These loose monetary policies have made bond yields extremely unattractive, compelling traders to shoulder greater risk by bidding up stocks well beyond prices that are justified by projected earnings and economic growth.

But now, the Federal Reserve is less accommodating and the European Central Bank plans to start scaling back its monthly bond purchases in April.

Excessive optimism over Donald Trump’s proposed agenda also has driven up share prices, but this catalyst already is losing steam.

The Trump Bubble: About to Pop?

Joseph P. Kennedy, the ruthless patriarch of the political dynasty and the first SEC chairman, once said: “It’s not what you are, but what people think you are that is important.”

Trump’s career rose on the strength of that truism, as he cultivated the image of a master at “The Art of the Deal.” But let’s examine an excerpt from that 1987 book:

“You can’t con people, at least not for long. You can create excitement, you can do wonderful promotion and get all kinds of press, and you can throw in a little hyperbole. But if you don’t deliver the goods, people will eventually catch on.”

As the Trump rally sputters, it seems that perhaps Wall Street is catching on to Trump. The spectacular demise of “Trumpcare” last Friday certainly demolished Trump’s reputation as a seasoned negotiator.

Jim Pearce, chief investment strategist of Personal Finance, says the weighing machine will soon make tough adjustments.

“What’s less clear is how much of his agenda Trump can accomplish, and how stock and bond markets will react…

“After recalibrating share prices based on the president’s agenda, the market now needs to winnow down the winners and losers. The effect this exercise will have on the overall market may be neutral or even slightly negative, depending on how well legislators can transform Trump’s words into actions.”

In the words of legendary investment guru Sir John Templeton: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Investors are fickle and they were counting on President Trump to be an adroit dealmaker. Now that Trump has suffered an ugly setback on his first legislative initiative, his efficacy is in question.

Fact is, this overvalued equity rally is based on unwarranted hopes that corporate earnings will rise faster than projected economic growth. Here’s a shrewd investment play on these imbalances, especially concerning corporate earnings: buy shares in the AdvisorShares Ranger Equity Bear ETF (NYSE: HDGE).

This exchange-traded fund focuses on U.S. based, mid- and large-cap stocks with low earnings quality or overly aggressive accounting practices, regardless of their brand name or favor on Wall Street.

To find these inherently dangerous stocks, HDGE managers scrutinize income statements to uncover hidden weaknesses. This ETF focuses on the empirical numbers, not media hype or wishful thinking. The approach is bottom-up and fundamental, to pinpoint imminent operational deterioration. After finding equities with particularly weak fundamentals, the fund shorts them.

With net assets of $162.97 million, HDGE loads up on the very stocks that tend to fall the hardest in a bear market. Top HDGE holdings include SNAP (NYSE: SNAP), the Internet mobile chat company that launched a frothy IPO this month and Caterpillar (NYSE: CAT), which got hit this month with a federal tax fraud investigation.

Another major HDGE holding is Motorola Solutions (NYSE: MSI), a company that HDGE managers deem extremely overvalued because of undue optimism over the company’s ability to dominate its market of radio handsets for government first responders.

Since November 9, HDGE has fallen roughly 12%. But over the past month, as investor euphoria has collided with reality, the ETF has risen about 2%. The S&P 500 has gained about 10% and fallen about 2%, respectively, over those time frames.

Think of HDGE as one of Benjamin Graham’s weighing machines.

Got a question about how to trade amid today’s excessive market valuations? Drop me a line: mailbag@investingdaily.com — John Persinos

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