Don’t Be The Greater Fool
P.T. Barnum, famous American showman of the 19th century, purportedly said: “There’s a sucker born every minute,” which brings me to the greater fool theory.
The greater fool theory refers to those who buy an investment based on the notion they will be able to sell it at a profit to a “greater fool.” In other words, the price of the asset in question is determined not by its inherent value, but rather by irrational expectations. Today I will show you how to avoid becoming that fool.
To be sure, there’s more to this extended rally than unwarranted exuberance. The Commerce Department reported Tuesday that sales of new U.S. single-family homes rose more than expected in May, indicating that the economy could be on the verge of recovering from the coronavirus-induced recession.
The three main U.S. stock market indices soared Tuesday on the news. The Dow Jones Industrial Average rose 0.50%, the S&P 500 climbed 0.43%, and the technology-intensive NASDAQ composite rose 0.74% to reach an all-time high.
New home sales in May jumped 16.6% from the previous month, to a seasonally adjusted annual rate of 676,000 units, the Commerce Department reported. Sales fell 5.2% in April to a pace of 580,000 units. The consensus estimate of economists was for new home sales to climb 2.9% to a pace of 640,000 in May. Sales last month jumped 12.7% from the same month a year ago (see chart).
In additional good news, data firm IHS Markit reported that its flash U.S. Composite Output Index increased to a reading of 46.8 in June from 37 in May. The monthly index tracks the manufacturing and services sectors, with data derived from surveys of senior executives at private sector companies. A reading below 50 indicates contraction.
The manufacturing sector’s downturn slowed, with the flash Purchasing Managers Index (PMI) climbing to 49.6 from 39.8 in May. The survey’s services sector flash PMI rose to 46.7 from 37.5 in May.
Glimmers of hope are appearing overseas as well. The IHS Markit’s euro zone Flash Composite PMI Index rose to a reading of 47.5 from May’s 31.9.
The COVID wild card…
Tuesday’s housing and PMI data suggest that the global economic contraction might not be as bad as feared. The wild card, of course, is the COVID-19 pandemic. Until the virus is vanquished, risk-on assets are vulnerable.
Investors remain jittery about the spread of the virus. In pre-market futures trading Wednesday morning, stocks were poised to open lower.
A spike in new coronavirus cases throughout the country is offsetting positive economic data. Several states have reported record daily increases in COVID-19 infections, especially in the South and West, due to premature re-openings of businesses.
Coronavirus cases are rising, not falling, in the U.S. and other countries. If governments don’t get a handle on fatalities, we could witness a second round of lockdowns. The stock market rally since March has been driven by large-cap tech stocks that have gotten pricey, indicating an asset bubble that’s in search of a pin.
Investors also are losing sight of the fact that fiscal stimulus, which has helped buoy the stock market, is running out and Congress is unlikely to enact more. Millions of individuals and businesses already are encountering difficulties in paying the rent, mortgages and other basic expenses.
The coming wave of personal and business bankruptcies is likely to trigger another round of selling on Wall Street. We’ve witnessed irrevocable damage to many small businesses and high unemployment is likely to linger longer than the actual crisis itself. Even when COVID-19 fades, society will suffer a collective form of post-traumatic stress syndrome that inhibits a return to pre-COVID levels of confidence and spending.
It’s also worth noting that the pandemic and subsequent recession undercut stock buyback programs, a major impetus behind recent rallies. Exacerbating the situation are negative earnings projections, as well as guidance that’s either been withdrawn or remains unreliable.
So what’s an investor to do? Raise cash by pocketing some of your biggest gains, especially on pricey large-cap tech stocks. Make sure your portfolio contains safe haven stocks.
Asset allocation is one of the most crucial decisions in investing. Our flagship publication, Personal Finance, recommends the following portfolio allocations under current conditions (see pie chart).
These allocations are a general rule of thumb and should be tweaked according to your risk tolerance. Stage of life is an important factor as well.
For example: relative youth (aggressive growth); middle age (moderately aggressive); retirement in the next 10 years (income and moderately conservative); or retired (stability and income).
Since late March, the stock market has been disconnected from the fundamentals. The bulls argue that the worst is behind us, but we’ve probably been witnessing what’s called a sucker’s rally. As P.T. Barnum said, there’s one born every minute.
Editor’s Note: Does stock market volatility make you nervous? Despite all of the uncertainty we’re witnessing these days, there still exist opportunities to make outsized profits.
To find those opportunities, I suggest that you consider the advice of our colleague, the renowned options trader Jim Fink.
Jim Fink is the chief investment strategist of Velocity Trader, Options for Income, and Jim Fink’s Inner Circle.
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Now, Jim is making this bold promise: “If I don’t deliver 24 triple-digit winners over the next 12 months…I’ll cut you a check for $1,950.”
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John Persinos is the editorial director of Investing Daily. Send your questions and feedback to: email@example.com