Investment Philosophy III

This post deals with the handling of one of those rare years where speculation is rife and skilled investors can be almost certain of the impending bursting of the bubble that is to come. First of all, it would be important for the investor to identify what are the characteristics of such times and what are not.

Ridiculous as it may seem to us today, when we are in a bubble, the majority of the financial community actually believed that we are in a "new era". Perhaps not in an explicit sense, but for years earnings of most companies had been growing with monotonous regularity. Serious business depressions had become a thing of the past. In such circumstances, it seemed to many that it had become virtually impossible to lose by owning stocks. And many who wanted to cash in as much as possible on this sure thing bought on margin to obtain more shares than they could otherwise afford. Even though many felt strongly that the stock market was too high on those dangerous days, people were nevertheless entrapped by the lure of the market. Many would find themselves looking around to find new stocks that "were still cheap" and were worthwhile investments because "they had not gone up yet".

Nearly all bull markets have a well-defined characteristics in common, such as (1) a historically high price level, (2) low earnings yield versus bond yields, (3) much speculation on margin and most importantly (4) record high offerings of new common stock issues.

Contrast this with the situation where business was good and corporate earnings were rising steadily. Neverthelessm almost the entire investment community were mesmerized by a simple but fallacious comparisons to the past. It was remembered that few years after the Civil War, a period of immediate prosperity was followed by the panic of 1873 and almost 6 years of deep depression. A somewhat similar period of prosperity after World War I was followed by the Crash of 1929 and even deeper recession about the same length. In WWII, the costs of war had run on a per diem basis about ten times that of WWI. When the "war stimulus and rebuilding effects" run out all hell would break loose. "Therefore" reasoned the dominant invstment view of this period "current excellent earnings don't mean anything". They will be followed by a horrendous crash and a period of extreme adversity when all would suffer. The recession did come but were overwhelmingly minor as to what was expected.

In view of the above reasons, the answer that I would produce would be to hold on to existing shares of outstanding companies, cease all buying operations and sell whatever companies that were less than truly outstanding. The underlying reason is that though the investor can be sure about the impending catastrophe, he cannot be sure of the timing and magnitude of the troubles that is to come. Prices of outstanding companies can multiply itself several times during periods of prosperity and the decline in prices is not likely to be as large as those of run-in-the-mill companies. Even at the lowest price in the depths of the recession, one cannot guarantee that it would be lower than the price the investor was so eager to sell.

However, allow me to conclude this post with a practical observation that is based on numerous experience rather than theory. When the general market is high, there are always a number of individual issues that appear definitely undervalued even by objective standards, and consequently even more attractive in contrast to the inflated value of other stocks. The investor may be tempted to think that these are unusual opportunities. But that is a time that calls for especial caution. Not only the "neglected security" continue neglected for the remainder of the bull market, but when the downturn comes, it is likely to decline in price along with the general market and to fully as great an extent. In a word, beware of "bargains" when most stocks seem very high.