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Investing vs. Gambling

InvestorPlace logo InvestorPlace 2/18/2021 Jeff Remsburg

A GameStop nightmare … are we near the top? … beware of stock market “peer pressure” … Eric Fry’s words of wisdom

Salvador Vergara had visions of GameStop riches.

So, the 25-year-old security guard made a bold move …

He took out a $20,000 personal loan and used it to purchase GameStop shares, getting in at $234.

As I write Wednesday morning, those shares are now valued at $47.71.

That’s an 80% loss — on a loan that requires full repayment, as well as regular interest payments.

With the GameStop drama now in the rearview mirror (mostly), we’re able to digest what happened with greater perspective.

There are lessons to be learned, as well as areas of concern to monitor. Today, we’ll dive into all of this and more with the help of our macro specialist, Eric Fry.

In his latest issue of Investment Report, Eric provides a post-mortem on the GameStop story that serves as a powerful reminder of the difference between investing and gambling.

But what happened with GameStop is more than just wild investor behavior; it’s a symptom of a larger dynamic involving where we are in this investment cycle.

Right now, the market is nosebleed expensive by many valuation metrics … investors are growing increasingly greedy, with other mini-GameStop’s booming and busting … and investor-patience is out-of-vogue, to say the least.

Together, all of this makes for a dangerous market.

Today, we’ll look at this with Eric’s help. The goal is to re-establish our North Star of wise investing. If you want to join in with the craziness, fine, but do so with your eyes wide open, in a manner that won’t jeopardize your long-term investment goals.

Let’s make sure your quest for gains doesn’t end in your own Salvador Vergara/GameStop meltdown.

***GameStop revisited

For newer Digest readers, Eric is our global macro specialist and the analyst behind Fry’s Investment Report. He also happens to be a veteran investor with decades of experience and one of the best long-term track-records in the entire investment newsletter industry.

Turning to GameStop, here’s Eric summarizing what recently happened:

Whenever the history of the 2020-’21 bull market is finally written, the “Reddit Wars” will capture at least a couple prominent chapters …

For several days in a row in early January, the self-described “degenerates” from WallStreetBets goaded one another to buy as many GameStop shares as possible … and then defiantly clutch those shares with “diamond hands.” …

But these victories would be short-lived, as the main brokerage firm that had been supporting this army abruptly banned its clients from placing “Buy” orders for GameStop …

Like the infamous Depression-era bank robbers, the WallStreetBets community became populist folk heroes — who “stole” from the rich and inflicted pain on the establishment.

Unfortunately, just like Bonnie and Clyde, many WallStreetBets investors are now slumped over in the bloody remnants of their portfolios.

Salvador Vergara, who we highlighted at the top of this Digest, is one such “slumped over” investor.

Eric writes that this type of wild market behavior isn’t new. He points toward one of history’s most famous stories of market absurdity — Holland’s “tulip bulb mania” of the early 1600s.

At the peak of the mania, a single bulb changed hands for 5,200 florins, which was more than three times what Rembrandt charged for painting “The Night Watch” just five years later.

That amount of money was enough to buy a home in Amsterdam — for cash.

Back to Eric on how history repeats itself:

Sound far-fetched?

That identical history repeated itself two weeks ago, when 1,000 shares of GameStop temporarily soared to more than the median value of an American home.

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Let’s bring all of this back to today’s market …

***What does this mean for investors right now?

Here’s how Eric puts it:

Are we in the midst of bubble-type conditions? Should we be concerned?

The short, but unhelpful answer is, “Probably so.”

We should be concerned … but not terrified.

Eric then makes an important point that we’d be wise to remember …

While no two speculative bubbles are identical, they share one specific trait — an indifference to traditional assessments of value.

Gallery: 8 Stocks to Buy for Beginners in a Hot Market (InvestorPlace)

From Eric:

Speculative assets break free from their moorings to any rational valuation and begin drifting on a volatile and unpredictable sea of emotion and fantastical expectations …

In most stock market phases, traditional, fundamentals-based investment strategies hold sway. Established investment professionals, using timeworn analytical tools and valuation metrics, invest in stocks that offer some plausible version of GARP — growth at a reasonable price …

During bull markets, however, the rules change … or seem to change …

Late in a bull-market cycle, however, optimistic investors do not merely bend the rules. They discard them entirely … like college kids on spring break.

The GameStop experience is a crystal-clear example of “spring break” stock market behavior. But it’s hardly the only rule-bending happening today.

As I write, the price-to-earnings ratio of the S&P 500 is 40.08 — the third-highest reading in the last 150 years.

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Yet rather than bailing on stocks, investors are showing what Eric calls “indifference to traditional assessments of value.”

In this case, the indifference is arising because investors are explaining away high PE ratios thanks to 0% interest rates. The argument is that stock valuations are permitted to be higher than usual because rates are 0%.

Now, we agree with this in general. We’ve even pointed toward 0% rates here in the Digest as a reason why stocks can go higher.

But — and it’s a critical “but” — today’s anemic rates don’t give investors a license to abandon all valuation-concerns.

It’s a bit like, say, your child who has an 8 p.m. bedtime. Because the child took a long nap during the day, perhaps that justifies a 9 p.m. bedtime — even 10 p.m.

However, no one would try to argue the nap justifies a 4 a.m. bedtime.

On this note, my friend and quant investor, Meb Faber, recently looked at this argument of “0% rates mean today’s valuations are justified.”

From Meb:

When they say that “high stock valuations are fine since interest rates are low”, what they really mean is “high stock valuations are fine since interest rates are low, therefore future stock returns will be ok.”

Honestly no one really cares about if current multiples are “justified”, what they really care about is if those valuation multiples and low bond yields produce higher or lower stock returns in the future.

After walking through a forecast of future returns (which are depressingly low compared to what we’ve enjoyed in recent years), Meb suggests stocks should see only limited benefit from today’s 0% rates:

So, this low bond yield environment could add one or two percentage points to real earnings growth. That would take real returns from 0-2% to 1-4%.

Still not great.

Now, this doesn’t mean stocks won’t continue rising — after all, investor sentiment trumps all else. And right now, sentiment is bullish/greedy.

But it does mean we have to be realistic when we look at the case for more gains to come, and the size of those potential gains.

***We’re in a wild market, so be on guard against your own FOMO (fear of missing out) and your own reasons to behave in risky ways

We’re in a market that wants to climb. That’s great for generating returns, but it’s also great for making foolish choices.

After all, it’s hard to make, say, 8% on your portfolio while your neighbor is doubling his money in some Reddit-fueled “stock-du-jour.”

Too much of this and the next thing you know, you’re scouring the Reddit-boards at night, looking for the next 5X-overnight moonshot.

Given this, right now, pause …

Take a moment to remind yourself of your investment goal. As importantly, remind yourself what your investment time-frame is.

Similar to peer pressure, today’s market is pressuring you to abandon your wiser, more-patient impulses and join in the party.

It’s critical that you see this for what it is …

Back to Eric:

Just like a fling bears little resemblance to a marriage, the WallStreetBets style of trading bears little resemblance to investing.

These traders aren’t usually looking to hold a given stock for a long time, just for a good time. They have little patience for … well … patience.

Their collective buying resembles a hummingbird that flits from flower to flower — pausing momentarily to draw a little nectar, then darting off in some other direction.

This “instant gratification” school of investing is accentuating a trend that has been intensifying for more than 50 years.

As the chart from Reuters below shows, investors used to measure their holding periods in years, not months. But short-termism is pushing holding periods down to all-time lows.

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Source: Reuters

Now, if you want to join in with the exciting, tulip-bulb craziness, great — do it!

But do so with a reasonable amount of money that won’t derail your long-term goals if it goes up in smoke.

As for your broader portfolio, even though we have 0% rates as a tailwind, keep something in mind …

Valuations still matter.

For perspective, in Meb’s paper, he notes that in order for investors to enjoy 10% gains from today’s market price, it would mean that valuations would need to climb to their 1999 dot-com peak.

I’m not saying that won’t happen — it could easily happen. In fact, I expect it to.

But the point is, what’s on the other side of that peak? Is it a knife-edge drop?

Years of go-nowhere returns?

A slow bleed that erodes your portfolio over a decade? We don’t know.

But it’s unlikely to be another 10-year smooth climb that doubles price-to-earnings ratios from here.

In light of this, enjoy our current, bullish market, but have a plan for if/when it changes so that you don’t have your own Salvador Vergara story.

I’ll let Eric’s wisdom and market outlook wrap things up:

The stock market always offers measures of both risk and reward, although not always in equal doses.

That’s why it is always essential to focus on both sides of the investment proposition, no matter how manic or depressive stock market conditions may be …

Bottom line: Be aware of these new influences, but maintain course and speed.

Have a good evening,

Jeff Remsburg


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