Bubble Stock Investing

I invest in gold and silver, mostly miners.

Most people, I expect, are unwilling or don’t have the temperament to put all their eggs in one basket. The most familiar of the highly liquid investments is stocks – shares of most of the companies you know and love plus many that you’ve never heard of.

But, by pretty much any objective measure, stocks are in Bubble territory today, and the FED has started a tightening cycle – and has promised major tightening leading up to the mid-term elections this November.

I suggest that you still can make money in stocks today, using a strategy that Hedge Funds originally were designed to use – buy stocks that you think have the brightest prospects and sell short stocks that likely will be dogs (by comparison). If your ‘good’ stocks indeed do better than your ‘bad’ stocks, then you’ll make money. It matters not whether they both go up, both go down, or the ‘good’ is up and the ‘bad’ down, so long as the ‘good’ does better than the ‘bad.’

Selling a stock short means that you borrow stock from somebody who owns it today, then sell those shares. If the stock goes down, then you buy the stock and return those shares to the person you borrowed them from, and you make a profit by selling high and then buying low). Of course, if the price goes up, you’ll wind up with a loss (as Lou Costello used to say, “Oh, you can lose, too!”).

There are several ways to choose the ‘good’ stocks and the ‘bad’ stocks. One way is to use a professional service like Value Line (US stocks) or Stockopedia (foreign stocks). You also can utilize a group like The Motley Fool and their CAPS community.

Or, you can do your own research, and that’s easier than you may think. For example, the Dow 30 Industrials are well known, very large companies. At current prices, some are expensive and some are cheap compared to others in this index. Three valuable measure of cheap vs expensive are:

1. The current PE Ratio

2. Growth prospects

3. Current Dividend Rate

All else being equal, a stock with a high PE Ratio is expensive compared to a stock with a low PE. All else never is equal, but we use what’s available. (You can substitute Book Value per share, etc if you like.) Several studies have shown that, in general, high PEs mean lower future returns and low PEs mean higher future returns.

High expected future Growth tends to translate into better prospects for the stock than lower Growth. This Growth usually is measured by Earnings Per Share (EPS) forecasts.

Now, while professional analysts generally do a lousy, biased job of forecasting a company’s future earnings, surprisingly they do a very decent job of forecasting relative EPSs for different companies. If they say two companies will grow earnings by up 20% per share for one and the other maybe up 5%, the actual relative results may be +50% vs +20% or they may be +20% vs +5% (as forecast) or they may be +5% vs -10%.

For our purposes, the actual forecast numbers are less important than the relative performance expectations of the analysts.

The Dividend Rate is important because, in the long run, the reason investors own a business is to get a return from the profit that the company generates. A company has a choice of reinvesting profits to grow the company or of ‘spending’ part of those profits to reward the people who own the company, the stockholders, through issuing Dividends.

Since Growth and Dividends are alternative uses of the profits, I will add them together. So, a company with expected Growth of 15% and a Dividend Rate of 5% would have a combined measure of 20%.

Using the Dow 30, we can set up a grid dividing the stocks according to PE Ratio on one axis and by Growth + Dividend on the other axis, and we would get roughly 7 or 8 stocks in each box.

The High Growth + Dividend / Low PE stocks are the ones which ‘should’ do the best, while the Low Growth + Dividends / High PE stocks should do the worst.

Now, suppose you have 7 stocks in each of these two boxes, and that you want to invest $10,000 in each stock. For the Best 7 stocks, that would be $70,000 total, but for the Worst 7 stocks, you would be required to put up only half, or $5,000 each, totaling $35,000, for a grand total of $105,000.

If you wanted to invest less – fewer stocks – you could divide the grid by 3 in each direction (Low, Medium, or High PE on one axis and Low, Medium, or High Growth + Dividends on the other axis. That would get you maybe 3 stocks in each box, requiring $45,000 grand total for your Best plus Worst.

If you wanted to invest more, you could use some other list of stocks, such as the S&P 500 stocks, and then divide the grid to get the desired number of stocks in each box.

So, how much could you hope to make? If you had used Value Line to choose your stocks, their Best vs Worst choices (over their 50+ year history) averages a spread of 18%. Of course, since you have to invest in both Long and Short (half the amount), that would come down to a 12% spread.

While this might work most years, there are no guarantees. I’m not doing this today with my own money – as I said at the top, I’m in gold and silver – but I expect to do this once gold and silver prices reach my targets.

Also, while I like this idea, I’m not recommending that you try it. All I’m doing is providing another possible alternative for investing when stocks are in Bubble territory, as they are today. Good luck.

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