How to Quit Being An Ignorant Investor

We’re now officially through the first quarter, but I for one am not breathing a sigh of relief.

During Q1, the Dow Jones Industrial Average gained 4.6% to close at 20,663.22, its sixth straight quarterly gain.  The S&P 500 jumped 5.5% to 2,362.72 and the Nasdaq Composite Index, powered by tech giants, climbed a robust 9.8% to 5,911.74, its best quarterly performance since 2013.

But this market isn’t driven by individual stocks. Far from it.

Right now, most investors are following a painfully ignorant investing “strategy” that will leave them the most exposed and least hedged at the moment when stocks are most overvalued and vulnerable to a correction.

Here’s how not to make their mistake – and what to do instead.

The ETF Bubble Means Most Investors Don’t Know What They Own

This quarter’s bull market has been largely bolstered by ETFs and computer trading, which begs the question of what investors are really thinking.

There is now $2.8 trillion invested in US ETFs and record amounts of capital are being added to this pile of money every month.  In the first two months of the year, investors bought another $124 billion of ETF shares.  This means that investors don’t have to buy individual stocks because ETFs do the work for them.  This means they know absolutely nothing about what they own.

But rather than their ignorance giving them pause, it is emboldening them and leading them to borrow record levels of margin debt (margin debt hit a record $528.2 billion in February) and express record levels of bullishness in various surveys at precisely the moment in time when they know the least about their investments!  For the moment, ignorance is bliss, but ignorance always ends in tears and this time will be no different.  When that happens, these park-their-brains-at-the-door investors will be screaming at their wealth managers and investment advisers and asking them to explain how they could possibly be losing money in the stock market since that isn’t supposed to happen in a world where central banks are supposed to bail everybody out.  But even their wealth managers and investment advisers don’t know anything about what’s inside these ETFs because the whole point of investing in these vehicles is to abdicate any responsibility to do fundamental research or think independently.  Instead, ETFs are the perfect vehicle for group thinkers in a world of fake news. (I’ve discussed the ETF phenomenon at greater length here.)

The ETF bubble will end badly and when it does, investors will have only themselves to blame for being too lazy to do the hard work of investing for themselves.  You sometimes have to wonder if they go out of their way to act like fools.

For those of us who prefer less ignorance and more profit, here’s what I suggest.

Paying Attention Always Pays Off (Especially in These Sectors)

Certain industry sectors are flashing warning signs that all is not well in the US economy.  Auto loan delinquencies are rising sharply, for example. And the retail sector is looking like the streets of Aleppo.  Nine retailers filed for bankruptcy in the last three months, the highest number since the financial crisis when 18 retailers bit the bullet.  The casualty list includes Gordmans Stores, Gander Mountain, Radioshack, HHGregg, BCBG Max Azria, Michigan Sporting Goods Distributors, Eastern Outfitters, Wet Seal and Limited Stores, and there are more to come.

The number of retailers on Moody’s distressed list is at the highest level since the Great Recession.  Many companies were bought by private equity firms that loaded their balance sheets with debt and in some cases took out their equity investments by borrowing money to pay themselves dividends, leaving the retailers with too much debt and on the verge of insolvency (see for example J Crew and Payless).  Even retailers with healthy balance sheets are seeing their stock prices buffeted by the structural headwinds of ecommerce and flash fashion:  Macy’s Inc. (NYSE:M), L Brands Inc. (NYSE: LB), Target Corporation (NYSE: TGT), and others that I have recommended as shorts at Zenith Trading Circle).

The defeat of the bill to fix Obamacare isn’t going to help matters either since consumers in recent years were forced to divert spending from discretionary items like shopping to higher healthcare insurance premiums and out-of-pocket expenses. Investors shrugged off the defeat of the bill to defeat Obamacare, which may be brought back for a vote in a week or two.  If a revised bill is approved, the market may resume its move up to even more exalted valuation levels. Investors should avoid retail stocks or short them; the carnage is only in its early stages.

In addition, the tech sector is one to keep an eye on, though for slightly different reasons.

Stocks enjoyed an unusually strong first quarter though the gains didn’t occur exactly as expected.  While all eyes were on Washington, DC and the new policies of the Trump administration, the market was not powered higher by the sectors that most directly benefit from such financial and energy deregulation.  Energy stocks actually fell by 7.3% as oil prices stumbled and financials only gained 2.1%.  The big winner was technology, which gained a huge 12% led by Apple Inc.‘s (NASDAQ: AAPL) 24% quarterly jump that added $144.8 billion to its market cap, and more than 18% gains for Facebook, Inc. (NASDAQ: FB), Amazon.com, Inc. (NASDAQ: AMZN) and Netflix, Inc. (NASDAQ: NFLX).

Other than Apple, which remains reasonably valued though subject to the limits of large numbers (i.e. it can only grow so much on such a large revenue and profits base), these other tech giants are trading at extremely rich valuations that can only be described as irrationally exuberant.  I wouldn’t run out and short these stocks but I would seriously think about taking profits if you own them (other than Apple which you can hold).

Granted, it takes some work to actively watch and trade these sectors (a lot more than if you parked your brains in an ETF), but you’ll end up with far less egg on your face.

Sincerely,

Michael

12 Responses to “How to Quit Being An Ignorant Investor”

  1. GPG: If the average investor could hold the S&P500 for at least 10 years (not get frightened and sell onsevere market downturns), average down on major sell offs, she would do far better than most mutual or hedge funds and bonds. Likely not as well as you, but far better than most.

    Buffett agrees, a rather good stock picker (but why IBM?)

  2. When an investor buys ETFs, it does not mean that they are ignorant. There is a place in everybody’s portfolio for an ETF. You may like a sector and want to spread your risk among many companies instead of a single stock. Take Biotech for example. Most people will not know whether a clinical result will be successful or not or which company is the target of a tweet. It is better to buy an ETF.

  3. I didn’t realize until very recently that ETFs are considered to be derivatives until recently, which was incentive enough to get out. Especially when I discovered that there is no guarantee that holders will be able to sell if they crash.

  4. Augustus Gloop

    Totally agree on the ETF bubble idea. The stock market tries to make the largest number of people look stupid at the same time…we are almost there. The conversations between investors and their advisors will go like this “why are my ETFs trading at significant discounts when we bought them at premiums?…That seems to be adding significantly to the huge losses I’m already incurring…And wasn’t diversification (owning multiple ETFs) suppose to insulate me from all of this?”

  5. Augustus Gloop

    Right on with the ETF bubble discussion. The market tries to make the largest number of people look stupid at the same time…We are obviously nearly there. Upcoming investor/advisor question…”why are my ETFs trading at huge discounts when we bought them at premiums? This is adding to my already huge losses. And wasn’t diversification among multiple ETFs suppose to protect me?”

  6. Ken, these are the points that Shah Gilani, part of the Money Morning crew, has been making. It’s tempting to look at ETFs, but then why pay a manager (there are management fees) for the performance that one can get by making his own decisions.

  7. Mack – because the ‘management fee’ is often less than 0.02% per year, and because an ETF provides diversification most people don’t get choosing their own stocks, and because less than 10% of professional money managers outperform the S&P 500 (you can buy the ETF). The track record of individual investors is even worse than the pros. Those are some reasons.

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