a few things to consider before you go bargain hunting

Warren Buffett famously advised investors to “be greedy when others are fearful.” With stocks all over the world getting clubbed in recent days, there is no shortage of fear out there. The question is: will all that negative sentiment become another “wall of worry” that the markets climb to new highs? I can’t say for sure. No one can. I will say that during yesterday’s gruesome selloff, I spent more time adding to my fund’s short book than searching out potential buys. That’s because, even with the Dow and S&P suffering their worst weekly declines in four years, I still see wildly, even stupidly overvalued companies everywhere I look.

To put things in perspective, all you have to do is take a peek at the S&P over the last five years:



This week’s rout barely registers on that chart. It will take a whole lot more fear to unwind all those years of greed. And that’s not the only reason to be cautious if you’re thinking about “buying the dip.”

China could easily get worse. The immediate culprit for the global selloff is, of course, China. Despite increasingly desperate interventions by its government, its stock markets continued to collapse. The real worry isn’t Chinese stocks, though. It’s Chinese growth. Make no mistake: if China doesn’t start growing briskly again, and fast, this past week’s troubles are only the beginning of the pain.

We’re not doing so hot either. Our own economic growth hasn’t topped 3 percent in six years. We’ve only grown 1.5 percent in the first half of this year. That’s not going to cut it. And while the S&P 500 index has posted record gains, corporate profits among S&P 500 companies have been heading in the opposite direction. They barely grew in 2014 and, after dropping 2 percent in the second quarter of 2015, they will likely be flat for the full year.

The Fed can’t babysit stock markets forever. After eight years of failing to raise interest rates, the Federal Reserve is now trapped, a victim of keeping  rates too low for too long. Besides crushing savers and warping our capital markets, this policy has left the Fed powerless to address another unexpected financial crisis. Janet Yellen and the other Fed governors aren’t dumb. They know this, and while everybody on Wall Street seems to think this past week’s downturn will naturally lead to another delay, I think it could show the Fed just how badly it needs to raise rates so that it won’t be caught out if things really go south. Not only that, the agency’s credibility is on the line. Team Yellen has all but guaranteed a .25 percent rate hike at their scheduled September meeting (and possibly a second hike at their December meeting). If they reverse course again, they will (rightly) be viewed as nothing more than lapdogs to Wall Street.

To be sure, with so many stocks getting hammered this past week, there are almost certainly great opportunities out there. But I would recommend focusing on established, dividend-paying companies and resisting the urge to buy cult stocks that sell at huge multiples of revenues. You know the ones I’m talking about. Stocks like Tesla, most biotechs, and the so-called “FANG” quartet of Facebook, Amazon, Netflix, and Google. After rising almost threefold from early 2009, the S&P 500 is likely to produce below par results in the next 12-24 months. In a worse case scenario–if things deteriorate in China and corporate profits continue to trend down—it could get cut in half.


One thought on “a few things to consider before you go bargain hunting

  1. John Huber

    Hi Scott, I’m a big fan of the book and I enjoy your analysis. But I thought I’d comment regarding the macro comments and overall stock market comments. I find it almost* impossible (not absolutely impossible, but almost) that stocks drop 50% in the next year or two. I think overvaluation alone rarely causes this type of selloff. Based on my study of market history, overvaluation tends to create mediocre returns over the subsequent years (so I agree that the returns won’t be great, or maybe even negative over the next few years), but 50% crashes rarely if ever are the result of overvaluation, with the exception of manias (1929 or 2000 for example). But even in those years, we were on the cusp of significant recessions/depressions. So short of banking crises, manias, or extremely poor economic conditions domestically (none of which I see currently), I think 50% down is not in the cards.

    Also, as I’m sure you know, a 50% crash is extremely rare, occurring just 4 times in the last 100 years (2 of those times in just the last 15 years).

    Anyhow, I think it’s extremely unlikely, but that said, I agree that the market isn’t cheap, and it certainly could go down much more than it has year to date.

    But I’m a bottom up stock picker so what do I know?

    Anyhow, I enjoy the book, and the blog. Keep up the great work.

    Reply

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