Investment lessons from 1928

It’s time to follow ‘good time’ Charlie Merrill’s advice – stop overpaying for trash and put your financial house in order, says Tim Price.

We have been here before. And it did not end well. Precisely 86 years ago, in March 1928, ‘good time’ Charlie Merrill, the head of Merrill Lynch & Co., warned his clients to get out of the stock market.

“Take advantage of present high prices and put your own financial house in order.” Few of his clients took his advice, and for a while Merrill looked like a fool. History, of course, has been kinder to his memory.

More recently, in March 1999, went public in one of the most delirious episodes in initial public offering (IPO) history. Having been priced at $16, the stock closed its first day’s trading at $69 – a 331% return for those investors who could get in at the offering price.

A year and a half later, amid the wreckage of the dotcom collapse, the shares were trading at less than $5 apiece.

Human beings are, of course, prone to herd mentality and the dangers of groupthink. For as long as people interact with each other, markets will oscillate between cycles of greed and fear, generating profits for momentum traders and, ultimately, for contrarians.

But when it comes to mania, our digital economy does seem to be blessed with a peculiar surfeit of irrational exuberance.

V Prem Watsa of Fairfax Financial Holdings recently highlighted the rather bubbly valuations on offer in the ‘social media’ sector.

Twitter, for example, has a market capitalisation of $28bn and trades on roughly 38 times sales. It doesn’t have a price/earnings (p/e) ratio, because it doesn’t have any earnings, only losses.

Professional networking site LinkedIn has a market capitalisation of $22bn and trades on 15 times sales. It does have earnings though, and therefore sports a robust p/e of 887. By any stretch of the imagination these are nosebleed valuations and they will snag the unwary.

Social media stock prices may be absurd, but the US stock market as a whole is not exactly cheap as judged by a variety of well-recognised metrics. Robert Shiller’s cyclically adjusted p/e ratio (or Cape) stands at over 25 times.

It has only been demonstrably higher in 1929 and 2000 – both years in stock market history that need little further introduction.

(There is good news here for British investors, relatively speaking: on a forward p/e of 13 and with a dividend yield of over 4% compared to the S&P 500’s rather miserly 1.9%, our FTSE 100 looks pretty fairly valued.)

Which is not to say that stock markets cannot go higher. Only a fool would try to time any market, particularly one being goosed by billions of dollars of quantitative easing (QE), as that of the US is. But this gets us to the point: which markets can we trust, when central banks are doling out monetary stimulus like it’s going out of fashion ?

As John Phelan of the Cobden Centre points out: “The Federal Reserve has become an enabler of the financial havoc it was designed (a century ago) to prevent”.

The overall level of market valuation, then, has to be a concern for any investor focused on capital preservation in real terms (ie, after inflation). But another major concern has to be the potential impact on the stock market of a bear market for bonds.

Somewhat ominously, the Fed threw $500bn at the US Treasury bond market last year – and bond prices still fell. Given that the Fed – under its new boss, Janet Yellen – is scheduled to be out of the bond market entirely by the end of this year, is it plausible that bonds will simply shrug off the departure of the biggest buyer in the market?

And given geopolitical events, is it plausible to expect support for the US Treasury market from the likes of Russia or China?

I have lately been re-reading the bible of investment management, otherwise known as The Intelligent Investor by Benjamin Graham – mentor to Warren Buffett, among others.

Graham was forged in the white heat of the Great Depression, and formulated an investment response known for its ‘margin of safety’ – namely, ‘deep value’ investing.

Here is what he had to say about stockmarket risks: “Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.”

This can be summarised more briefly:

• Rule number 1: don’t buy rubbish.

• Rule number 2: don’t overpay for the good stuff.

At some point, interest rates are going to rise. That will put pressure on both bond and stock markets. This will not end well for investors overpaying for trash.

If your portfolio is heavily overweight in stocks – congratulations; you should recently have enjoyed some good returns. You may now wish to follow ‘good time’ Charlie and put your own financial house in order.

• Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report.