The Secret Behind Macroeconomics & Value Investing (Part 3)

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Step #2.  Use Common Sense

This is by far the best tool you have in your tool set.   As the saying goes,  “If it sounds too good to be true, it probably is”. Meaning and as you have probably noticed, most market pundits (whether it’s the economists, talking heads or the money managers) are perpetually bullish. No matter what the situation  is they are always talking about how great things are and how all stocks will be going up over the next 12 months.

That is an excellent point of view to have if you are working in the self-help inspirational type of an industry, but a dangerous one to have if you are working with stocks. If you haven’t noticed, stocks do go down at times. Sometimes they collapse (aka 2007-2009). That is why having your own, well researched common sense opinion is so valuable.

Case and point, today’s economic environment presents us with a perfect  example. (Written Nov 7th, 2013)

Majority Opinion:  Today’s stock market closed at an all time how with the Dow at 15,746. If you listen to the main stream media, the economists, read the newspapers and magazines, listen to market pundits and talking heads you would undoubtedly walk away with an overwhelmingly BULLISH opinion. According to most of them the US stock market and the US Economy are in the early stages of a major bull run and economic recovery. If fact, you would probably be so excited that you would invest  every single penny that you have.

Common Sense Opinion:  Yet, if you would listen to my or form your own opinion you would see an opposite point of view.  You would understand that today’s economic recovery is nothing more than a mirage driven by a massive infusion of credit into the system through monthly QE of $85 Billion, low interest rates and massive amount of speculation. After digging deeper you would see that all asset classes (stocks, bonds, real estate and even art) are in a massive speculative bubble that is unsustainable.

Digging even deeper and looking at the technical picture you would probably think twice about going long here. Instead of looking at the market and saying it’s at an all time high with many years of bull left on the table, you would probably look at the market and say, “Hmmm, this market is way overbought and given the current economic environment and the fact that everyone is so bullish I think the market is setup for a large bear move”. Instead of going long you would consider either getting out of the market all together or going short.  Your research and common sense understanding of the economic situation would clearly support that decision.

As you can see the difference between Majority Opinion and a Common Sense Opinion is vast. One would have you buying every stock under the sun while the other makes you want to run for the hills. Which one is right?  Well, that is for you to decide, but I would always pick a well researched Common Sense Opinion from a trusted source.  More often than not it pays to do so.  

In conclusion, following the two easy steps above will put you well ahead of the competition within a short period of time.  It will put you on the fast track of fully understanding the macroeconomic picture and what is going on in our financial markets.  More importantly, you will become self proficient and 99% more accurate than most of the economist and talking heads out there. You will be able to make much better investment decisions and avoid unnecessary losses most often caused by following the crowd.   

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The Secret Behind Macroeconomics & Value Investing

The Secret Behind Macroeconomics and Value Investing

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By now we have looked at value investing and what it is, how to determine the intrinsic value of any stock, what the margin of safety is and how to apply it properly, what types of stocks to look for and what to avoid.  Still, there is one more thing to consider. Macroeconomics.

I am a firm believer that as an investor one should understand Macroeconomic factors prior to making any sort of an investment.  While not an important part of an equation for short term traders, it is an incredibly important factor for most value investors who’s investment time frame is oftentimes counted in years. A miscalculation on macroeconomic front could have severe consequences on your overall investment. Let me give you an example.

For simplicity sake and without going into too many details, let’s assume that you have looked into buying a home building stock in early 2007. After doing a lot of research and valuation work you cannot believe your eyes. For some reason the stock is selling at 60% discount to its Intrinsic Value and the growth rate remains over 20% on all fronts.  Everyone is excited about the real estate market and your work shows that this stock should at least double over the next 12 months.  Based on your work you are 100% confident that this particular stock is a Rocket Ship. You can’t believe how lucky you are as you begin drool just thinking about how much money you are going to make.   

Yet, you have just missed an incredibly important point that only macroeconomic analysis can provide.  You have missed the fact that the overall US Economy and the Real Estate/Financial industry in particular are in a giant bubble that is about to blow up.  You have missed the point that when that bubble does blow up it will take the entire economy and the real estate/financial sector in particular down with it. Big time. Further, when that happens your significantly undervalued home builder stock price is likely to collapse even more because it is directly tied up into that sector. 

That is exactly what happened. Even though home building stocks were already down significantly at the start of 2007 (indicating substantial value), they proceeded to decline even further (50-80% further) when the credit bubble of 2007-2009 finally blew up.

Point being, looking at the company or the sector alone, is not good enough. You must have an overview of the overall economic environment  in order to avoid situations as described above.   A value investor with a clear macroeconomic point of view would have never even looked at home builders in 2007. Well, maybe from the SHORT side, but that’s about it. Bottom line is, any good investor worth his salt should always be aware of where we are in the economic cycle. That is where macroeconomic analysis comes in.

Do not despair.  You do not need a fancy degree from a business school to understand macroeconomics. It is probably best that you don’t have one. That way you have an open mind to see how easy and straight forward this analysis can be.

First, you must understand something very important. Do not pay any attention to the financial media (or media in general) and/or professors of economics and/or the economists themselves.  All of that data and all of their fancy economic models are nothing more than garbage. If their models worked, these people would be on Wall Street making millions of dollars instead of playing with their numbers and/or teaching others.

Let’s make it as simple as possible when it comes to economists with their own interest on the line.  Simply ignore ALL of them.  Don’t give them even a split second of your attention. 

To be continued…..

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