|September 18, 2009|
The Third Wave is the Third Rail
According to the Daily Sentiment Index, 90% of respondents are bullish on stocks.
Ninety percent. This is the herd. And if there is one investment principle you can take to the bank it is this: The herd is always wrong. Always!
Steve McDonald, contributor to IDE's Sound Profits says, "The herd enters the market in what I call the third wave. When I speak at investor conferences, I joke with the audience that in Greek, "third wave" means loss."
Here's how Steve puts it:
The 90% of investors who are now bullish (after a 55% rise) and are just now getting into the market are the Third Wave. They will hang on for a few more weeks or months at the top of this phase and then sell when it drops – which it will – at a loss.
So why do investor's get caught-up in the herd mentality?
In his book Influence: The Psychology of Persuasion, professor Robert Cialdini says we fall into herd mentality for a few reasons.
How do you use this information to make money?
First, you upgrade the majority of portfolio to the highest quality companies – those with low levels of debt that are still generating strong cash flows. And you should follow an investing discipline like one we use in our private newsletter, Sound Profits:
It takes guts to play the contrarian game. But history has proven that this is how great investors become wealthy.
Does the U.S. need to take on more debt?
The United States' debt-to-GDP ratio recently broke 370%. That means we have borrowed $3.70 for every $1 of output. And some analysts suggest the ratio could approach 500% in the years to come.
Ken Fisher, CEO of Fisher Investments, is actually encouraging this. He believes the U.S. is under-leveraged.
Let's not forget that Fisher was making the same argument about debt before the real estate market crashed. Or that he said everything was fine right before the Lehman collapse. Or that he blew up his clients in the dot-com bust.
But let's stick to the issue at hand… the U.S. is under-leveraged?
Aren't we drowning in credit card debt? Didn't we borrow too much to buy overvalued houses we couldn't afford in the first place? Doesn't the U.S. government already borrow $1.8 trillion more than we take in?
"People have a hard time envisioning that you can in fact be under indebted"
Fisher contends that the U.S. return on assets is still high. He compares it to a business. "If we are a business and our return on assets is too high, we ought to be borrowing more money to get more assets."
What he fails to acknowledge is that there is a big difference between productive debt (like when a profitable company borrows money to increase manufacturing capacity) and debt that is used to buy new furniture, family vacations and flat screen TVs. Not to mention the stupidity of the government borrowing money to fund destructive wars and programs like Cash for Clunkers.
The sharp increase in personal and corporate bankruptcy filings suggests that we are over-leveraged. And given the nature of compounding interest, the solvency of our very government could soon be in question.
Warren Buffett has pointed out that "there is nothing evil or destructive about an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt."
But right now Americans are not seeing an increase in income or assets. We're seeing less of both. Right now we need less debt, not more.
The problem is that what we should do and what our politicians will do are two totally different things. The U.S. government debt ceiling has already been raised three times in the past two years. Lawmakers are about to raise it yet again. As debt-to-GDP grows, our ability to service that debt goes down. The value of the dollar will crash. And interest rates will soar.
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