The U.S. Needs More Debt? What is this Guy Smoking?

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 First Wave: These are the luckiest people in the world. They somehow hit the market exactly at the bottom. Pure luck. This cannot be calculated. Members of the lucky sperm club can usually be found here. The Second Wave: These are the 20-60-20 players. They leave the first and last 20% of any stock move and keep the middle 60%. These are the pros and the most experienced investors. They wait for a definitive move before betting their money. And they have learned from many beatings that the herd is always wrong. So they know when to get out. The Third Wave: These are the investors who see or hear about others making money and want to be just like them. The investment is based on nothing but social proof or the desire to fit in. This is the herd. These people are distinguished by making serious life-changing decisions based on no research, but rather on what they guess is happening. 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. "First, we seem to assume that if a lot of people are doing the same thing, they must know something we don't. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof." There's No Need to Buy Gold and Bury It in Your Backyard… You don't need to buy a single ounce of gold to make money in the soaring gold market. If gold goes nowhere, you should still make money. If precious metals continue to rise (even slowly) you could make a fortune. And if the metals soar? Let's just say your grandchildren will be thanking you… Discover the secret behind this "No-Gold Gold Rush" right here. 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: Don't buy a full position all at once. But one-third to one-fourth of your position, and then complete the transaction over a period of time, buying on dips. Limit your position sizes to no more than 5% of your overall portfolio and protect your positions with stop losses and trailing stops. Be cautious when the herd is overwhelmingly bullish (like right now) and brave when the herd running is for cover (like in March). 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? How a Starving Peasant Went From Living at the YMCA to a Net Worth of Over $8.2 Million Ted P. was $40K in debt. He had to get a loan so he could eat. Now, with a net worth of over $8 million, Ted has agreed to share the powerful secret that helped him amass a fortune. "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. Got gold? Get some here. Good Investing, Bob Irish Investment Director Investor's Daily Edge We want your feedback! Let us know your thoughts on this article. Email us at Email: feedback@investorsdailyedge.com Market Window FINANCIAL ADVISORY BOARD Bob Irish - Investment Director Andy Gordon - Editorial Contributor Jon Herring - Editorial Director Ted Peroulakis - Editorial Contributor Christian Hill - Managing Editor Dr. Russell McDougal - Editorial Contributor Steve McDonald - Editorial Contributor Michael Masterson - Consulting Editor