Two weeks ago I suggested that investors sell Exxon Mobil and use the proceeds to buy Wal-Mart Stores. If you’d made the trade that day, then you’d be ahead 11% overall — Wal-Mart is up 3.6%, and Exxon Mobil is down 7.4%.
I imagine most people didn’t follow my advice, and I understand why. It’s nearly impossible for investors to bring themselves to make investments that are deeply contrary to the prevailing consensus. In this case, the consensus all year has been that energy prices were going to go up forever, and that oil company stocks would go up forever, too. And the consensus has been that retail-oriented companies would get killed as high energy prices sucked all the money out of consumers’ wallets.
But anytime the majority of investors believes something, it just has to be wrong. And even if it’s right, you can’t make money on it because it’s already fully reflected in prices. So you just have to bet against it; hence my idea to sell Exxon Mobil and buy Wal-Mart.
In the last two weeks energy prices have started to fall. All evidence indicates that the economy is ticking along just fine even in a post-Katrina world of higher oil and gas prices. The consensus is wrong — again.
The difficulty that investors have in betting against the consensus is partly real, and partly psychological. The real part is that most people get their information from pretty much the same sources, so it’s inevitable that they’ll all tend to think the same thing at the same time. The psychological part is that even if you’re one of the lucky few who has different information, it takes unusual self-confidence to think that you alone are right and the rest of us are wrong. It’s not just that you’re being modest. It’s that if you invest based on your unique idea, and it turns out you are wrong, then you’ll feel like a complete idiot. But if you go along with the crowd, even if you lose money, it won’t feel so bad because everyone’s in the same boat. Misery loves company.
These ideas explain the enduring success of so-called value investing. When you buy a stock that’s been beaten down and no one else will dare to buy it, you can be sure you are buying the bottom because everyone who could possibly want to sell already has.
These ideas explain the constant disappointment of momentum investing. When you buy a stock that’s been soaring, you feel confident because you are going along with the crowd. You get that warm, glowing feeling that the whole world is on your side. That’s the problem. When the whole world has already bought a stock, what’s going to make the stock go higher?
In my opinion, right now pretty much the whole stock market (other than the energy sector) is a value play. Nobody’s really all that interested in stocks, and lots of investors shun them. That’s perfectly natural after the terrible bear market we went through in 2001 and 2002 that came on the heels of the irrational exuberance years. Right now everyone wants to own bonds.
That’s the consensus: Love bonds, hate stocks.
So we find the relationship between stocks and bonds in a position of near-historical imbalance. The yield on 10-year Treasury bonds right now is about 4.46%. The yield on the S&P 500 (considering total forecasted earnings, not just dividends) is 7.02%. That’s a difference of 2.34 percentage points, which is a greater difference than at almost any time in the past two decades.
Here’s what that means. Investors demand 4.46% to hold riskless bonds. They demand 2.34 percentage points more to hold risky stocks. Those 2.34 percentage points represent what’s called the “risk premium,” or the amount that investors demand to bear extra risk.
By historical norms, investors typically demand only 10 basis points (0.1 percentage point) as a risk premium. They are willing to take the risk of stocks for almost no premium at all, because they want the upside potential that equities can offer but bonds can’t.
But today, everyone loves bonds and hates stocks. They don’t believe there is any upside to stocks. So they want a big risk premium instead.
Here’s what everyone is missing. The day will come when the consensus changes. Someday stocks won’t be hated anymore, and bonds won’t be loved. When that happens, the risk premium will go away. And the consequence of that is that stock prices will soar.
Not because of some fantastical development in the economy. Not because irrational exuberance will come back. No, rising stock prices will be a natural and inevitable consequence of the risk premium going away. It’s simply a recalibration of stock prices to bring them into historical alignment with bond yields, given the level of corporate earnings. And it will happen. It’s just a question of when.
Don’t tell me it’s impossible. It wasn’t impossible for Wal-Mart to rally in the face of doomsday in the consumer economy. It wasn’t impossible for Exxon Mobil to collapse in the face of record oil prices.
And it’s not impossible that stocks will be valued properly again someday. Just wait. And while you wait, think about how much better you’re doing by accruing more than 7% a year in earnings, while bonds pay 4% — without offering any upside potential.
Just be patient and have courage. And when everyone around you says you’re crazy, take comfort in the fact that, in investing, the majority is always wrong.
The above is an “Ahead of the Curve” column published October 21, 2005 on SmartMoney.com, where Luskin is a Contributing Editor.
