This Market Is Getting Crazy - Here’s How Buffett Says To Invest In It

April 23, 2018

This Market Is Getting Crazy – Here’s How Buffett Says To Invest In It

  • We’ll discuss some news first, including commodity prices, chip guidance, and covenant ratios.
  • Then we’ll put things into perspective and see what an investor can do in this market.
  • I’ll give you a few tools that will make investing easy for you, if you can handle them.



Introduction

Last week, the stock market was positive for half of the week and then negative for the remainder.

Figure 1: S&P 500 last week. Source: CNN Money.

This volatility and direction seeking is a sign of the very late stages of a bull market and increased risks that still provide the opportunity to get out for those who are overweight stocks.

Another signal that we are in the late part of the economic cycle is rising commodity prices. Remember how I was positive on metals last summer? Well, metals are up 50% since then.

Figure 2: Bloomberg Industrial Metals Index. Source: Bloomberg.

This is exactly what happens in the late part of an economic cycle. Commodities go up just as there is a lot of demand at peak productivity, and the consequence is inflation.

As commodities are the start of manufacturing, sooner or later, they will push other prices higher. And that is why the FED has been raising rates rather quickly lately.

Figure 3: Federal funds rate in the last two years. Source: FRED.

Stable inflation is good, but sharp jumps in inflation aren’t good because it destabilizes the economy and if people start feeling like higher prices are coming, they start buying more things and further spur inflation which could make it difficult for the FED to keep things under control. Some FED officials have been saying that they might let inflation run a bit, but I see that as a very risky strategy and their rate activity tells us that what they are doing is trying to normalize things quickly.

However, while the FED is tightening a bit, the ECB and BOJ keep putting money into the system which is crazy and completely distorts the financial environment we are living in.

Figure 4: ECB is still buying 30 billion euros of securities per month. Source: ECB.



The three major banks are going in opposite directions and is something to think about as it’s an unprecedented episode and we have no idea how it will end. However, what I find amusing is that we are in the late part of the economic cycle but still have stimulating policy in the U.S.—albeit policy that is looking for normalization—and full-blown stimulation in Europe and Japan.

Will we ever see normalization? Who knows. But another reason for doubt comes from covenant quality.

Debt covenants are agreements between a company and a creditor, usually stating limits or thresholds for certain financial ratios that the company may not breach.

Covenant Quality

Now, despite all this quantitative easing, covenant protections ratios continue to deteriorate which indicates that investors are accepting more and more risk in order to get to some kind of return. This is something that destabilizes the whole market and a risk to keep an eye on.

Figure 5: Debt covenants ratios deterioration. Source: Moody’s.

Another cyclical indicator is that the world’s largest chip maker revised its guidance on softer demand for smartphones and less crypto mining.

Figure 6: Lower demand for smartphones. Source: Reuters.

The point here is that nothing can grow forever and that’s something that we should all be aware of. TSMC’s (NYSE: TSM) stock is down significantly over the last week, but still up incredibly over the last 5 years.

Figure 7: TMSC stock over the last 5 years. Source: CNN Money.

All this data, good economic news with higher commodity prices, and finally some inflation on one side, with riskier financial constructions, and continued monetary easing on the other makes investors really wonder what they should do. There is a way to make things much easier for investors, let me quickly elaborate on that.



What Should An Investor Do In This Market?

When in doubt, look to Buffett. One of his most important quotes is this:

“Buy stocks you would want to hold if the market were to close for 10 years.”

So, whatever you own, whatever you do when investing, you can make your life much easier by answering this question. If you can make the switch from looking at stock market prices on a daily basis and start looking at the businesses you own, everything is much easier when it comes to investing.

The point is that no one knows what will happen with stocks in the next day, month, or year. And even if there is a high chance for a recession in the next few years, nobody knows whether it will happen but what certainly helps is looking at what you own, and being happy to own it no matter what happens. Let me dig a bit deeper as answering the question isn’t as easy as it looks.

Will We See A Recession In The Next 10 Years? Most Probably, Yes.

Will we see higher interest rates, higher inflation, and a tighter credit market? Most probably, yes.

Will we see more monetary easing in the next 10 years? Most probably, yes.

Will we see disruption coming in various new technological forms? Most probably, yes.

Unfortunately, when answering these questions, you will find a lot of things that you don’t like and perhaps only a few that you do like. At this moment in the market and economic cycle, those stocks you wouldn’t mind holding if the market closes for 10 years—and only those—are the ones you should own.

This is also important from an investing perspective. We are all mostly net buyers of stocks over our lifetime and thus we can’t really avoid investing as timing the market is costly, but what we can do is accumulate a bit more cash when little that we like that gives a strong yes answer to all of the above questions, and be very aggressive when there are a lot of yeses.