Dan Ferris on the most important investment rule for today's market


By Dan Ferris in Extreme Value:

According to the folks at investment firm Grantham, Mayo, Van Otterloo, & Co. (GMO) stocks under $5 have outperformed those over $50 by more than 90%. That's a lot of fireballs streaking through the financial firmament.

The stock market has many investors looking up now, too. The American Association of Independent Investors (AAII) sentiment index is 50% bullish and only 35% bearish (15% neutral). It was 70% bearish back in March. Everyone was looking down then.

Now, they're all looking up. They don't want to miss the fireworks. Psychologists call it "recency bias," where you assume that what just happened recently will continue to happen indefinitely. When "up" is happening all around you, it's normal to abandon any thought of "down." I strongly caution you, especially when taking new positions - don't forget to look down. Don't buy because stocks have gone up. Buy only what is cheap and safe.

Looking down right now isn't easy. Some of the world's most famous and successful investors are having trouble doing it. Author, hedge-fund manager, and former Morgan Stanley analyst Barton Biggs isn't looking down. He says it's a new bull market. George Soros isn't looking down. He says the economic stimulus worked and the bottom is in.

The godfather of all hedge-fund managers, Michael Steinhardt, got it right, I believe, in a recent interview when he said, "I'm not saying we're in a zone of reasonable valuation... [I'm saying] you can't talk about valuation so readily." It's really hard to know if stocks are overvalued or undervalued right now.

The solution to this is simple, but terribly hard for most investors to execute. Jeremy Grantham of the aforementioned GMO says it best. He's learned from decades of experience and research that, "The best long-term predictor of future stock market gains is the current value of the market (yield, price/sales, price to replacement cost)." Since the current value of the market is difficult to fathom, you need to be careful about the current value of any stocks you buy.

Don't worry about the overall market. Worry about how much you're getting paid for the risk you're taking. The yield has to be high enough or it's not worth buying, no matter how you measure it. When you do find a company that's cheap enough and safe enough, there's nothing left to do but buy.

Crux note: Dan Ferris is the editor of Extreme Value, a deep value-focused advisory service. To access Dan's latest recommendation, a global force in the pharmaceutical world due for a major rally, click here...

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