Is It Time to Bail Out of the Market?

Europe's in crisis, the U.S. economy is stagnant, and unemployment is anchored around 9% -- time to bail out of the market, right?

And, Jim, you say, Bloomberg just reported that the number of shares sold short is approaching Lehman levels. That must mean that the market is bound to head lower, surely?

Wrong.

In fact, with valuations at near-record lows and corporate profits at record highs, now could be the perfect time to buy those blue chip companies at a price that's hard to beat. Read on, and I'll give you a chance to download a special free report that details five stocks The Motley Fool owns and that you should, too.

Three reasons you'll want to buy
Yes, it's true. Bloomberg reported that the number of shorted stocks climbed to the highest level since the Lehman blow-up of 2008. The number of borrowed shares climbed to 11.6% of stock in September, up from 9.5% in July. Some of the Dow components had notable numbers: Alcoa (NYSE: AA  ) is the most shorted stock in the Dow, while Pfizer (NYSE: PFE  ) and General Electric (NYSE: GE  ) had the biggest gains in short interest last month among NYSE stocks.

Sounds scary. But should you follow short-sellers or at least dump the shares you own?

"The Lehman collapse is way too clear in people's minds," explained one strategist at Nordea Bank. "They don't want to get burned as much again."

But that attitude will ultimately burn investors in the long run, as they sell out of solid companies at depressed valuations and buy into low-return assets like bonds and CDs.

With short interest at Lehman-like levels, should short-sellers worry you? On the contrary, you know what followed the Lehman debacle -- some of the best and quickest returns on America's blue chips in a decade. Or as Bloomberg noted, "Bearish bets last increased faster in March 2009, the same month the S&P 500 began a bull market that doubled its value."

After all, those short-sellers had to get back into the market and buy, driving the price of shares back up. So the high number of short shares now also means that there's clearly a pool of investors out there who will be forced to buy later on.

And there are some signs that the short trade is getting crowded. According to the chief U.S. equity strategist at Deutsche Bank, "Valuations and short interest are approaching Lehman levels. It's not very easy to continue to take larger and larger short positions." That's good for bulls.

So short pressures could be abating, meaning that positive market news could even lead to a short squeeze, sending shares higher. And I don't want to be the one getting left behind by a bull market.

Moreover, there are two other reasons that you should be optimistic: high corporate profits and low valuations.

Following a rough couple of years and painful downsizing, corporate America has turned into a lean, mean, money-making machine. Profit growth in the S&P 500 has returned to its historical average since the 1960s.

But surprisingly, valuations aren't taking account of that profitability. The S&P is trading at just 10.4 times the forecast for 2012 earnings. That's well below the historical average of 13.7 during recessions since 1957.

So that all spells opportunity for the long-term investor.

But what do I buy?
Just because S&P stocks as a whole are profitable and cheap doesn't mean you should buy any old stock. Instead, you should focus on buying value-priced stocks with a history of solid profit growth. The low valuations help insulate you from market panic, while profit growth means you can expect future stock gains.

One good place to begin is with Berkshire Hathaway (NYSE: BRK-B  ) , the conglomerate run by superinvestor Warren Buffett. The company comprises some 80 businesses with durable competitive advantages and is trading at an incredibly cheap valuation -- just 1.1 times book value.

Plus, Buffett has put something of a floor under shares. He's stated publicly that he would consider repurchasing Berkshire shares when they are trading for less than 1.1 times book value. Berkshire is sitting on a pile of cash, so it can back up its words, and Buffett is not one to talk idly.

Also of interest are names like Philip Morris International (NYSE: PM  ) and Intel (Nasdaq: INTC  ) . Each company trades at a reasonable valuation (15 and 10 times earnings, respectively), dominates its markets, and generates gobs of cash. Plus, each has a solid practice of rewarding shareholders with a steadily rising stream of dividends. Right now Philip Morris offers a 4.7% yield, while Intel offers a 3.7% payout. These are rock-solid blue chips companies that provide a bank-beating yield and long-term upside. It's hard to see how you can go wrong over the next five to 10 years with these stocks.

If you're more aggressive on the yield front and don't expect or require capital gains, you might opt for Annaly Capital (NYSE: NLY  ) . This mortgage real estate investment trust trades at tangible book value and offers a 15% yield. Things look solid for this dividend giant as long as interest rates remain low. This company thrives on business conditions that sink other stocks, meaning it can make a good hedge for your portfolio.

Want more?
So, far from bailing out of the market, now may be a great time to pick and choose your winners for the next decade. If you're intrigued by the possibility of scoring good long-term returns, you should download our special free report "5 Stocks The Motley Fool Owns -- And You Should Too." The stocks (including one named above) were selected by our top analysts, and The Motley Fool has put real money behind the picks. It's complete free, so you have nothing to lose, just click here.

Jim Royal, Ph.D., owns shares of Annaly, Philip Morris, and Berkshire. The Motley Fool owns shares of Philip Morris, Annaly, Berkshire Hathaway, and Intel. Motley Fool newsletter services have recommended buying shares of Intel, Philip Morris, Berkshire Hathaway, and Pfizer. Motley Fool newsletter services have recommended creating a diagonal call position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 11, 2011, at 4:45 PM, WealthCoachOz wrote:

    Good to see a balanced article that acknowledges the downside but doesn't stay there in the doom & gloom. Buffett says "the time to be greedy is when others are afraid" and there is much fear in the market right now; consequently, also massive opportunity. Buying with high yield and low book ratio is something that is incredibly safe -- I call this the "PENTAgram" : high PE, low NTA. Thanks for showing the opportunity.

    Jeremy Britton DFA SAFin AAHA HHDPH

    www.24HourWealthCoach.com

  • Report this Comment On October 11, 2011, at 9:08 PM, TigerPack1 wrote:

    Actually, short selling exploded in 2006 and 2007 right at the top! The heightened level of short selling actually helped to peak the market and came BEFORE a 50% price drop in stocks between 2007-2009...

    http://finance.yahoo.com/news/Short-Selling-Rises-Most-bloom...

    An increase in short selling over a period of time by itself is not the best indicator of short-term price behavior, one way or the other.

    Given stock mutual funds have almost NO cash right now to meet future redemptions, the market is in deep trouble if a black swan event appears, like a military coup in Saudi Arabia or Greece.

    I would be more comfortable with your argument, IF institutions and mutual funds had liquidated longs more aggressively the last few months, and the global economy was not entering a Depression.

    Otherwise, good article and argument.

    When people are scared to leave the house, like in early 2009, that will be the time to buy stocks again... Just my opinion. I don't see much fear from investors or experts yet. EVERYONE is picking a bottom and using the same arguments as 3 months ago to be bullish, namely low rear-view mirror valuations and too much negativity.

    What if the negativity is well placed, and the economy is headed for a serious downturn in business profits? Not many people are taking this part of the argument to heart, despite Asia, Europe and America slipping into negative growth AT THE SAME TIME.

    P.S. you may be right in the end that this is a good time to buy, but I will keep my cash on the sidelines until Greece files for bankruptcy and America actually gets for real and cuts spending.

  • Report this Comment On October 11, 2011, at 10:26 PM, SUPERMANSTOCKS wrote:

    Buffet is right! Look at PSUN for a quick buck over the next few months. Look at SNV for a longer buy and hold. Also, the only 2 companies I'd be buying out of this list would be AA and GE. The rest are overrated. Although that does not mean they might not be a good buy. I am just not buying them.

  • Report this Comment On October 11, 2011, at 11:34 PM, moneyman35 wrote:

    If you haven't bailed out yet you should have. The way i see it the market isn't even oversold at these levels, there is still a lot further too go.

    But thats just one guys opinion...

  • Report this Comment On October 11, 2011, at 11:53 PM, police12345 wrote:

    Wonder what the markets will do when the European Union is dissolve, and Germany and Russia become allied in a post EU melt down?

    Germany is the EU's strongest economy, and they not going to continue bailing out Greece, Italy, Portugul or Spain.

  • Report this Comment On October 11, 2011, at 11:58 PM, moneyman35 wrote:

    @ police12345 "when?"

    So you know this is gonna happen for sure? If you can predict events like that, will you please be my portfolio manager??

    We could run the world together!!

  • Report this Comment On October 12, 2011, at 2:04 AM, dividendgrowth wrote:

    Some people have too little respect for the market and too much confidence in themselves.

  • Report this Comment On October 12, 2011, at 3:05 AM, AndyBrisman wrote:

    Have you heard that Google Plus is already losing points and the traffic has already dropped for 60%!!!!!

    http://www.coldscoop.com/2011/10/11/are-google-plus-users-ha...

  • Report this Comment On October 12, 2011, at 5:53 AM, dbtheonly wrote:

    Moneyman,

    Germany & Russia allied to, "We could run the world together!!"?

    Been there. Done that. Even had the Japanese kicking in. Didn't have a happy ending.

  • Report this Comment On October 12, 2011, at 10:01 AM, mikecart1 wrote:

    What I can't stand on here or on tv or anywhere is when the market drops 200 or 300 points, the world is going to end. The next week when it goes up the same amount, everything is solved and back to great times. The fact is is that people don't account for short covering, ETF influence, and how the indexes are even calculated!!! AAPL goes up $10-20/share and Nasdaq usually will usually rise because AAPL has over 15% influence on the index itself!!! Same with the DOW. There are a few stocks that have a heavy weight on that index. These are the facts:

    1) Obama is losing control of his presidency and unable to pass anything

    2) Europe is going down in flames; not if but when

    3) Iran is trying to start WWIII and that will cause US Debt to rise to whatever is after trillion

    4) The US economy is going down in flames with real unemployment near 20%

    5) People are starving to death in Africa

    Bottom line, the global crash is going to be epic and that is all you need to know.

  • Report this Comment On October 14, 2011, at 12:35 PM, ChrisBern wrote:

    (a) The market is NOT cheap. There are only a few statistically reliable measures of valuation--CAPE and Q-Ratio. By both measures, the market is currently 25-35% overvalued. Given the headwinds of debt, there is zero chance I'm buying a market which is that overpriced.

    (b) Are bonds always a "low-return" asset? Long-term bonds e.g. VUSTX have returned upwards of 30% this year. What has the overpriced S&P 500 done in that same time period? Lost almost 10%. I'm not a buyer of bonds at today's price, but when the peanut gallery was saying that stocks were cheap and bonds expensive 10 months ago, they were dead wrong!

  • Report this Comment On October 21, 2011, at 11:33 AM, Zeppelin6880 wrote:

    Chris Bern is spot on right with his comment the market isn't cheap. My question to the author Jim Royal is how can he make a statement like this "valuations at near-record lows" with no data to support it? By every reliable measure, Q-ratio, CAPE (Shiller's P/E), Total stock market/GNP, etc the stock market is overvalued, like Chris Bern said, by 25-35%. So to make a statement that valuations are cheap, I just can't agree with that unless you support it with some evidence.

    Also, I would argue that the exact time NOT to buy the market is when corporate profit margins are at record highs. That statement was so disturbing to me. I mean, have you ever heard of mean reversion? Do you think corporations will be able to maintain these margins when commodity inputs increase? I mean, really think about that statement. The reason the market is discounting the profit margins are because they know they are temporary and will eventually revert to their historical mean, if not overshoot it and go below it. So to say jump into the market because stocks are cheap and companies are earning record margins is a foolish (with a lowercase f) statement in my opinion.

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