Use Prices as Guideposts

 | Jul 23, 2013 | 5:00 PM EDT  | Comments
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gm

Many investors today may feel like they are being pulled in two different directions. They are watching the market go up while trying to figure what to do: Wait, sell or buy?

My market forecasting ability is just as good as the next guy's, but it does appear to me that investors may have to come to terms with today's painful reality: The general stock market is no longer serving up compelling opportunities. There aren't many market truisms, but this one can't be disputed. Future market returns diminish as the market climbs higher and higher. A security that has appreciated 50% is a gain that is no longer available to current investors.

Someone who picked up Apple (AAPL) at $200 a share tripled their money when the shares touched $600. The buyer at $600 has to see a share price of $1,800 to realize the same experience. Yet investors seem to go wrong in understanding this simple math when buying stocks. Someone purchasing Apple at $600 because of a forecast that Apple shares will reach $900 was optimistically buying a stock and hoping that it would lead to a 50% gain. (Note: I only use Apple as an example because it's a widely known stock today.)

Every investment decision has an opportunity cost. The buyer of Apple was forgoing other less "desirable" opportunities without giving any consideration to the price-to-value relationship. A year ago, if you would have polled investors about whether Apple or General Motors (GM) was the better investment, most people would have quickly picked the former based on the desirability of Apple and its products. Most investors would have neglected to take into account the current share price between the two names and compared that with the intrinsic value. Over the past 12 months, GM is up 90% while Apple shares have fallen 29%.

Today, I would look at names such as Netflix (NFLX) and Blackberry (BBRY). Netflix is firing on all cylinders while Blackberry seems to be taking two steps back for every step forward. Netflix gets favorable ratings from analysts while Blackberry is hardly an analyst favorite today. Blackberry does have some serious concerns but the price of $9 gets you $5.50 a share in cash -- along with a business that many thought would have gone under by now. The market has seen companies that have successfully executed much more difficult turnarounds than this one. Investors got a taste of Blackberry's potential when shares climbed from $6 to $18 in little over a year.

The above example aside, the important point for investors to understand is the market reality. Prices are the best guideposts for future market returns and they provide the best buy and sell signals.

I was one of few voices touting Bank of America (BAC) when the stock was trading below $6 a share when the consensus was nervous about the balance sheet. I wasn't smarter than anyone else, I just recognized that its price at the time was a very attractive buying signal. The shares have almost tripled since then. BofA would have to trade as $40 a share for that to happen again.

In sum, I recommend heeding Warren Buffett's advice: Let the market guide you, not instruct you.

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