August 2017 Newsletter

The Stakes Keep Getting Higher in the World’s Biggest Casino

As you probably know, the stock market broke another record recently when the Dow Jones Industrial average hit 22,000 for the first time ever.1 Naturally, all the Wall Street cheerleaders celebrated and gushed about the market’s “strength.” At the same time, Donald Trump claimed credit for the milestone—even though the market has been on an emotion-fueled upward trajectory for more than eight years. While it’s true his election has added more emotional fuel to the rally, it’s also true that corporate earnings and economic recovery overall have continued to lag far behind the overinflated market.

In theory, to justify record-high market prices, you should have a booming economy, not just the promise of one, but with GDP growth still barely at two percent and the Fed still unsuccessful in its attempts to manufacture inflation, we’re just not there. Basically, this stock market is levitating without fundamental support. It’s like the floating woman in the magician’s trick where the magician runs a hoop around the woman’s body to show there’s nothing suspending her from above or her supporting her from below. Sure, it looks impressive, but as an audience, we know it’s just an illusion. The question for everyday investors is: how much of your life savings do you want to have invested in an illusion?

I believe the stock market is always a gamble compared to other investment options, and an overvalued market not supported by economic fundamentals is simply a gamble in which the stakes are especially high. As I discussed in last month’s newsletter, the difference between gambling and true investing is a question of control. I illustrated this with the FanDuel analogy: If you bet on the New England Patriots to win, you may think you and team owner Robert Kraft have a lot in common because you’re both “invested” in a Pats victory. But, only Robert Kraft is truly invested because he owns the team and has some level of control over whether they win or lose. You have no such control. It’s the same as the difference between majority shareholders who own enough stock to have controlling interest in a company and everyday investors who are minority stockholders with no control; the former group is investing while the latter group is just gambling.

The Pricing Paradox

The value of control and how a lack of it works against everyday investors becomes even more evident when you consider the following paradox:

Say you have a business and decide to sell it. If the business is worth $1M, you should be able to sell 49 percent of it for $490K or 51 percent of it for $510K. But, that’s not how works. In truth, you’d be lucky to get about $350K for the 49 percent, but you could ask for about $650K for the 51 percent.

Why can you ask almost twice as much for that additional two percent? The answer is control. The 51 percent gives the buyer controlling interest, so as a seller on the open market, you must discount minority interest, but you can demand a premium for controlling interest.

Why is it then that when one publicly traded company makes a tender offer to buy majority shares of another, they typically come in with an offer that is only 5 to 10 percent over the current price per share—as opposed to almost double the price? There are only two possible answers for this question. Either the board of directors of the selling company is accepting too little from the buyer, or we, the average investors, are overpaying for that company every day when we buy its minority shares. Somehow, I don’t think any board of directors is going to be that “charitable.” I think the real answer is that the discount for minority shares is not priced into the market, which means that, by definition, everyday investors are always overpaying for stocks on the open market.

The distinction between investing and gambling is one of the main things I strive to teach as a financial educator—along with the fact that there are options beyond the stock market that do offer a level of control and therefore are legitimate investments. When you purchase an individual bond, for example, it comes with a contract providing two guarantees you don’t get with a bond fund (which is technically defined as the stock of a company that owns bonds). Those guarantees are income generated at a fixed interest rate for the life of the bond and the return of your principal if you hold the bond to maturity. That’s a true investment because the contract gives you the power to hold the bond issuer accountable. Most options in the fixed-income realm are contract based and therefore qualify as true investments.

Two Slot Machines

Here’s another analogy that I welcome you to share with friends or family if you’re concerned they might be gambling too much with their retirement savings without realizing it. Explain that when buying a stock, you must do three things right in order for the purchase to pay off, all of which involve some guesswork: you have to buy the stock correctly, it has to go up in value, and you have to sell it correctly. By comparison, when you buy an individual bond or bond-like instrument, you only have to do that first thing: buy it correctly. If you do that (ideally with the help of an advisor who specializes in such instruments), your investment will pay off, and you have a contract saying so. It may not pay off to the same extent that your stock might if you do all three things right, but you run far less risk of losing money.

Once you’ve explained all that, ask your friends this question: If you went to a casino and saw one slot machine that paid a big jackpot if you hit triple 7s but nothing if you didn’t, and you saw another machine that paid a smaller jackpot for triple 7s, but also paid you something no matter what you hit, which machine would you play? Most people instantly see the sense in choosing the second machine, which represents contractual, income-based investment strategies. But, even for people who choose the big-jackpot-or-nothing option, which represents the stock market, a follow-up question usually changes their mind: what if the money you were gambling with was your life savings? Unfortunately, that’s just what a lot of everyday investors are still unwittingly doing in what I call the World’s Biggest Casino (a.k.a. the stock market), even as the stakes climb higher.

1. “Dow hits 22K for first time; Tesla earnings on tap,” Yahoo Finance, Last modified August 2, 2017, https://finance.yahoo.com/news/dow-hits-22k-first-time-tesla-earnings-tap-2-192304709.html

Copyright © 2017. All Rights Reserved, Pacific Financial Planners, LLC.

Pacific Financial Planners, LLC is an Independent Registered Investment Advisor. Securities offered through Western International Securities, Inc., headquartered in Pasadena CA. Pacific Financial Planners, LLC and Western International Securities, Inc. are separate and unaffiliated. The material contained within are the opinions of Jerry Slusiewicz only and are neither an offer or recommendation to buy or sell any securities or strategies mentioned. You should always check with your professional financial advisor and/or tax advisor before taking any action on any of the securities or strategies contained on this site.

Your Money Talks

KLAA AM 830
Saturdays 1-2 p.m.

For over 15 years, Jerry has provided radio listeners the opportunity to ask questions on the air about their investment needs. Some of the areas he covers include life matters such as risk management, retirement & estate planning, college educational funding, life insurance, annuities, long-term care and ways to safely increase your nest egg.

Call Jerry today with any questions or comments regarding this article.
(800) 449-9501

OR

Visit our website for FREE Financial Planning Resources.

Social Share Buttons and Icons powered by Ultimatelysocial
YouTube
LinkedIn
LinkedIn
Instagram