Separating the Signal from the Noise as Stocks Peak

Successful investing involves focusing on the facts and stats that matter, and disregarding the information that is of no decision-making value.

Unfortunately for investors, most of the information that the mainstream media bombard us with every day is useless when determining how to grow your nest egg.

James Montier, a partner in the well-respected global investment firm GMO, says it this way in his book Value Investing:

“Often in the investment business, which has an obsession with minutiae, too much time is spent trying to figure out more and more about less and less, until we know everything about nothing. Rarely, if ever, do we stop and ask ourselves what we actually need to know!”

Along the same line, statistician turned best-selling author Nate Silver became famous for coining the phrase “separating the signal from the noise.”

Coming off last year’s astonishing 32 percent run-up in the U.S. stock market, it’s now more important than ever for you to be able to sort out what’s signal and noise in the current financial environment to protect your profits and grow your portfolio.

U.S. stocks are less stretched than they were at the beginning of the year.

As I have pointed out in previous Money and Markets columns, the current stock market valuation is stretched, as measured by the current price-to-earnings ratio.

Granted, valuations are slightly less stretched than they were at the beginning of the year because U.S. stocks, as measured by the S&P 500 Index, have fallen 2.6 percent this year (as of Monday’s close). But that decline represents only a marginal improvement in pricing, which means that this market is still expensive — don’t let anyone try to convince you otherwise. And an expensive market is by definition a treacherous market to attempt to earn even greater returns.

In an expensive market there are two factors — and only two — that you have to be concerned about: inflation and growth.

I prepared the table below that summarizes how precarious the current situation is for investors seeking higher returns from today’s levels. That’s because, as the table shows, there is only one likely economic scenario that’s good for stocks.

And the sweet spot is an environment of price stability where inflation (as measured by PCE, or Personal Consumption Expenditures) does not tick up by more than 2.5 percent on an annualized basis and overall economic growth continues to bump along at a growth rate of 2 percent to 3 percent.

Fortunately for stock market investors, that’s where we currently sit. However, as I wrote in last week’s Money and Markets column, we recently received a bit of a wake-up call from emerging markets’ signals that growth is slowing, which — as my table shows — is bad for stocks.

That’s because if growth expectations slip below 2 percent, stock prices will be in trouble unless the Fed reverses course on its current tapering policy. Likewise, if we hit a highly inflationary environment — meaning inflation running at a rate in excess of 3.5 percent — stocks will also tumble no matter what the economic growth rate is (unless growth kicks into high gear too, which is not likely given current economic conditions).

And of course, a deflationary environment is just simply terrible for stocks as it is for all other paper assets. So let’s keep our fingers crossed that we’re beyond that hurdle in the current economic recovery.

There you have it. Only one out of the six most likely economic outcomes is good for stock investors. Now, that’s what I call threading the needle!

But all things considered, that’s exactly what I expect to happen in the coming months. In my view, economic conditions will remain in the sweet spot. But I must admit to being more concerned about lagging growth than I am about runaway inflation.

That’s why I continue to recommend that you consider large, high-quality, global franchise companies with superior earnings power for the core of your portfolio — because growth is the magic elixir that will cure all our current economic ills.

Be vigilant, guard your capital, and remember that inflation and growth are the signal. Everything else is noise.

Best wishes,

Bill

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.