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    The market is too high, it has to go down…

     

    I bet you have heard this more than a few times recently. Some investment gurus came out of their tombs and are back with their favorite REM song: “This is the End of the World as we Know it”. They had to hide for a few years after telling the world that 2008 marked the death of capitalism. Six year after the biggest financial crisis, it seems it was just like a bad dream and everything is back on track. But some people will tell you it’s impossible for the market to go up forever. They are right, there will be corrections, but it doesn’t mean the system will collapse this time.

     

    Are We Really Paying Too Much for Stocks?

     

    This is the right question you should ask yourself; are you paying too much for your next trade? I recently increased my position in Johnson & Johnson (JNJ) even if the current P/E ratio was over 19.

     

    Truth is if I had waited a few weeks, I could have bought it a few dollars cheaper (the stock lost 5% in 5 days after posting great financial results). But that’s easy to say when you are playing Monday morning quarterback on your trades.

     

    The real truth is Johnson & Johnson is a great company. The dividend will continue to rise in the upcoming years and the stock will continue to show growth. New drugs will be marketed and profits will continue to grow. This is why there isn’t a perfect time to buy JNJ, but there is a perfect trade to make: buying the darn stock.

     

    I don’t mind the exact timing of my trade for that reason: I focus on buying a company that will grow in the future. The price may be slightly high, but I don’t mind because it will continue to rise. Waiting for the perfect dip never served me. If you have a technique for that, please let me know.

    How About the Market Average P/E Ratio?

     

    Now back to our gurus saying the market will crash because it is overvalued. I like when I read such things as I always wonder where they get the numbers to back their prophecies (if they back it up with anything at all!).

    The following chart shows you the average P/E ratio of the S&P500 according to two important economic metrics: the strength of USD and the strength of inflation.

     

    Average P/E Ratio

      Low Inflation High Inflation
    Weak USD 15.2 13.6
    Strong USD 16.4 13.9

     

    As you can see, the moment where stocks are at their peak in terms of valuation is when there is a strong dollar and a low inflation. Does that ring a bell? The USD is getting stronger as its economic environment improves. Inflation is still very low and under control. Therefore, the historical average of the S&P 500 PE Ratio should be around 16.4. We currently show a P/E ratio of 15.7. What does this tell me? There is still room for the market to grow!

     

    What I like even more is the fact that the market has been up this year not because we have changed PE multiples, but because companies make more profit now that they were making a year ago.

     

    This is exactly what we are looking for: companies increasing their sales and increasing their profits.

     

    This is why I’m buying more JNJ and this is why I’m 100% invested; because I believe the company I own in my portfolio will continue to generate profits.

     

    When you look at the overall P/E ratio valuation, most bubbles burst when the S&P 500 reaches high levels of 20 to 22. We are definitely far away from that. And if it ever goes to this level, I’ll be the first to tell you ;-). In the meantime, I’ll keep buying… and buying… and buying…

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    After the amazing ride we had in 2013, many investors have decided to sell a part of their portfolio and cash out their profits. They did this because they are waiting for the next dip to buy again. The problem is that since the small dip of 5% (where those guys were probably still waiting hoping it would hit 10%), the market is surfing on another good year.

     

    We still have a little bit of volatility, but overall, both the Canadian and US markets are set on cruise control to finish over +10%. However, this scenario will happen only if the good news keeps coming in. You know, the type of news that makes me want to buy more stocks…because this is what you should do: keep buying more stocks if you have money parked somewhere.

     

    The P/E Ratio is not that Bad

    I agree with you, the easy money is gone for good. There aren’t awesome buying opportunities these days on the market. But it doesn’t mean there aren’t opportunities at all. Both the S&P500 and TSX60 are traded around their historical average values for P/E (16-17). Therefore, most stocks are currently fairly valued.

     

    This also means that if companies keep posting better results, their stocks will continue to rise and follow the same ratio. In fact, this is pretty much what has happened since the beginning of the year. Stocks are following alongside their profits and this is a very good thing for everybody; this means there is not a bubble ready to burst.

     

    Companies Still Have Cash

    For the most part, companies have never kept this much in liquid assets as they do nowadays. They have focused on paying down their debts and reducing their costs over the past 5 years and have kept a very tight budget.

     

    What does extra cash mean for investors? One of these five things:

    #1 Dividend increases

    #2 Stock buybacks

    #3 Mergers & Acquisitions

    #4 Additional investments in R&D to innovate

    #5 The ability to endure a rough stretch (recession)

     

    When I increased my position in Apple (AAPl) a few weeks ago, I bought a company that is sitting on billions. This money is ready to be redistributed to me as an investor through many channels. I would rather buy shares now and keep their dividend in the meantime instead of waiting on the sideline earning 1% from the money market.

     

    The Train is Still Not Steaming

     

    As I’ve previously mentioned, I don’t see the stock market train steaming yet. In the US, there isn’t a big bubble ready to burst. The housing market is growing slowly, consumers’ confidence is rising and employment is getting better. The deleveraging phase is over and consumers have started to buy goods again.

     

    In Canada, the housing market still worries me but it seems that we are landing softly on a zero growth level (eventually) without any crashes.  Mind you, banks are well capitalized and it will not affect their balance sheet too much as profits now come various sources apart from mortgages.

     

    What is Expensive Today will be out of Range Later

     

    If you think the market is expensive right now, you might not be in a good position to manage your portfolio. I’ve talked to people who told me the market would burst last year while others told me the same thing about 2012. Still, we are now past the mid-year of 2014 and the stock market continues to grow.

     

    At the moment, there are plenty of good reasons why stocks are going up. I’m not saying that everything is perfect (far from it), but there are enough factors telling me price will keep going up. What do you prefer; not buying right now, missing the dividend to buy in maybe 2-3 years at today’s price after the stock market will eventually drop?

     

    I think I’m better off buying dividend stocks, cashing in the distributions and continue my ride on the market. What would you do if you had $5,000 to invest? Would you buy stocks or keep waiting?

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    Last Monday, I mentioned the possibility of using a margin account to invest in a TFSA account. To my knowledge, only Questrade offer TFSA margin accounts. It’s kind of counter intuitive when you think about it: why would you borrow money to invest in an account where you can’t deduct the interest?

     

    The idea of leveraging in Canada is often linked to the fact we can deduct the interest from your investment income. I’m not a tax expert but the general concept is that you are allowed to deduct the interest from a loan when the money has been used to invest and there is a reasonable expectation of profit. For example, if you borrow 100K at 5% to invest in a bond paying 2%, you can’t really deduct the interest as it is pretty obvious you will lose money.

     

    However, this tax rule doesn’t apply when you borrow money to invest in a tax sheltered account (an RRSP or TFSA for example). So what’s the point of borrowing to invest in a TFSA?

     

    Because my Expected Return is Bigger

     

    If I invest $1,000 in my TFSA margin account and borrow another $2,000, I will have $3,000 to invest. I would pay 6% interest on $2,000, a cost of $120. This represents 4% of my portfolio. By selecting my stocks carefully, I can probably build a portfolio that will pay all interest within 12 months, maybe instantly.

     

    There are many Canadian stocks that would fit in this portfolio:

    Telus (T) 3.71%,

    BCE (BCE) 5.04%

    ScotiaBank (BNS) 3.85%,

    Corus (CJR.B) 4.39%

    Emera (EMA) 4.20%

    National Bank (NA) 4.05%

    Riocan (REI.UN) 5.21%

    Rogers (RCI) 4.19%

     

    This is a short list but it’s more than enough for me to build a $3K portfolio. I would probably buy 2 stocks at first and build on that. The idea is to pick stocks that will pay the interest with their dividend.

     

    Then, the dividend growth will be “in my pocket” along with the overall growth of the stock value. When I look at my current portfolio, my YTD total return is 7.4%. It is a great combination of dividend payouts and stock growth. This is what I would like to create with this margin account.

     

    You Have to be More Aggressive

     

    A margin account is not for the faint of heart. If you don’t want to go “all-in”, it’s better off not doing it at all. I was surprised to find over 100 stocks on the Canadian market showing both EPS and positive revenue growth over the past 5 years and paying over 4% in dividend yield. Then, it’s a matter of researching deeper and look carefully at each company. The short list I just pulled for this article is coming from stocks I know well and that were part of my quick stock filter research.

     

    Let’s say I wouldn’t have any problem building a “bank & telecom” portfolio with my TFSA. This could be a good idea to maximize both dividend payouts and overall growth of the portfolio. I’m not completely done with the idea of investing on margin but I must admit this is getting serious in my mind right now.

     

    Please note that I didn’t mention any US stocks in this article because dividends paid by US companies in a TFSA are subject to withholding taxes (30% if you don’t do anything, 15% if you take care of it). I explain how you can save 15% withholding tax in my book; Dividend Growth Freedom Through Passive Income Canadian Edition.

     

    What do you think? Should I go ahead and use the power of leveraging?

     

    Disclaimer: I own shares of T, BNS, NA

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