Making Sense of Volatile Markets
August 20, 2007
Given the volatile action exhibited by financial markets over the past several weeks, I want to take a moment to share some thoughts and perspective and, hopefully, provide some level-headed thinking amidst the storm. I fully understand the difficulty trying to remain calm and composed when the stock market is struggling, but we need to be extremely careful not to overreact and make short-sighted decisions based on emotion. Believe me, if there were some special button (like the red Staples button) I could push to make all this volatility go away, I would. Unfortunately, no such button exists.
What I can say is that following the crowd is generally not the way to achieve long-term success in the financial markets. While it may feel good to be relieved of the stress by exiting the stock market, you will ultimately need to re-enter the market at some point in the future, and getting the timing of that right creates a dilemma in and of itself. History shows that, even considering the 20 worst years of U.S. stock market performance (1962-82), the folks who intend to enjoy a two- or three-decade retirement without any stock investments will not have enough growth to overcome the long-term erosive effects of inflation. Unfortunately, market conditions are not always pleasant but, based on nearly two centuries of data analysis and over appropriate holding periods, stock performance shows “mean-regressive behavior.” In other words, the short-term periods of relatively good or bad performance even out over time and typically produce similar positive results. Moreover, despite the fact that correlation among various assets in short periods can be high, they too return to normal relationships with time. Finally, these market dynamics are not unique to U.S. stocks; they apply to markets around the globe as well. As long as humans continue to pursue ways to improve their lives and demand better goods and services, economic progress will continue and the markets will grow.
I made a comment to a client earlier this summer that emphasizes the contrarian mentality and objectivity we must maintain to stay the course: “Stocks are reaching their all-time highs so, knowing me like you do, it won’t surprise you that I am suggesting we increase your bond allocation.” Therein lies the key— having a willingness to sell investments that have already provided strong returns in favor of those that are undervalued. You may not sell at the absolute peak of the market, but you will be ahead of the curve. As we have said at various times in the past, “sell greed and buy fear.” Today’s market is ripe with fear and not greed, creating buying opportunities for prudent investors.
Looking at the markets on a daily basis and following economic data as we do, the rapid climb of the Dow Jones Industrial Average from 13,000 in late April to 14,000 in mid-July may have been a case of too-far, too-fast, particularly in light of the already-weak U.S. housing market and with consumers struggling with higher food and gas prices. Just because the stock market has come off its highs, however, does not mean a prolonged bear market is in the cards. Can it happen? Sure. Anything is possible. However, it remains a low probability event given other known data. In fact, the market’s behavior since 2003 has been abnormally calm compared with its historic performance, and the recent spike in volatility has been somewhat of a return to normalcy.
There are legitimate times to sell investments and cut losses, but we believe now is not that time. The number of high quality companies being sold at valuations not seen in many years is growing and, while there is no guarantee the recovery in the market will be rapid, the opportunities for making decent returns with blue chip investments over a reasonable time frame are improving.
Fundamentally, the global economic picture is not that different than it was on July 19th when the Dow Jones Industrial Average hit its all-time high of 14,000. What is different today is that global investors are less willing to hold risky debt securities, and this turbulence in the credit markets has generated concern that capital for legitimate business and consumer investment will not be as readily available as it once was. This could constrain global economic activity in the next few months but, over time, the elimination of poor lending standards and over-leveraged speculation will likely provide greater stability in the markets.
Another important consideration is that stock valuations today are radically different from where they were in March 2000 when the Tech Bubble burst. At that time, the S&P 500 Index was trading at nearly 32-times forward earnings estimates. Today it trades at roughly 15-times, and economic activity abroad is much stronger. Previous bear markets have ended—not started—when valuations reached 14-times forward earnings. And, while earnings growth is slowing, corporate America is flush with cash. As of the end of June, the S&P 500 companies held close to $1.0 trillion in cash on their balance sheets. This represents tremendous buying power and can be used for a variety of purposes, including stock buybacks, strategic acquisitions and dividend increases, all of which would support stock values.
Part of the challenge investors have at this time is getting an accurate assessment of the size of the subprime mortgage problem. Central Banks around the globe are requesting that financial institutions report the level of problem loans, while hedge funds are revaluing their portfolios to reflect the drop in value of their underlying investments. Not all of this data is yet available so, until general conclusions can be reached, market volatility will likely remain elevated. Nevertheless “reality” often is in the middle and that is how we have and will continue to manage portfolios and provide advice.
All of this said, I want to assure you that we are not taking the unfolding events in the financial markets lightly, nor are we in any way ignorant of broader economic and geopolitical issues which must be weighed in any investment decision. We are reviewing every investment and adjusting allocations as needed. With new cash, we are being deliberate and cautious putting it to work.
There are many more thoughts I could share with you but, to keep this brief, I will close with an analogy to keep in mind while watching the markets. Remember that any transaction in the financial markets involves three participants: the seller, the buyer, and the market maker (in the case of the NYSE, a floor specialist, and a computer network for the NASDAQ). The market maker is charged with keeping an orderly flow so as to match buyers and sellers. On most days, this activity is relatively straight-forward. However, there are periods when it becomes very challenging. To make good on their responsibility to provide an orderly market, the market maker must hold an inventory of shares of stock. Now, imagine you are a manager of a local Macys. It is March 20th and you notice you have an excessive amount of winter coats still on the racks. What do you do? You mark them down. First 20%, then 30%, then “buy one, get one free,” etc. At some point buyers return and get a great deal. The coat bought at a bargain may not have immediate use or value because Spring is in the air and it won’t be used, but in eight months, after the first frost, the owner is happy to own a great coat not only because it keeps him warm but also because the same coat is back on the rack at Macys for triple what you paid.
Relating this story to the stock market today, investors are selling many companies indiscriminately and the market maker (our Macys’ manager) has no choice but to mark down the price until buyers emerge. What is the result? Stocks are on sale!
As always, please call or e-mail us if you need our direct attention. We can walk through your personal situation and make certain the strategies and investments you have give you the best chance for success and security over the long run. We cannot make any guaranties regarding market activity, but we will remain prudent, objective and disciplined in our effort to guide you consistently with principals that have stood the test of time.
Jack E. Payne, CFA
Chief Investment Officer