Time Heals All Wounds
January 22, 2008
Over the past six months and particularly over the past three weeks, global stock markets have struggled badly. On the back of on-going issues in the credit markets, enormous sub-prime mortgage write-offs in the banking industry and fears of a U.S. economic recession, there have been few places to hide. The major global indexes are now approaching bear market sell-off levels (defined by market participants as declines of 20% or more from the previous high). Times like these understandably shake one’s confidence and elevate fear. However, it is that very instinct that leads to short-sighted decisions and poor long-term results.
Over the past 72 hours, Mike and I have had several discussions on the events now unfolding in the markets. Although I wish these events were different, there is no magic dust we can sprinkle on stock investments to allow everyone to avoid all of this selling pressure, nor do we have a crystal ball regarding when it might dissipate. Unfortunately, funds allocated to stocks will face downside exposure from time to time which is why we favor selling into market strength. We do know that an emotional decision to sell everything just because the herd is selling is typically the wrong decision over the long-term. With that said, we can add a few points of insight that might help:
1. Current stock valuations are nowhere near the economically unjustifiable levels they reached just before the bear market of 2000-2002. This was the height of the tech-stock bubble when the S&P 500 was selling at 28 times forward earnings and many tech stocks were at 60, 70 or even 80 times earnings. Today, the S&P 500 trades at 13 times forward earnings and now sports a dividend yield over 2.0%. Despite reduced earnings growth forecasts for 2008, reasonable market valuations should reduce the longevity and severity of the declines.
2. We are keeping some perspective of the long-term cycles in the stock market. Recently, a few noted strategists have recently pointed out that, despite the fact that U.S. stocks have doubled in value from October 2002 through October 2007, annualized stock market returns over the past ten years have been far below their long-term average of 10.7% and have even under-performed U.S. Treasury bonds during that span. While this may not be encouraging, the sell-off we are now experiencing, combined with the de-leveraging of the global capital markets, may be the final chapter of the “secular” bear market thus setting the stage for a new “secular” bull market in U.S. blue chip stocks. (“Secular” means a long-term trend while “cyclical” means a short term trend.) Over the past 100+ years, the U.S. stock market has enjoyed an ebb and flow of secular trends, both bull and bear, and these typically span periods of 12 to 17 years. Within each secular trend investors enjoy cyclical rallies of shorter duration perhaps 3 to 6 years.
To give you some historical perspective, the U.S. stock market struggled with a secular bear market through much of the 1960s and 1970s. However, within that time period, the great “nifty-fifty” stocks produced very positive returns in the early 1970s. This secular bear market was followed by a secular bull market that got underway at the height of “doom and gloom” in 1981 and lasted until March of 2000. During that run, stocks went through some fairly scary periods (like “Black Monday,” October 19, 1987) and the Asian currency crisis in 1997-98. So, with U.S. large cap valuations becoming more attractive relative to other asset class and even compared to foreign stocks, a trend reversal for U.S. large cap stocks may be on the horizon. Remember, trends often change at a time of extreme pessimism - something that is becoming more apparent and widespread with each current trading session.
3. The current hot investments in the capital markets are U.S. Treasury Bills, Notes and Bonds. While we like these securities for the steady return and lower volatility they provide, the principal of these investments will erode over time when adjusted for the impact of inflation and taxes. This is particularly true today. On Friday, January 18th, the yield on the benchmark 10 year U.S. Treasury Note closed at 3.64%. Thus, an investor in an off-the-run 10 year note would lock in a return to maturity of 3.64%. That may seem like a good deal compared with the declines in stock market values, but is it really a good deal over the next ten years? In the past 12 months, U.S. consumer inflation as measured by the consumer price index (CPI) increased by 4.1%. While that rate is higher than its historical average of roughly 3.0%, a bond investor today has minimal upside and will have negative inflation-adjusted returns. Factor taxes into the mix and you are committing to very limited returns for treasuries over an entire decade. “Well, you can always trade out of them if things get better,” one might say. True, but thinking through this scenario might provide a different conclusion: when the economy starts to show indications of improvement, the Fed will shift to a neutral bias and interest rates might begin trending higher. In such a scenario, trading before maturity would give an investor a capital loss. This outcome is exactly what investors who are piling into bonds should be trying to avoid.
4. In times like these, we are reminded that stocks are designed to be long-term growth investments. When held for periods of 10 or more years, stocks are rarely out-performed by other asset classes. In fact, for holding periods of greater than 20 years, stocks are the only asset class that always out-performs inflation. This is critically important for any individual or family, including retirees, to maintain constant purchasing power over time. The fact that we may be approaching the end of one of those rare decades when stocks failed to out-perform bonds is likely strong evidence that they may regress toward long-term average performance and thereafter deliver better-than-expected returns in the future.
5. To realize the best returns, it is highly important to stay in the game so as not to miss out on the days offering the best market rallies. Ibbotson & Associates, a popular keeper of long-term capital market data, has calculated the results of investing $1 in the S&P 500 Index in 1926 and holding over time. This investment would have grown to $1,216,000 by year-end 2005. However, had an investor missed just the 30 best days in the market over the entire time frame (which represents fewer than 1% of the trading days in this time span), the value of the $1 would have grown only to $17,856 This is a huge difference! The point is, nobody can pinpoint when a rally will ensue, so we stay invested even if the allocation is below long-term target.
With all of this said, we do believe some adjustments are needed in the near term for many of our clients. This is particularly true for clients that already rely on their portfolios for supplemental income (or those who will need to draw on their portfolios for cash flow over the next few years). Specifically, we are recommending stock allocations overall move below target policy weight by up to 10% with greater emphasis placed on reductions in Small Caps and Emerging Market Stocks which have enjoyed an extended period of above-average returns. We will be communicating the changes we make to your portfolio individually. For our younger and more aggressive clients still in the wealth accumulation stage, we look at this sell-off as a great buying opportunity, especially for those funding 401(k) and 403(b) retirement savings plans. Some re-balancing may be in order at this juncture, but given the long-term needs for growth, stocks continue to offer your best hope despite the near-term challenges. Finally, we are being extremely deliberate with new lump sum cash to be invested. Although we believe that the stock market appears to be relatively cheap, there is no technical sign yet we have seen the bottom.
In closing, we want to reiterate our commitment to guiding you through good times and bad. Despite our youthful appearance, Mike and I have been through many difficult market periods. If the selling and volatility in the market is causing you discomfort, please let us know and we can evaluate both your long-term strategy as well as all of your current portfolio holdings.
We’ll be in touch as the activity in the global capital market unfolds.
Jack E. Payne, CFA
Chief Investment Officer