"The four most expensive words in the English language
are ‘this time it's different.'"
Sir John Templeton
The markets are painful. They have been for awhile. The conventional
view is that the economy and markets will remain under pressure
for some time, perhaps even for a few more years. It's
hard to argue against the consensus given the current balance
of headlines, economic data points, and market losses.
The fear is primarily driven by a view that this recession is
darkly different than past recessions and that this bear market
will necessarily have to be deeper as a result. While there is
some truth that there are some disturbing differences between
this cycle and past ones, it's useful to remember that
the stock market can ascend even if economic growth is stagnant
or contracting. It's also useful to remember that recessions
and bear markets always end -- and usually much more quickly
and definitively than most anticipate.
Remember When?
It's also useful to remember how quickly the conventional
view is proven wrong. Let's review some of the major conventional
views in recent years -- all of which were supported by
headlines, economic data points and market action at the time:
- In 2008 inflation was a top concern as commodity prices
and official inflation data were rising and in some cases were
rising sharply. Now, deflation concerns dominate.
- Also heading into 2008, the consensus view was that
the global economy and markets had "decoupled". In
other words, if the U.S. economy and markets suffered, the international
markets, especially emerging markets, would not suffer nearly
as much -- if at all. Last year, however, international
markets, especially emerging markets, lost significantly more
than the U.S.
- Going back to 2007, consumer confidence was at historically
high levels and it was hard for many to believe that consumers
would retrench. Now, less than a year and a half later, consumer
confidence has plummeted to new lows.
- Also into 2007, "liquidity" was the leading
reason why the stock market would keep going higher, even with
those investors who acknowledged that valuations were too high.
Needless to say, months later, a historically severe "liquidity
crisis" took hold.
- Also up until 2007, even though fixed income credit
spreads (i.e., the difference in yields between government bonds
and non-government bonds such as corporate bonds) were trading
near multi-year extremely tight spreads (i.e. expensive), it
was widely considered that non-government fixed income was attractive
given how low Treasury yields were and how stable the economy
was. In 2008, however, high yield bonds were down 26% while long-term
Treasuries were up 23%.
- Even into 2007, over-all stock market volatility was
at historic lows for a few years and it was widely believed that,
thanks to enlightened central bank policy and the innovative
new ways to manage risk through financial market securitization,
this was likely to persist for many years. In 2008, however,
we just lived through the sharpest market volatility in 70 years.
In fact, volatility quadrupled from levels just a few years before.
- The common view up until a few years ago was that housing
prices could not go down, and if they did they wouldn't
be down much or for very long. House prices did peak in 2006
and are now off nearly 30% from peak levels.
Each of these views had plenty of economic and media support
at the time. Each also had satisfaction in that the markets
continued to confirm those views, at least for a period of
time. Each, however, proved to be significantly wrong, and
proved to be wrong a lot more quickly than people expected.
Current views on the economy -- as solid as they may seem
right now -- could end up equally wrong.
Bear Markets Do End
Even though the strong consensus view is for more losses ahead,
two key points should be remembered. First, stocks typically
rebound in advance of an economic recovery. As we have frequently
written, "stock markets often climb a wall of worry" meaning
that stock market prices often rise in the face of negative
news and investor doubt. The second item to remember is that
every bear market is eventually followed by a bull market,
and those bull markets are often bigger than many investors
expect.
A recent study by Fidelity Investments reminds investors who
flee to cash during bear markets about the potential cost of
missing the early stages of a market recovery. Historically,
the very early stages of market recoveries have provided the
largest percentage of returns per time invested.
Examining the last 14 bull markets going back to 1930, each tend
to have one thing in common: front-loaded performance. For example,
the first month of a bull market produces an average return of
14%, which comprises on average 12% of the entire bull market
performance. The first three months produce an average of return
of 18%, which comprises on average just under 20% of the entire
bull market.
The key conclusions of the Fidelity study are that by definition
new bull markets are not known until after the market has gained
20%. Investors who move completely out of stocks during bear
market declines (defined as 20% drop in price) may want to re-consider
doing so given how powerful gains typically are off market bottoms
coupled with the difficulty of finding the exact bottom. As the
saying goes, no bell will ring on the day of the market bottom.
Triumph of the Optimists
One of the more outstanding investment books is called "Triumph
of the Optimists" (Princeton University Press, 2002), which
was written by Elroy Dimson, Paul Marsh, and Mike Staunton. The
data for the book, which examines capital markets returns from
17 different countries going back to 1900, was recently updated.
The data should be reassuring for the long-term investor.
Since 1900, the United State's stock market, after inflation,
returned about 6% a year. Government bonds beat inflation by
2% a year and Treasury bills (short-term) beat inflation by 1%.
Inflation during this time averaged roughly 3% a year.
Over the last 50 years, which obviously incorporates the dismal
performance of the current decade, stocks still beat bonds by
approximately 2% a year on average and bills by nearly 4%.
The United States has been one of the best performing markets
over the last century plus. It is reasonable to assume that the
experience may not be as strong moving forward. As such, capital
market returns for the world minus the U.S. are a bit lower.
Since 1900, stocks, after inflation, have been up just under
5% a year, while government bonds and bills each beat inflation
by approximately 1% a year. Inflation for the world, ex-U.S.
also averaged about 3% a year.
What does all this data mean? In short, despite all the economic,
political, and cultural volatility and turmoil of the last 100
years or so, stocks still produced the best long-term returns. There is no reason to think that won't continue moving
forward.
Valuations Suggest Above-Average Returns
The numbers above don't even factor in valuations. If valuations
are considered to be low, which they are now, then return expectations
should be increased.
To be fair, valuations typically have minimal impact in explaining
capital market return over extremely long-term time periods.
They are also typically poor predictors of short-term term performance.
Where they are strong is in helping predict performance over
time periods such as a decade or so. And now, valuations are
low, hinting that returns over the next decade could even be
better than the long-term averages cited above.
There are many ways to look at valuations. Perhaps the most popular
is the price to earnings ratio, otherwise known as the "P/E
Ratio". Price/earning ratios are computed in different
ways. At KIM, we like to look at a "normalized" price/earnings
ratio. Normalization means to adjust earnings to minimize the
cyclical impact of the economy's ups and downs. It is argued
that this creates a smoother and ultimately more effective valuation
measure. We also like to look at five years of data (four years
of historical operating earnings data plus one year of forecasted
operating earnings).
In the last week of February, and using official S&P data
through the end of last month, the normalized P/E dropped to
11x. This is the lowest the 5-year normalized P/E has been since
July 1984 (for the record -- the 10-year annualized return
10 years after that date in 1994 was nearly +16%). This P/E is
also 45% undervalued to its 50-year average P/E of 20x. This
P/E ranks among the lowest decile of P/Es over the last 50 years
using this metric (lowest 17% of all P/Es going back to 1871).
Some like to adjust the P/Es for other factors. There's
an argument to do so. First, some like to adjust P/Es by inflation
rates. In short, P/Es tend to be higher in environments where
inflation tends to be fairly average (around 3%/year) and stable.
Conversely, P/Es tend to be lower in deflationary environments
or when inflation is rising rapidly. Interestingly, the historical
five-year inflation rate is actually quite average at present,
which suggests that P/Es should be well above-average, not below.
The twist, of course, is that there are strong deflationary and
inflationary cross-currents at present. This situation bears
monitoring.
Others suggest that P/Es should be adjusted by changes in tax
rates, regulatory policy, interest rates and transaction costs.
All else being equal, P/Es should be lower if any of the above
increase. Currently, it could be reasonably anticipated that
most of these factors are more likely to increase in the years
ahead than decrease.
Question Grab Bag
In the remaining space for this month's commentary, we
are going to provide a quick answer to some of the many questions
we have received in recent weeks. We'll keep it brief here,
but please feel free to contact us if you'd like more detail:
Q: Valuations may seem fine, but aren't earnings getting
crushed?
A: Corporate earnings were indeed decimated in the fourth quarter
of 2008 and guidance for 2009 earnings growth has also been significantly
lowered. Nonetheless, there are positives. First, earnings revisions
are not getting worse. Second, earnings house cleaning was massive
enough that the impact of extraordinary items should be fairly
minimal in the first half of 2009. Lastly, and perhaps more importantly,
despite the lower guidance for 2009, earnings growth -- whether
one looks at reported or operating earnings growth - -is expected
to be over +20% in 2009. The stock market should like that.
Q: Won't high unemployment keep the economy and markets
down?
A: The unemployment rate has historically been a lagging economic
indicator while the stock market tends to be a leading indicator
of economic activity. In fact, according to data from Ned Davis
Research going back to WWII, when unemployment is above 6%, the
stock market tends to gain 13% over the next 12 months. When
unemployment is between 4.3% and 6.0%, the stock market's
average gain per year drops to about 5%. When unemployment is
below 4.3%, the stock market return has been about 2% per year.
Q: GDP was sharply down last quarter and is likely to be down
in the quarters ahead. Fed Chairman Bernanke and even Warren
Buffett think the economy will struggle this year. Stocks can't
rally in the face of that, right?
A: The stock market typically leads the economy. Just look at
recent history. Stocks peaked in the fourth quarter of 2007 and
are now down over 50% from all-time peaks then. Nominal GDP meanwhile,
reached its all-time peak in the third quarter of 2008 and is
now down about only 1%. Real (i.e., adjusted for inflation) GDP
peaked in the second quarter of 2008 and is now down only about
2%. In short, GDP does not need to move higher for stock prices
to rise.
Q: Won't massive government spending hurt the economy
more than it will help?
A: Most likely no -- and yes. First, as for the first half
of our answer, the government has the ability to spend money
when the rest of the economy is not spending as much. In short,
the government has the ability to potentially stabilize, or at
least minimize economic losses to some extent, in the short term.
Longer term, however, government spending -- which is typically
related to higher taxes -- is generally not considered as
optimal as private spending. A study by Rob Arnott, the chairman
and founder of the firm Research Affiliates, did a regression
study where a 1% increase in the tax burden as a percentage of
GDP had a nearly one-for-one downward impact on GDP, and only
about 10 cents on the dollar of the higher taxes actually made
it to the government.
Q: Won't the American consumer be down and out for a
long time?
A: This is an important question as the answer will shape the
economy in the years ahead. Savings rates are back on the rise
and consumer debt levels are dropping. This is good for the long-term
health of the economy. Nonetheless, will we go back to the savings
rates of past generations? Has the 24/7 world of constant real-time
information and opinion transformed our culture in any way? Do
families still play Monopoly, or do they now just play Wii? In
short, in a world of internet shopping and quick and easy cash-less
transactions, it seems unlikely that consumer debt levels and
saving rates are likely to go back to prior generation levels.
Q: Should I be more concerned about deflation or inflation?
A: This may be one of the more critical issues to monitor in
the months and years ahead. There are clearly some major deflationary
factors in place right now, but given the massive increase
in money supply in recent months, it would be quite reasonable
to see higher inflation -- perhaps even significantly
so -- in the years ahead. If inflation did in fact significantly
uptick, this could take a bit of the starch out of the long-term
valuation argument. Again, this is something to closely monitor.
Q: Does investment decision-making change given the government's
increased role in the economy?
A: This is another good question, and clearly deserves more than
a one paragraph answer. Given that the government's role
in the economy is likely to expand, the short answer is that
the rhetoric and policy out of Washington will indeed be a bigger
factor in driving market performance. Nonetheless, when it comes
to the stock market, the basic rules of investment success of
buying companies with growing earnings at good prices remain.
Q: Could the market continue to extend to new lows?
A: Even if the market is cheap and oversold, it can, of course,
continue to move to new lows and get even cheaper and more
oversold.
Q: What should an investor do if the market goes to new lows?
A: If one has a balanced, diversified portfolio with a long-term
value orientation, the bias should be to buy market weakness.
Q: Are you personally investing in the stock market?
A: Absolutely.
What to Do Now
As we have talked about before, there are two elements of investing.
First, there is the rational side of investing. In this report,
we reviewed multiple items, including long-term market history,
expected earnings growth, as well as the current valuations of
the market. It appears to be a great time to buy. Emotionally,
however, it's not so easy. All of us can appreciate that.
If you are currently in cash, or have positioned your portfolio
quite conservatively given your long-term objectives and risk
tolerance, you may have avoided a lot of the market damage. Now
might be a good time to start wading back into the market. One
way to do so is to set up a plan and stick to the plan. One approach
could be to dollar-cost average over three equal installments.
Put one third of the assets into a balanced, diversified portfolio
now, another third in three months, and the remaining third in
another three months after that. The key is to maintain discipline
through thick and thin.
If currently invested in a balanced, diversified portfolio, there's
a good chance you haven't re-balanced your portfolio in
quite some time. This might be a good time to re-balance your
portfolio back to target weights. For current KIM clients, we
will be periodically rebalancing for you.
If currently invested, but nervous, there is no shame in selling
down to your "sleeping point." Many investors' risk
tolerance evolved in recent years as their financial situation
or objectives changed, or as they learned more about their emotional
reaction to market volatility. There are various ways to sell
to a sleeping point, but selling everything to cash is typically
not the healthiest option for long-term portfolios, especially
when the market is arguably cheap and oversold. Ratcheting down
exposure gradually tends to be a better approach.
These are just some of the actions investors can take right now.
Given the recent market volatility and emotion, now may be a
good time to communicate with your account managers and see what
action you might be able to take.
Living with Volatility
A few years ago, we were all spoiled to some extent with the
several years of below average economic and market volatility.
It now appears, however, that the near future will remain quite
volatile. Regretfully, volatility is destabilizing. Volatility,
however, also means opportunity. And now, given that the market
is well off its all-time highs and at its cheapest levels in
decades, the key is to stay involved, at least to the extent
you are comfortable. Managing and monitoring volatility through
a balanced, diversified portfolio remains the best option for
many investors.
To close this month's commentary, let's hear some
words from Benjamin Graham, who remains arguably the most influential
investor of the past century, and who wrote his classic text "Security
Analysis" during the depths of the Great Depression:
"The investor who permits himself to be stampeded or
unduly worried by the unjustified market declines in his holdings
is perversely
transforming his basic advantage into a basic disadvantage. Price
fluctuations have only one significant meaning for the true investor.
They provide him with an opportunity to buy wisely when prices
fall sharply and to sell wisely when they advance a great deal." Benjamin
Graham
Sincerely,
