The
markets and economy were in crisis mode in October. Some say it was
primarily a financial crisis; some say an economic crisis. Yet others
say more specifically
it was a credit, liquidity or collateral crisis. While there is truth
to each of these statements, what connects them is a loss of confidence.
This
loss of confidence is more than just concern about future economic
prospects; it also reflects how investors and consumers feel about
their present situation.
Additionally, it is a lack of trust in the financial markets. As a
result of this lack of confidence, activity and prices in the financial
markets have fallen and economic activity has contracted.
One
notable and recent example of plummeting confidence was the
statistical survey of Consumer Confidence (by the global non-profit
organization Conference
Board) for the month of October. In short, US consumer confidence
tumbled to its lowest level on record (the data series was
established over forty
years ago) as Americans became much more pessimistic about their
current situation and prospects.
Among the myriad of factors
that impact consumer sentiment, the financial sector has been a
driving force, including concerns
about the liquidity,
valuation, and security of financial assets either personally
owned or owned by others. Weaker stock prices, for instance, negatively
impact consumer
balance sheets and moods. Thus, it probably doesn't surprise many
that sentiment dropped so drastically given that the stock market just
experienced
its largest monthly drop since October 1987. People also tend to "pay
attention" when the President, Federal Reserve Chairman, and Treasury
Secretary all publicly discuss the possibility of a potential financial
catastrophe! Lastly, it could be argued that the political season has
also had a negative
impact on the country's mood.
Weaker stock prices of late may explain a part of why consumer
sentiment is so low now, but is there a relationship between
extreme levels
of consumer sentiment and future stock market returns? Yes, there
is -- but it might
be surprising. Research has shown that stock market returns have
tended to be well above average in the periods following lows
in consumer sentiment.
What makes this really interesting is that consumer sentiment
is also considered a leading indicator of a weaker economy.
The thought goes that
if consumers are pessimistic about their situation, they will
tend
to purchase fewer goods and services. This makes sense.
So,
how does one reconcile the notion that low consumer sentiment is
a leading predictor of economic weakness but also of stock
market strength? Understanding this is a key part of appreciating
how the market
works
and
discerning how to incorporate economic data into the investment
decision-making process.
As the saying goes, the stock market is a discounting mechanism.
This means that the investment process should be forward-looking.
Money should
be invested in those areas that should be the most likely
to generate an attractive rate of return moving forward, not in
those areas
that generated the best returns in the recent past.
This forward-looking
nature is a major reason why the stock market typically leads the
economy. The standard rule of
thumb is that
the stock market tends to bottom four-to-six months before
the economy does.
This also
means, of course, that the stock market has usually already
found its footing and has started to move higher, in the
face of current
economic data that
is still generally quite negative.
So, while plummeting
confidence is a key reason the markets have fallen so much this
year, and may mean that the economy
will continue to be weak
in the months and quarters ahead, it is not necessarily
a reason investors should sell stocks now. If anything,
low levels of
consumer or investor confidence
are typically very good market entry points for the long-term
investor.
Government vs. Free Markets
With the massive government intervention of late, much
of it led by individuals who are generally considered
to be pro-market policy-makers, many investors seem
to be quite concerned
that this
has been
a
radical new
shift in economic thinking -- abandoning free markets.
Not so.
Back in the early 1970s, President Nixon made the
comment that "We
are all Keynesians now." He meant that policy-makers
of all political persuasions subscribed to the economic theories
of John Maynard Keynes who
believed in the power of the federal government to
influence and shape the national economy, and impact the
business cycle through monetary and fiscal
policy. But in fact, Keynes' impact on policy-makers
goes back all the way to the Great Depression.
In short, Keynes' key idea was that when there was less than full employment,
the government could increase employment either by reducing taxation or increasing
public spending, which would increase "aggregate demand" in the
economy. This policy could be particularly effective when private demand
was considered insufficient to maintain economic stability, particularly
during periods of economic and financial stress -- such
as we have today.
Indeed, even economists who believe in limited government
recognize the important countercyclical role that the
government can
play during periods of economic and financial stress
as either (or both) the "lender of
last resort " and the "spender of last resort."
Animal Spirits
Another notable Keynesian observation was how "animal spirits" move
the markets:
"
Even apart from the instability due to speculation, there is the instability
due to the characteristic of human nature that a large proportion of our
positive activities depend on spontaneous optimism rather than mathematical
expectations, whether moral or hedonistic or economic. Most, probably, of
our decisions to do something positive, the full consequences of which will
be drawn out over many days to come, can only be taken as the result of animal
spirits -- a spontaneous urge to action rather than inaction, and
not as the outcome of a weighted average of quantitative benefits multiplied
by quantitative probabilities."
These animal spirits (or lack thereof) form the basis
of much investor behavior, especially over short
time periods. In the
current environment,
despite the increased likelihood of better long-term
returns,
the urge to get out of the market, where it feels
safer, has dominated price action ... animal
spirits are in full retreat.
Indeed, many of the fundamental and technical templates
and relationships that have provided a framework
for effective investment decision
making have not worked in recent months. While it
could be
argued that market and economic
activity through the end of September were still
within the templates of recent decades, the volatility
and
market behavior in October
was clearly "outside
the box."
Nonetheless, both the extent of the losses and the
extent of the pessimism have created an interesting
attitude among many fundamentally-based money
managers. In short, they are excited. Some are the
most
bullish they have ever been in their careers. Also,
as recently observed
by an "old salt" in
the industry, with many years of money management experience, when everybody
seems to be saying that "nothing works" for
making investment decisions, that is usually a sign of
the market trying to bottom.
How Long Before I Get My Money Back?
Though Keynes's views on investing evolved, he once stated that a
rational investment policy would be ineffective because of the irrationality
of the
markets. While we agree that emotions dominate the market in shorter
time periods, we disagree with the notion that a rational investment plan
for
long-term investment is ineffective.
"Long-term" is a phrase many investors now greet with the concern that
they may never recover all of their recent losses (as measured from their
all-time investment portfolio value peaks). The answer, however, is probably
along the lines of "not as long as you might think," though the
best answer depending on the individual situation is that "it depends." The
investor's time horizon and financial markets make a difference, but
the answer also depends upon whether or not the investor abandoned (albeit
temporarily) the stock market until there was "more clarity." Selling
investments after losses not only converts temporary
losses into permanent losses, but it foregoes the opportunity
to participate in the
eventual recovery.
Assuming an investor stayed the course during past
bear markets, how long did it take to recover losses?
Looking at the worst
12-month returns since 1957 (excluding the current
bear
market), the stock market
was actually
able to recover all of its losses over the next
12 months eight times!
While that is not necessarily our expectation,
history suggests that it is possible.
What Can We Expect For a Long Term Return?
Now, let's look at the situation in a different light. This
time we will take a glimpse at what the long-term return for the
stock market
might
be if we assumed simply an average earnings growth
rate and an average price/earnings ratio over the next dozen years.
Currently, 2009 earnings forecasts for the S&P 500 are widely divergent.
On an operating basis (which excludes one-time, non-recurring items) the
forecast is $94/share. But reported earnings which don't exclude
those items are expected to come in at $48/share. Such a wide divergence
(reported
earnings only 50% of operating earnings) is highly unusual. Over
the last 20 years the relationship has been closer to about 90%. In the
past when
there has been a difference that big, explosive growth in reported
earnings generally reconciled this historical relationship.
However, we also believe that operating earnings
expectations for 2009 have likely not been reduced
enough. So, for
the sake of illustration, if
we think that $94 is too high and $48 is too
low, let's just split
the difference and say that earnings for 2009 are more along the
lines of $71.
In terms of earnings growth, over the long run
earnings basically grow at about the same rate
as nominal GDP or about 6% a
year. At that growth
rate, earnings will double in 12 years. That
takes earnings to $142/share for the S&P over that
time frame.
The average P/E for the past 50 years is
17.7
times earnings. Applying that to our $142 in
earnings gives us a value
for the S&P 500 12 years
from now of over 2500 (or more than 2.5 times
its current level). That works out to a price appreciation
of over 8% a year, excluding dividends
which
are currently over 3% a year. Add in dividends
and it would seem reasonable to expect the market to
return nearly 12% per year over the
next dozen years.
With a 12% annual return, an all-equity S&P portfolio would
double in approximately six years. Of course, the markets are human
and much messier
than that, generating big gains in some years
and losses in others, but over
time returns are indeed determined by the long-term
fundamentals of earnings growth, valuations, and dividends.
Where to Invest Now?
In the equity market, large-cap stocks appear
particularly attractive right now. This may
seem counterintuitive since large caps generally
tend to lag in stock market rallies, but what
makes
this environment different is that large caps
are trading at extremely cheap
levels compared to small
caps. This is especially so for higher quality
large-cap names. This valuation gap has been
building for several
years, but
has been exacerbated
recently
by institutional investors reacting to the
sharp market declines by selling their most liquid
names (typically large-cap stocks),
as they
are typically
easier to sell. Once the market stabilizes,
large caps
should recover some of that lost performance.
In addition, large caps tend to
benefit more than
small caps during periods when the government
is injecting massive amounts of liquidity into
the economy such
as
we are seeing today.
Given all that,
plus the fact that domestic large cap stocks
have been the
worst performing part of the stock market over
the last decade, we think it's their
time to shine.
For all the dislocation in the equity markets
of late, the fixed-income markets have seen
even more. While conventional Treasury bonds
have held their own in recent months, other
sectors in the
fixed-income markets
have
not fared well. As a result, some incredible
values
have appeared for the long-term investor. Corporate
bonds, investment-grade and high-yield, are
trading at extremely attractive yields compared
to conventional
Treasuries. Mortgage-backed and municipal bonds
are also relatively
cheap. Treasury
Inflation Protected Securities (TIPS) have
been hurt in recent weeks due to their relatively
illiquid nature (and waning inflation fears).
As a
result, 10-year TIPS are now selling at a breakeven
inflation rate of just 0.91%!
At those rates,
TIPS offer incredible value relative to nominal
Treasuries for investors who want a Treasury-only
portfolio. In fact, about the only areas
in the fixed-income markets that look expensive
are
conventional
Treasuries and
cash.
Fear and Attractive Valuations Equals Opportunity
The extreme crisis in confidence we are going
through has punished both the markets and
economy, and
we must acknowledge that
all the damage may not be done. But the flip
side of the
coin is that the critical preconditions
required for a fresh bull market -- good valuations and extreme fear -- are
now in place. While short-term movements in the markets are primarily a function
of volatile investor confidence and "animal spirits," we believe
that eventually the long-term fundamentals of earnings growth and
low valuations will provide patient investors attractive returns going
forward.
Sincerely,
