For a while there, it looked liked the market would continue to go straight up without pause. Last week, stocks—especially the beleaguered financials—were on a tear. This week, they’ve dropped back significantly (although they did rise +1% today). The market never goes straight up, and I’m actually pleased that we’re taking a breather, because investors were getting ahead of themselves. Think about it: in only 2 months, the S&P 500 had risen nearly +40%. It was time for a rest. As of today, the S&P 500 is “merely” up +34% from its March 9 low.
Whether this is a bear market rally or a nascent bull is beside the point; predicting short-term market moves is impossible anyway. The bears say the recovery will be too weak to justify a continued rise in stock prices. The bulls say that the market had priced in a depression, and we’re ending up with “just” a severe recession, meaning prices got too low and need to rise. Who knows and who really cares? Prices of nearly everything—not just stocks—dropped to depression-like levels. But now the global credit markets are clearly in recovery, and the economy will eventually follow. Already, it’s clear the economic cliff-dive that began last September has abated, the rate of decline has slowed dramatically, and some areas are already in an early uptrend. The world hasn’t come to an end (sorry, Dr. Doom).
It’s about now in the market cycle that investors again start making irrational decisions. Panic is just a memory, and despair is fading. Indecision is the order of the day. “Do I buy or do I sell? Do I take my money and run or do I put more to work now that the coast seems clear?” In trying to make these difficult decisions, many investors look to “anchors”: prices of individual assets and market indices that seem to have special significance. Problem is, these anchors are almost always meaningless and thus misleading.
For example, in early March the S&P 500 was at a bear market low of 666. Today it is at 893, a +34% gain in only 2 months. Many people say: “Too far, too fast. Must be a bear market rally.” These people have “anchored” that 666 value, giving it special meaning and significance. The unspoken assumption is that 666 was an accurate measure of the stock market’s value, and that the current level of 893 is thus too high because stocks shouldn’t rise so fast. But what real significance does 666 have, other than the level of the S&P on a particular day? Maybe 893 is closer to the market’s intrinsic value, or maybe the correct number is 1,000. We just don’t know, and of course, both current prices and intrinsic value change continuously.
The key point is that the market low of 666 is just an arbitrary, and basically meaningless, number. But people will be anchored to it and reference it for months and years to come. This “anchoring bias” is compounded by another cognitive error that investors typically make, called “recency bias.” This is the natural tendency to remember recent events more clearly and to weight them more heavily than more distant events. Remember when all the market pundits were referencing current prices to the bull market high of 1576 from October 2007? But today you don’t routinely hear that “stocks are cheap because they’re 43% below their highs.” Rather, they’re expensive “because stocks are 34% above their lows.” We anchor to the more recent number and tend to forget the older one. But in reality, both the high and low values are just arbitrary numbers of no significance except to statisticians and market historians.
We do the same thing with individual stocks, anchoring their highs and lows (emphasizing whichever of these is more recent). Take, for example, BHP Billiton, the world’s largest mining company. Many investors think it is becoming expensive because at a recent $50 per share, it’s doubled from a low of $25 in only 6 months. You don’t hear anyone saying it’s cheap because the stock is down 48% from a high of $96; that anchor is too far in the past. Again, these numbers should have no significance to the methodical investor, because there are only 2 prices of any importance: today’s, and what you think the stock will be worth in several years. Everything else is noise.
Another common anchor, perhaps the most often used (and abused), is the most meaningless of all: the price you paid for a stock. How often have you heard (or said), “I’ll sell the stock when it recovers to my purchase price” or “I’ll sell it after it doubles” or “I’ll sell it if it falls 20% below my purchase price.” If Mr. Market doesn’t care about high and low prices, how indifferent must he be to the price you paid? Basing a sell decision for a stock in relation to your purchase price makes no more sense than selling your house solely because it’s now worth twice what you paid. You should sell your house when you need to move, no matter what its current value. Similarly, the only reason to sell a particular stock is because you believe that the money would be better deployed elsewhere: in a different stock, in a different type of asset, or in consumption. The current price of the stock, whether in comparison to its recent high or low, or to your purchase price, is completely irrelevant. (It is relevant, however, in comparison to your assessment of the stock’s intrinsic value).
So don’t get too anchored; go with the flow, because prices and values are fluid. And don’t make the mistake of assuming that recent price movements have any impact on future prices. If a stock has recently doubled, it’s not necessarily expensive, but could potentially double again. Similarly, if it’s just fallen in half, it’s not necessarily cheap and worthy of purchase. It might halve again. In other words, random prices are just that: random. And “past performance does not predict future results” is totally true with individual stocks and the market as a whole. The future cares not a whit about the past, nor does Mr. Market, and neither should you.
Friday, May 15, 2009
Friday, May 1, 2009
March was nice, but April was nicer
I wanted to quickly recap April’s market performance. For the month, the MSCI ACWI (All-Country World Index) rose +11.8%, one of the best monthly performances in history. Tacking on March’s +8.2% rise, we now have a 2-month rally that’s totaled +21.0%. And since its March 9 low, the MSCI ACWI has soared +31.1%.
Despite this stellar performance (or perhaps because of it), many investors are worried. Are stocks moving up too fast? Could this just be another of those bear market “head fake” rallies that will give up the ghost as did several prior ones? These fears are not unfounded, as there’s been a lot of bad news recently, and much more still to come. Add to that the recent outbreak of Mexican swine flu, and there’s plenty to worry about.
But as I’ve said so many times before, bear markets climb a wall of worry. The time for successful investors to be brave is when most others are scared. And the data continue to suggest that the majority remain bearish and afraid:
“In this week’s latest survey of Investment Advisors, according to Investors Intelligence, more advisors are bearish than bullish. In fact, for the past 4 weeks the number of bullish advisors has been falling as the market has moved forward. Basically the market continues to climb a wall of worry. While earnings have been poor as everyone was expecting, the surprise has been that in many key places, they haven’t been as bad as expected....
“With the majority of advisors not believing in the rally, probably means it still has more room to move on the upside over the coming weeks.”
(The above is from STIR Research, whom I’ve quoted before.)
If my recent conversations are any indication, most of you feel the same way, much more afraid of another drop than of missing the new bull market. All this pessimism is good, and adds to my confidence that the lows are finally behind us. Much data, moreover, are suggesting an end to this recession sooner than most had thought. It looks like we won’t have to wait until the end of 2009 for the economy to start growing again; that could happen as soon as next quarter. No, the stock market isn’t crazy, it’s just doing its job, which is to discount the future.
A note on swine flu: Even if we do see a global pandemic, the social and economic toll are likely to be significantly less than in prior ones, and certainly nothing like what we saw with Spanish flu in 1918. And even during that horrific period, when over 20 million people died worldwide, the Dow Jones Industrial Average gained +26.4% in the year following the month during which the pandemic first started to mushroom. Strange as it may seem, pandemics are not necessarily bad for stocks.
But today’s situation is far different from 1918, and even from the other, smaller, flu pandemics of the 20th century. First, the new virus was identified early, and public health measures have been quickly put in place worldwide. Second, the current swine flu virus doesn’t appear to be any more virulent than normal flu, in sharp contrast to the 1918 Spanish flu or the recent avian flu. Third, we have the ability to make vaccines today, though it will be several months before one is available. Fourth, we have 2 antiviral drugs in ample supply that are highly effective in reducing symptoms of the virus. Fifth, new research indicates that the majority of deaths from Spanish flu were from bacterial pneumonia superimposed on the original virus, for which we have safe and effective antibiotic treatment today.
Most of the people who die or become seriously ill from flu virus are the elderly and the infirm; most children who succumb have ongoing medical problems. Healthy children and adults typically come through the illness unscathed, even without antiviral drug treatment. And the bulk of the economic effects of a pandemic come not from the illness itself, but from attempts to reduce the spread of the virus. Quarantines (both voluntary and imposed), work absences, reduced travel and shopping, can all contribute to an economic slowdown. The key is to protect yourself without becoming a drag on the economy.
Despite this stellar performance (or perhaps because of it), many investors are worried. Are stocks moving up too fast? Could this just be another of those bear market “head fake” rallies that will give up the ghost as did several prior ones? These fears are not unfounded, as there’s been a lot of bad news recently, and much more still to come. Add to that the recent outbreak of Mexican swine flu, and there’s plenty to worry about.
But as I’ve said so many times before, bear markets climb a wall of worry. The time for successful investors to be brave is when most others are scared. And the data continue to suggest that the majority remain bearish and afraid:
“In this week’s latest survey of Investment Advisors, according to Investors Intelligence, more advisors are bearish than bullish. In fact, for the past 4 weeks the number of bullish advisors has been falling as the market has moved forward. Basically the market continues to climb a wall of worry. While earnings have been poor as everyone was expecting, the surprise has been that in many key places, they haven’t been as bad as expected....
“With the majority of advisors not believing in the rally, probably means it still has more room to move on the upside over the coming weeks.”
(The above is from STIR Research, whom I’ve quoted before.)
If my recent conversations are any indication, most of you feel the same way, much more afraid of another drop than of missing the new bull market. All this pessimism is good, and adds to my confidence that the lows are finally behind us. Much data, moreover, are suggesting an end to this recession sooner than most had thought. It looks like we won’t have to wait until the end of 2009 for the economy to start growing again; that could happen as soon as next quarter. No, the stock market isn’t crazy, it’s just doing its job, which is to discount the future.
A note on swine flu: Even if we do see a global pandemic, the social and economic toll are likely to be significantly less than in prior ones, and certainly nothing like what we saw with Spanish flu in 1918. And even during that horrific period, when over 20 million people died worldwide, the Dow Jones Industrial Average gained +26.4% in the year following the month during which the pandemic first started to mushroom. Strange as it may seem, pandemics are not necessarily bad for stocks.
But today’s situation is far different from 1918, and even from the other, smaller, flu pandemics of the 20th century. First, the new virus was identified early, and public health measures have been quickly put in place worldwide. Second, the current swine flu virus doesn’t appear to be any more virulent than normal flu, in sharp contrast to the 1918 Spanish flu or the recent avian flu. Third, we have the ability to make vaccines today, though it will be several months before one is available. Fourth, we have 2 antiviral drugs in ample supply that are highly effective in reducing symptoms of the virus. Fifth, new research indicates that the majority of deaths from Spanish flu were from bacterial pneumonia superimposed on the original virus, for which we have safe and effective antibiotic treatment today.
Most of the people who die or become seriously ill from flu virus are the elderly and the infirm; most children who succumb have ongoing medical problems. Healthy children and adults typically come through the illness unscathed, even without antiviral drug treatment. And the bulk of the economic effects of a pandemic come not from the illness itself, but from attempts to reduce the spread of the virus. Quarantines (both voluntary and imposed), work absences, reduced travel and shopping, can all contribute to an economic slowdown. The key is to protect yourself without becoming a drag on the economy.
Friday, April 24, 2009
The real thing?
No, I don’t mean Coke. I’m referring to the stock market rally, now 45 days old and not falling apart, despite considerable bad news and a pretty crummy earnings season. Could we finally be in the early stages of a new bull market, rather than one of those head-fake rallies that we most recently saw in late November to early January?
One of the characteristics of a new bull market is that most investors don’t recognize it until it is well underway. After a “normal” bear market, it typically takes an up move of 25–35% before the majority of investors realize that the lows are history. After this record-setting global collapse, one might expect investors to be even more cynical, requiring a 35–50% rally before most of them become believers. By then, of course, the easy money will have been made.
As this rally ages, and the lows and panic of early March fade further into the past, I continue to see signs that this one will stick. Little by little, several professional investors with excellent track records, and whose opinions I value, are saying that it’s becoming safer to buy stocks, and are putting their remaining cash to work. Some who were extremely bearish in March are turning bullish. At the same time, the vast majority of investors, both professionals and amateurs, are doubting the rally, keeping their funds in cash or bonds, and waiting for the market to drop 20% or more. They may have a very long wait.
Investor sentiment surveys are especially revealing. Two I follow are Investor’s Intelligence (a survey of investment newsletter writers) and the AAII Investment Survey (of individual investors). Both were extremely bearish in early March, with the AAII survey hitting a low not seen for at least 18 years. Since then, sentiment has understandably improved, but is still only slightly better than it was last fall, when the world seemed certain to end. In other words, most investors remain bearish despite a 25% jump in stock prices over just 6 weeks. This suggests that the “wall of worry” remains solid, which is a bullish sign.
The overall market is acting well, with virtually every sector participating in the recovery. More importantly, economically sensitive sectors, including technology, materials, industrials and consumer discretionary stocks, have been outperforming defensive sectors such as utilities, healthcare and consumer staples. This is an indication that some investors are looking forward to the economic recovery and are becoming more willing to take on risk. All of this bodes well for a continued financial and economic recovery.
This week was the first in 7 that stocks lost ground, but only a little. In fact, there has not been a drop of more than –5% since the rally began. This is typical of early bull markets, as investors with lots of cash wait in vain for that big pullback so that they can invest near the lows. But that big pullback rarely comes. Here’s an explanation from SITR Research:
“... at the start of a new bull market move, rarely will the market accommodate those investors [who are waiting for a big drop]. Our good friends at Ned Davis Research did a historical study of market pull backs at the start of new bull markets. The conclusion: the pull backs are small, typically way under double digits.
“The logic is simple; investors have hordes of cash by the end of a bear market cycle. Unfortunately most of that was raised right near the end of the bear market, which has to happen to make it the end—investor panic.... So, we have investors sitting with cash, saw the market rally, and wishing that they had invested some of their money near the low several weeks ago.
“They are now hoping for a pullback to put some of that cash to work. So when the pullback starts, there are always just a few who get anxious, and start nibbling and buying before the pullback gets very large. That little bit of buying attracts other buyers who had been sitting on the sidelines also, and the combination keeps the pullbacks small and shallow.”
Currently, we appear to be in a period of “consolidation,” when the major averages start trading in a relatively narrow range as individual stocks gyrate more wildly. Such periods can last several weeks or more, and are great times to put money into stocks and other “risky” investments. The market doesn’t run away from you, but at the same time, the movements of individual stocks relative to each other can enable one to take advantage of temporary pricing anomalies. The goal is to sell those stocks that become temporarily overvalued and buy those that are temporarily undervalued: an ideal time to rebalance portfolios. (I can’t promise the market won’t continue to rise strongly during the rebalancing process, but that’s still OK.)
Some of you have already received your new portfolio proposals, and the rest of you will over the next week or so. (Each portfolio is customized, so I can’t do them all at once.) I invite questions, both general and specific. I can’t know where you’re confused or disagree with me unless you tell me.
One additional point that I can’t emphasize enough: the financial markets always recover well before the economy. And the general public doesn’t start feeling good until many months, or even years, after the economy has bottomed. By the time Joe and Jane Main Street realize the recession is over, and the press prints mostly good news, half or even two-thirds of the bull market is already behind us. The prices of stocks and other assets are not rising now because things are good or even improving, but because the “smart money” can finally conceive of an end to this recession and financial crisis.
One of the characteristics of a new bull market is that most investors don’t recognize it until it is well underway. After a “normal” bear market, it typically takes an up move of 25–35% before the majority of investors realize that the lows are history. After this record-setting global collapse, one might expect investors to be even more cynical, requiring a 35–50% rally before most of them become believers. By then, of course, the easy money will have been made.
As this rally ages, and the lows and panic of early March fade further into the past, I continue to see signs that this one will stick. Little by little, several professional investors with excellent track records, and whose opinions I value, are saying that it’s becoming safer to buy stocks, and are putting their remaining cash to work. Some who were extremely bearish in March are turning bullish. At the same time, the vast majority of investors, both professionals and amateurs, are doubting the rally, keeping their funds in cash or bonds, and waiting for the market to drop 20% or more. They may have a very long wait.
Investor sentiment surveys are especially revealing. Two I follow are Investor’s Intelligence (a survey of investment newsletter writers) and the AAII Investment Survey (of individual investors). Both were extremely bearish in early March, with the AAII survey hitting a low not seen for at least 18 years. Since then, sentiment has understandably improved, but is still only slightly better than it was last fall, when the world seemed certain to end. In other words, most investors remain bearish despite a 25% jump in stock prices over just 6 weeks. This suggests that the “wall of worry” remains solid, which is a bullish sign.
The overall market is acting well, with virtually every sector participating in the recovery. More importantly, economically sensitive sectors, including technology, materials, industrials and consumer discretionary stocks, have been outperforming defensive sectors such as utilities, healthcare and consumer staples. This is an indication that some investors are looking forward to the economic recovery and are becoming more willing to take on risk. All of this bodes well for a continued financial and economic recovery.
This week was the first in 7 that stocks lost ground, but only a little. In fact, there has not been a drop of more than –5% since the rally began. This is typical of early bull markets, as investors with lots of cash wait in vain for that big pullback so that they can invest near the lows. But that big pullback rarely comes. Here’s an explanation from SITR Research:
“... at the start of a new bull market move, rarely will the market accommodate those investors [who are waiting for a big drop]. Our good friends at Ned Davis Research did a historical study of market pull backs at the start of new bull markets. The conclusion: the pull backs are small, typically way under double digits.
“The logic is simple; investors have hordes of cash by the end of a bear market cycle. Unfortunately most of that was raised right near the end of the bear market, which has to happen to make it the end—investor panic.... So, we have investors sitting with cash, saw the market rally, and wishing that they had invested some of their money near the low several weeks ago.
“They are now hoping for a pullback to put some of that cash to work. So when the pullback starts, there are always just a few who get anxious, and start nibbling and buying before the pullback gets very large. That little bit of buying attracts other buyers who had been sitting on the sidelines also, and the combination keeps the pullbacks small and shallow.”
Currently, we appear to be in a period of “consolidation,” when the major averages start trading in a relatively narrow range as individual stocks gyrate more wildly. Such periods can last several weeks or more, and are great times to put money into stocks and other “risky” investments. The market doesn’t run away from you, but at the same time, the movements of individual stocks relative to each other can enable one to take advantage of temporary pricing anomalies. The goal is to sell those stocks that become temporarily overvalued and buy those that are temporarily undervalued: an ideal time to rebalance portfolios. (I can’t promise the market won’t continue to rise strongly during the rebalancing process, but that’s still OK.)
Some of you have already received your new portfolio proposals, and the rest of you will over the next week or so. (Each portfolio is customized, so I can’t do them all at once.) I invite questions, both general and specific. I can’t know where you’re confused or disagree with me unless you tell me.
One additional point that I can’t emphasize enough: the financial markets always recover well before the economy. And the general public doesn’t start feeling good until many months, or even years, after the economy has bottomed. By the time Joe and Jane Main Street realize the recession is over, and the press prints mostly good news, half or even two-thirds of the bull market is already behind us. The prices of stocks and other assets are not rising now because things are good or even improving, but because the “smart money” can finally conceive of an end to this recession and financial crisis.
Friday, April 10, 2009
A New World Record
As a brief aside before resuming the portfolio email series, I would like to answer a query I’ve received from more than a few people. In the midst of the most powerful stock market rally since 1933, many are still wondering, “How low can it go?” In other words, if March 9 was not the ultimate low for this bear market, what’s the worst that could happen if the bottom is ahead of us rather than behind?
As you know, I’ve often used history as a guide. In that context, I’ve said that 2008–2009 has been the second worst bear market ever, exceeded only by the one in 1929–1932. Using that massive decline as the model, if the economy today were to become as awful as it was in 1932 (highly unlikely), we could be looking at another drop of more than –50%. Scary, yes. But there are two big problems with this comparison.
The first is that the 1929–1932 bear market was unique in taking stocks from extremely overvalued to extremely undervalued in a single 3-year decline. Normally, this process takes 10 years or more. For example, during the “lost decade” prior to this one, stock valuations peaked in 1968 and did not bottom until 1982, a period of 14 years.
The most recent valuation peak was in March 2000. If March 2009 marked the valuation low for this cycle, then the process took a total of 9 years, faster than average but far less than in the 1930s. The 1929–1932 debacle was really 2 powerful bear markets combined into one, and thus should have been roughly twice as severe as this one or the recent 2000–2003 decline. On the basis of this analysis, the current decline could already be over.
There’s yet a second flaw in using the US market decline in 1929–1932 as a model. Like today, the financial and economic crisis of the 1930s was worldwide, starting in the US and subsequently spreading overseas. But the US suffered disproportionately back then, both in the scale of its stock market decline and in the depth of its depression. This time, the pain is spread relatively evenly, with economic and market declines of roughly similar magnitude in a large number of countries. Thus, a better comparison to today’s market would be a global stock index, specifically the MSCI World index of 23 developed countries.
A global comparison also makes sense because the US represents a much smaller proportion of worldwide GDP and stock market capitalization today than in the 1930s (even without counting the emerging markets that aren’t included in the MSCI World index). So on a global basis, how does today’s bear market compare with others?
Until February 27 of this year, the 1929–1932 bear market was still the worst in world history, with a –54% decline in the MSCI World index after inflation. But on that day, the world record was officially broken. By the time the decline hit bottom on March 9, 2009, the MSCI World index had dropped a stunning –57.8% from its peak on October 31, 2007. Those of us alive today can now say that we’ve lived through the most severe bear market in world history!
Based on this analysis, what does history tell us about the ultimate low? It at least suggests that we’ve already been there, having exceeded the previous record drop. There is no reason (at least on the basis of history) to believe that global stock markets need drop any more from here. The knowledge that we made market history in 2009 is simultaneously sobering and encouraging.
In sum, history supports the notion that we have seen the lows. Valuation analysis comes to the same conclusion (see my email of March 10, “Are stocks cheap yet?”), as does investor sentiment. So even though the bad news is far from over, and the market will continue to behave badly from time to time, the worst may finally be behind us. I’m actually starting to think 2009 will be the best year for stocks since 2003. We’ll know for sure in less than 9 months.
As you know, I’ve often used history as a guide. In that context, I’ve said that 2008–2009 has been the second worst bear market ever, exceeded only by the one in 1929–1932. Using that massive decline as the model, if the economy today were to become as awful as it was in 1932 (highly unlikely), we could be looking at another drop of more than –50%. Scary, yes. But there are two big problems with this comparison.
The first is that the 1929–1932 bear market was unique in taking stocks from extremely overvalued to extremely undervalued in a single 3-year decline. Normally, this process takes 10 years or more. For example, during the “lost decade” prior to this one, stock valuations peaked in 1968 and did not bottom until 1982, a period of 14 years.
The most recent valuation peak was in March 2000. If March 2009 marked the valuation low for this cycle, then the process took a total of 9 years, faster than average but far less than in the 1930s. The 1929–1932 debacle was really 2 powerful bear markets combined into one, and thus should have been roughly twice as severe as this one or the recent 2000–2003 decline. On the basis of this analysis, the current decline could already be over.
There’s yet a second flaw in using the US market decline in 1929–1932 as a model. Like today, the financial and economic crisis of the 1930s was worldwide, starting in the US and subsequently spreading overseas. But the US suffered disproportionately back then, both in the scale of its stock market decline and in the depth of its depression. This time, the pain is spread relatively evenly, with economic and market declines of roughly similar magnitude in a large number of countries. Thus, a better comparison to today’s market would be a global stock index, specifically the MSCI World index of 23 developed countries.
A global comparison also makes sense because the US represents a much smaller proportion of worldwide GDP and stock market capitalization today than in the 1930s (even without counting the emerging markets that aren’t included in the MSCI World index). So on a global basis, how does today’s bear market compare with others?
Until February 27 of this year, the 1929–1932 bear market was still the worst in world history, with a –54% decline in the MSCI World index after inflation. But on that day, the world record was officially broken. By the time the decline hit bottom on March 9, 2009, the MSCI World index had dropped a stunning –57.8% from its peak on October 31, 2007. Those of us alive today can now say that we’ve lived through the most severe bear market in world history!
Based on this analysis, what does history tell us about the ultimate low? It at least suggests that we’ve already been there, having exceeded the previous record drop. There is no reason (at least on the basis of history) to believe that global stock markets need drop any more from here. The knowledge that we made market history in 2009 is simultaneously sobering and encouraging.
In sum, history supports the notion that we have seen the lows. Valuation analysis comes to the same conclusion (see my email of March 10, “Are stocks cheap yet?”), as does investor sentiment. So even though the bad news is far from over, and the market will continue to behave badly from time to time, the worst may finally be behind us. I’m actually starting to think 2009 will be the best year for stocks since 2003. We’ll know for sure in less than 9 months.
Thursday, April 2, 2009
Great March, Crummy Quarter, but better times ahead
True to it’s name, March came in like a lion and went out like a lamb. After continuing its recent tumble that began in early January, the MSCI ACWI (All-Country World Index) hit a bear market low on March 9 that was –58.4% below the all-time high set on Oct. 31, 2007. The magnitude of the drop makes this the most severe bear market since 1932. At its low, stocks were as cheap by most measures as they have ever been (as I discussed in a prior email). If the March 9 level holds (and it’s looking increasingly likely to me that it will), then it could well mark the low point for stocks in the 21st century.
Then, on March 10, global stock markets embarked on their most powerful rally since 1938, rising +22.6% in only 12 trading days before settling back a bit (although as of today’s close, we’re back up to the March highs). For the month of March, the MSCI ACWI rose +8.2%, reducing its loss for the first quarter to –10.7%. This was clearly crummy, but still better than the stunning loss of –22.4% during the 4th quarter of 2008.
So where do we go from here? Have stocks really hit their lows for this cycle? Is it finally time to start buying again? Obviously, I wish I knew for sure. And although I don’t, the character of this rally makes me feel like it is finally the real thing, a rally that will eventually (over 4 or 5 years) take stocks to new highs. My reasons are many, and include: 1) fundamental factors, such as the extremely low valuations seen on March 9; 2) technical factors, such as the divergence between the level of stock indexes during the decline and the number of stocks hitting new lows, and decreasing volume on down days with increasing volume on up days; 3) sentiment, which is still very low despite the rally, with most investors doubting its staying power and believing that even lower lows lay ahead; and 4) economic factors, which suggest that the rate of economic decline is slowing, and that an end to this recession may finally be in sight.
This rally, if I am right, is likely to humble both the bulls and the bears. The bulls will be humbled because real bull market rallies move upward in fits and starts, with many scary drops (such as the one we saw on Monday) that make one question the rally and potentially sell out prematurely. Countertrend rallies, on the other hand, tend to move almost straight up, rekindling a false optimism among investors. Bears will be humbled because in waiting in vain for those lower lows, they will miss out on a big portion of the rise, not investing until it’s clear that the prior lows are but a distant memory. Most investors will not, as they mistakenly believe, get back in at a level lower than that at which they sold. More likely, they won’t reinvest until stocks are some 20% to 40% higher than their exit points.
For those who might be concerned, I definitely don’t think it’s too late to load up on stocks. Based on yesterday’s close, and a historical average of 5 years for stocks to return to prior highs, one could reasonably expect an average annual return of around 17% per year through 2014. Certainly not bad, and significantly better than most competing investments. (Obviously, this is a projection, not a guarantee.)
Thus, if we’re really past the worst of this epoch-making bear market, and it’s not too late to fully invest in equities, it makes sense to re-allocate portfolios. Toward this end, I now plan to start re-allocating portfolios to prepare for the next phase of the economic cycle. This process should take about 2 months. During that time, I will be writing a series of emails explaining: 1) my portfolio construction process; 2) my short-term and long-term expectations for the global economy, corporate earnings and asset valuations; 3) my specific rationale for stock, bond, country and industry allocations; and 4) my choice of specific securities and the reasons for those choices.
I will also be contacting each of you individually to discuss your personal portfolio recommendations, which will be customized within the broader parameters to be outlined in the emails. More than ever before, it’s crucial that we’re each on the same page going forward, as the future is even more unknowable than usual.
Here’s to a brighter future
Then, on March 10, global stock markets embarked on their most powerful rally since 1938, rising +22.6% in only 12 trading days before settling back a bit (although as of today’s close, we’re back up to the March highs). For the month of March, the MSCI ACWI rose +8.2%, reducing its loss for the first quarter to –10.7%. This was clearly crummy, but still better than the stunning loss of –22.4% during the 4th quarter of 2008.
So where do we go from here? Have stocks really hit their lows for this cycle? Is it finally time to start buying again? Obviously, I wish I knew for sure. And although I don’t, the character of this rally makes me feel like it is finally the real thing, a rally that will eventually (over 4 or 5 years) take stocks to new highs. My reasons are many, and include: 1) fundamental factors, such as the extremely low valuations seen on March 9; 2) technical factors, such as the divergence between the level of stock indexes during the decline and the number of stocks hitting new lows, and decreasing volume on down days with increasing volume on up days; 3) sentiment, which is still very low despite the rally, with most investors doubting its staying power and believing that even lower lows lay ahead; and 4) economic factors, which suggest that the rate of economic decline is slowing, and that an end to this recession may finally be in sight.
This rally, if I am right, is likely to humble both the bulls and the bears. The bulls will be humbled because real bull market rallies move upward in fits and starts, with many scary drops (such as the one we saw on Monday) that make one question the rally and potentially sell out prematurely. Countertrend rallies, on the other hand, tend to move almost straight up, rekindling a false optimism among investors. Bears will be humbled because in waiting in vain for those lower lows, they will miss out on a big portion of the rise, not investing until it’s clear that the prior lows are but a distant memory. Most investors will not, as they mistakenly believe, get back in at a level lower than that at which they sold. More likely, they won’t reinvest until stocks are some 20% to 40% higher than their exit points.
For those who might be concerned, I definitely don’t think it’s too late to load up on stocks. Based on yesterday’s close, and a historical average of 5 years for stocks to return to prior highs, one could reasonably expect an average annual return of around 17% per year through 2014. Certainly not bad, and significantly better than most competing investments. (Obviously, this is a projection, not a guarantee.)
Thus, if we’re really past the worst of this epoch-making bear market, and it’s not too late to fully invest in equities, it makes sense to re-allocate portfolios. Toward this end, I now plan to start re-allocating portfolios to prepare for the next phase of the economic cycle. This process should take about 2 months. During that time, I will be writing a series of emails explaining: 1) my portfolio construction process; 2) my short-term and long-term expectations for the global economy, corporate earnings and asset valuations; 3) my specific rationale for stock, bond, country and industry allocations; and 4) my choice of specific securities and the reasons for those choices.
I will also be contacting each of you individually to discuss your personal portfolio recommendations, which will be customized within the broader parameters to be outlined in the emails. More than ever before, it’s crucial that we’re each on the same page going forward, as the future is even more unknowable than usual.
Here’s to a brighter future
Wednesday, March 18, 2009
The Fed gets serious
Anyone who has doubted the Federal Reserve’s resolve to get the credit markets and the economy moving again need only read today’s statement to become a believer. While some will question how quickly these efforts will jumpstart the economy, there should be little doubt that they will eventually bear fruit. The Fed’s moves today were stimulated by ongoing tightness in the credit markets, economic weakness, job losses and falling home and stock prices.
As expected, the Fed left short-term interest rates at historic lows near 0%. What was unexpected, however, and which galvanized both the stock and bond markets today, was their announcement that they would buy up to $300 billion of longer-term US Treasuries, and more than double their purchases of mortgage-backed securities up to $1.45 trillion. This “quantitative easing,” which the Fed last employed in the 1940’s, is designed to lower long-term interest rates, particularly mortgage rates. The Bank of England recently began a similar program with their own government bonds, and have succeeded in lowering long-term rates in the UK by 0.75%.
So we know from the Fed’s last foray into quantitative easing, and today’s experience in the UK, that it can work, and work quickly. In the 1940’s, the Fed targeted a 10-year yield of 2.5%, and these rates never went above that level for a decade. They were able to do so by holding only about 7% of outstanding Treasury notes and bonds, which today would amount to about $280 billion. So despite what some economists are saying, $300 billion should be sufficient, at least initially, to keep rates down. And today’s market reaction supports that: 10-year Treasury yields plummeted from 2.95% to 2.53%, the biggest 1-day drop in 47 years. Although the Fed has not stated a target interest rate, 2.5% seems to be what the market is betting on.
Lower long-term Treasury rates will translate into lower borrowing costs across the board, from corporations to municipalities to individuals. Even the US government will save money on interest expense. Lower rates, provided borrowers can obtain credit in the first place (a problem which other Fed and Treasury programs are targeting), provide an obvious benefit to the economy.
But the Fed did not stop there. It is simultaneously buying up to $1.45 trillion in mortgage-backed securities, in an attempt to further lower mortgage rates relative to other long-term debt. This represents about 12% of all outstanding mortgage debt in the US, and over 25% of debt guaranteed by Fannie and Freddie. I think there’s little question that taking this much debt off the market will substantially lower mortgage rates, and I suspect that 4% mortgages will become relatively common within the next few months.
Those of you contemplating a home purchase or refinancing should therefore wait a bit until making the plunge. I’ll be keeping a close eye on mortgage rates as well, and will let you know when I think they have bottomed. Note that in the past, the Fed was able to keep interest rates low for more than 10-years; thus I don’t expect rates to rise much until the economy is clearly on the mend.
The path to recovery will not be smooth, and there will be more pain and bad news to come. The current stock market rally, while it may continue for some time and potentially be very powerful, will undoubtedly be interrupted by some scary drops. And although March 9 may have set the final lows for this bear market, it is possible that they will be revisited or even violated somewhat before the new bull market is finally underway.
Fortunately, in addition to the Fed’s obvious resolve, there have been indications that the rate of financial and economic decline may be abating, which would likely precede a definitive turn upward. Housing starts were better than expected, as were retail sales. Commodity prices are rising (copper is up 22% in the past 30 days, oil up 31%). Oracle’s earnings came out better than anticipated, and they instituted a dividend for the first time (in contrast to many other companies that are reducing or eliminating theirs).
But perhaps most significantly, mergers and acquisitions (M&A) are seriously heating up. In the past few days alone, we’ve had several multi-billion dollar acquisition announcements: Pfizer buying Wyeth, Roche buying the rest of Genentech, and today, IBM buying Sun Computer. Big corporations have many $billions in cash looking for a higher-return home, and credit is again flowing to investment-grade companies. Many companies are selling at prices not seen for decades, and cash-rich firms are increasingly deciding that it’s safe to jump into the M&A fray.
Expect many more deals over the coming months and years. And keep in mind that much of the bull market of the 1980’s was driven by merger activity, at a time when companies had less cash and interest rates were far higher. Paradoxically, it is possible we will see a higher stock market in the face of a prolonged recession as stronger companies gobble up weaker ones. It will be fascinating to see how all this plays out; we certainly do live in interesting, if painful, times.
In future emails, I will expand further on how the Federal Reserve’s actions are likely to stimulate the economy. And I will give some detail on how I plan to position portfolios going forward, given all that’s happened and is likely to happen. We are clearly at an inflection point in economic history, one that will be written about for decades. It’s obviously crucial to prepare for the future based on the best information and reasoning one can muster, even if, in the end, the future is unknowable.
As expected, the Fed left short-term interest rates at historic lows near 0%. What was unexpected, however, and which galvanized both the stock and bond markets today, was their announcement that they would buy up to $300 billion of longer-term US Treasuries, and more than double their purchases of mortgage-backed securities up to $1.45 trillion. This “quantitative easing,” which the Fed last employed in the 1940’s, is designed to lower long-term interest rates, particularly mortgage rates. The Bank of England recently began a similar program with their own government bonds, and have succeeded in lowering long-term rates in the UK by 0.75%.
So we know from the Fed’s last foray into quantitative easing, and today’s experience in the UK, that it can work, and work quickly. In the 1940’s, the Fed targeted a 10-year yield of 2.5%, and these rates never went above that level for a decade. They were able to do so by holding only about 7% of outstanding Treasury notes and bonds, which today would amount to about $280 billion. So despite what some economists are saying, $300 billion should be sufficient, at least initially, to keep rates down. And today’s market reaction supports that: 10-year Treasury yields plummeted from 2.95% to 2.53%, the biggest 1-day drop in 47 years. Although the Fed has not stated a target interest rate, 2.5% seems to be what the market is betting on.
Lower long-term Treasury rates will translate into lower borrowing costs across the board, from corporations to municipalities to individuals. Even the US government will save money on interest expense. Lower rates, provided borrowers can obtain credit in the first place (a problem which other Fed and Treasury programs are targeting), provide an obvious benefit to the economy.
But the Fed did not stop there. It is simultaneously buying up to $1.45 trillion in mortgage-backed securities, in an attempt to further lower mortgage rates relative to other long-term debt. This represents about 12% of all outstanding mortgage debt in the US, and over 25% of debt guaranteed by Fannie and Freddie. I think there’s little question that taking this much debt off the market will substantially lower mortgage rates, and I suspect that 4% mortgages will become relatively common within the next few months.
Those of you contemplating a home purchase or refinancing should therefore wait a bit until making the plunge. I’ll be keeping a close eye on mortgage rates as well, and will let you know when I think they have bottomed. Note that in the past, the Fed was able to keep interest rates low for more than 10-years; thus I don’t expect rates to rise much until the economy is clearly on the mend.
The path to recovery will not be smooth, and there will be more pain and bad news to come. The current stock market rally, while it may continue for some time and potentially be very powerful, will undoubtedly be interrupted by some scary drops. And although March 9 may have set the final lows for this bear market, it is possible that they will be revisited or even violated somewhat before the new bull market is finally underway.
Fortunately, in addition to the Fed’s obvious resolve, there have been indications that the rate of financial and economic decline may be abating, which would likely precede a definitive turn upward. Housing starts were better than expected, as were retail sales. Commodity prices are rising (copper is up 22% in the past 30 days, oil up 31%). Oracle’s earnings came out better than anticipated, and they instituted a dividend for the first time (in contrast to many other companies that are reducing or eliminating theirs).
But perhaps most significantly, mergers and acquisitions (M&A) are seriously heating up. In the past few days alone, we’ve had several multi-billion dollar acquisition announcements: Pfizer buying Wyeth, Roche buying the rest of Genentech, and today, IBM buying Sun Computer. Big corporations have many $billions in cash looking for a higher-return home, and credit is again flowing to investment-grade companies. Many companies are selling at prices not seen for decades, and cash-rich firms are increasingly deciding that it’s safe to jump into the M&A fray.
Expect many more deals over the coming months and years. And keep in mind that much of the bull market of the 1980’s was driven by merger activity, at a time when companies had less cash and interest rates were far higher. Paradoxically, it is possible we will see a higher stock market in the face of a prolonged recession as stronger companies gobble up weaker ones. It will be fascinating to see how all this plays out; we certainly do live in interesting, if painful, times.
In future emails, I will expand further on how the Federal Reserve’s actions are likely to stimulate the economy. And I will give some detail on how I plan to position portfolios going forward, given all that’s happened and is likely to happen. We are clearly at an inflection point in economic history, one that will be written about for decades. It’s obviously crucial to prepare for the future based on the best information and reasoning one can muster, even if, in the end, the future is unknowable.
Monday, March 16, 2009
Can we trust the rally?
In the past few days, global stock markets have rallied about +10% from decade-plus lows. Today, the US market was again in rally mode, only to lose steam during the infamous final hour to close slightly down. The question on investors’ minds is, “Is this rally for real?” Will we see a significant rise in stock prices from here, or is this just another brief respite before yet lower lows?
It’s obviously too early to tell, but several signs suggest that this rally may have “legs.” Even if it is a countertrend rally rather than the first of a new bull market, it may last for a while and generate a welcome partial recovery in stock prices. My reasons for thinking this are several:
1. Volume has been higher recently on up moves than on down moves.
2. The number of stocks hitting new lows was declining even as the major averages took out their October and November bottoms.
3. The bulk of sellers recently appear to be individuals (“dumb” money) rather than hedge funds and institutions (“smart” money).
4. A lot of news lately has been better than expected:
• Several big banks announced that they’re actually making money so far this year.
• GE’s downgrade was less than expected and the company now has a stable credit outlook.
• Retail sales were higher than expected.
• Home sales were up in California.
Calling the end of this grueling bear market is still premature, but we’re overdue for a significant rally. Hopefully we’re in it now.
And regardless of the short term picture, the longer-term outlook for stocks remains bright. Sometime soon we will set generational lows for stock prices that we may never see again. Perhaps we already established these lows last week at an S&P 500 of 666 (a good omen?). Wherever and whenever that elusive bottom comes, we will look back on it years from now as an historic long-term opportunity that most people will have missed out of short-term fear.
It’s obviously too early to tell, but several signs suggest that this rally may have “legs.” Even if it is a countertrend rally rather than the first of a new bull market, it may last for a while and generate a welcome partial recovery in stock prices. My reasons for thinking this are several:
1. Volume has been higher recently on up moves than on down moves.
2. The number of stocks hitting new lows was declining even as the major averages took out their October and November bottoms.
3. The bulk of sellers recently appear to be individuals (“dumb” money) rather than hedge funds and institutions (“smart” money).
4. A lot of news lately has been better than expected:
• Several big banks announced that they’re actually making money so far this year.
• GE’s downgrade was less than expected and the company now has a stable credit outlook.
• Retail sales were higher than expected.
• Home sales were up in California.
Calling the end of this grueling bear market is still premature, but we’re overdue for a significant rally. Hopefully we’re in it now.
And regardless of the short term picture, the longer-term outlook for stocks remains bright. Sometime soon we will set generational lows for stock prices that we may never see again. Perhaps we already established these lows last week at an S&P 500 of 666 (a good omen?). Wherever and whenever that elusive bottom comes, we will look back on it years from now as an historic long-term opportunity that most people will have missed out of short-term fear.
Thursday, March 12, 2009
Are stocks cheap yet?
Today the stock market showed us that it is capable of going up as well as down, rising over +6%, which is obviously a nice change. Now we have to see if it can put in a few up days in a row, which it has had trouble doing for most of this year.
The impetus for today’s big jump seemed to come from Citigroup, of all places. Their CEO said that they’ve been profitable for the first 2 months of 2009, and that they expect this quarter to be their best since Q3-2007. If even Citigroup can make money in this environment, maybe the banking sector is finally on the mend after receiving $billions in bailout funds. Time will tell.
Whatever the reason for today’s move, it seems that the market “wants” to go up, as evidenced by several recent days that started with strong gains, only to be pared or turned into a loss during the final hour. In the fall, much of that final hour selling came from hedge funds; this year, it has been mostly individuals liquidating their mutual fund holdings. At some point, buyers will overwhelm sellers for more than one day, and the market will start to recover. Maybe today was the beginning of a longer trend; maybe not. We’ll know soon enough.
Regardless of what happens over the next few weeks or months, we need to feel confident that stocks really are cheap enough to buy. My last email talked about the long-term trend of stock returns and how far below trend we’ve recently fallen. As stocks gradually return to trend, they should provide above-average returns. Today, I’ll talk about stock valuations, looking at whether or not stocks today are historically cheap. I’ll do this by comparing today’s valuations with those during two major buying opportunities of the past century: 1982 and 1932.
The attached article contains the long version for those who want all the details. The Reader’s Digest version is below:
I wrote the article in part to respond to a New York Times piece entitled “Why Stocks Still Aren’t Cheap,” published on February 20, when the S&P 500 was nearly 10% higher than today. It proposed that because the 10-year average price-earnings (P/E) ratio of the S&P 500 was 14.5, below average but still well above the lows of 6 to 7 reached in 1932 and 1982, stock prices still had a ways to fall. I went on to point out the flaws in the author’s approach, and to do my own comparison of stock valuations today compared with those two prior periods.
I identified 4 shortcomings in the authors analysis: 1) 10-year periods, while they do smooth out the highs and lows of corporate earnings, are arbitrary; 2) the author didn’t account for inflation; 3) the proper or “justified” P/E ratio varies at different points in time owing to changes in interest rates, required return on stocks, payout ratios and expected earnings growth rates; and 4) accounting rules have recently changed, making comparisons with prior period earnings somewhat problematic.
To address these problems, I did the following: 1) calculated 5-, 10- and 20-year average P/E ratios at each time period (2009, 1982 and 1932) and averaged those; 2) adjusted earnings and prices for inflation; 3) calculated justified P/E ratios for each period based on interest rates and other data from the respective time period; 4) added an adjustment for recent accounting changes. I found that the last of these made little difference, so I eliminated it from the comparison.
The results indicated that stocks at 2009’s low for the S&P 500 were undervalued by about 12%, compared with a 14% undervaluation in 1932 and a 29% overvaluation in 1982. This analysis suggests that stocks today are compelling values, in line with the great buying opportunities of the past century.
I then went on to use several other valuation methods to compare stocks today with 1982 and 1932: price/sales (P/S) ratio, price/book value (P/B), price to replacement value (P/Q) and residual value. In all 4 cases, the actual measure today was below the justified measure, while in 1982 and 1932, at least one of these measures was higher than the justified value. The conclusion again was that stock valuations today compare very favorably with 1982 and 1932.
Lastly, I looked at 1974, which was a bear market bottom that did not precede a decade-plus bull market (the 1982 bear market was still to come). Valuations at that time appear to have been even lower than today, 1982 or 1932. Warren Buffett was a big buyer at that time; his superior results suggest that, if you buy stocks cheaply enough, you can make good money even if another major bear market will soon follow.
My conclusions were as follows: Putting all of these valuation measures together, we find that stocks today appear about as cheap as they did during two of the great buying opportunities of the past century, 1982 and 1932 (although perhaps not quite as cheap as in 1974). This doesn’t mean they can’t go lower still over the next few weeks or months. But their historically low valuations, based on my analysis of market history over the past 138 years, suggests that stocks should provide returns far above their historical average over the next 10 to 30 years.
I know I can’t time the bottom, but stock returns’ current distance below their trend line, plus the extremely low valuations suggested by my analysis, make me comfortable that buying stocks (or continuing to hold them) around these prices will eventually prove to be a very lucrative move.
The impetus for today’s big jump seemed to come from Citigroup, of all places. Their CEO said that they’ve been profitable for the first 2 months of 2009, and that they expect this quarter to be their best since Q3-2007. If even Citigroup can make money in this environment, maybe the banking sector is finally on the mend after receiving $billions in bailout funds. Time will tell.
Whatever the reason for today’s move, it seems that the market “wants” to go up, as evidenced by several recent days that started with strong gains, only to be pared or turned into a loss during the final hour. In the fall, much of that final hour selling came from hedge funds; this year, it has been mostly individuals liquidating their mutual fund holdings. At some point, buyers will overwhelm sellers for more than one day, and the market will start to recover. Maybe today was the beginning of a longer trend; maybe not. We’ll know soon enough.
Regardless of what happens over the next few weeks or months, we need to feel confident that stocks really are cheap enough to buy. My last email talked about the long-term trend of stock returns and how far below trend we’ve recently fallen. As stocks gradually return to trend, they should provide above-average returns. Today, I’ll talk about stock valuations, looking at whether or not stocks today are historically cheap. I’ll do this by comparing today’s valuations with those during two major buying opportunities of the past century: 1982 and 1932.
The attached article contains the long version for those who want all the details. The Reader’s Digest version is below:
I wrote the article in part to respond to a New York Times piece entitled “Why Stocks Still Aren’t Cheap,” published on February 20, when the S&P 500 was nearly 10% higher than today. It proposed that because the 10-year average price-earnings (P/E) ratio of the S&P 500 was 14.5, below average but still well above the lows of 6 to 7 reached in 1932 and 1982, stock prices still had a ways to fall. I went on to point out the flaws in the author’s approach, and to do my own comparison of stock valuations today compared with those two prior periods.
I identified 4 shortcomings in the authors analysis: 1) 10-year periods, while they do smooth out the highs and lows of corporate earnings, are arbitrary; 2) the author didn’t account for inflation; 3) the proper or “justified” P/E ratio varies at different points in time owing to changes in interest rates, required return on stocks, payout ratios and expected earnings growth rates; and 4) accounting rules have recently changed, making comparisons with prior period earnings somewhat problematic.
To address these problems, I did the following: 1) calculated 5-, 10- and 20-year average P/E ratios at each time period (2009, 1982 and 1932) and averaged those; 2) adjusted earnings and prices for inflation; 3) calculated justified P/E ratios for each period based on interest rates and other data from the respective time period; 4) added an adjustment for recent accounting changes. I found that the last of these made little difference, so I eliminated it from the comparison.
The results indicated that stocks at 2009’s low for the S&P 500 were undervalued by about 12%, compared with a 14% undervaluation in 1932 and a 29% overvaluation in 1982. This analysis suggests that stocks today are compelling values, in line with the great buying opportunities of the past century.
I then went on to use several other valuation methods to compare stocks today with 1982 and 1932: price/sales (P/S) ratio, price/book value (P/B), price to replacement value (P/Q) and residual value. In all 4 cases, the actual measure today was below the justified measure, while in 1982 and 1932, at least one of these measures was higher than the justified value. The conclusion again was that stock valuations today compare very favorably with 1982 and 1932.
Lastly, I looked at 1974, which was a bear market bottom that did not precede a decade-plus bull market (the 1982 bear market was still to come). Valuations at that time appear to have been even lower than today, 1982 or 1932. Warren Buffett was a big buyer at that time; his superior results suggest that, if you buy stocks cheaply enough, you can make good money even if another major bear market will soon follow.
My conclusions were as follows: Putting all of these valuation measures together, we find that stocks today appear about as cheap as they did during two of the great buying opportunities of the past century, 1982 and 1932 (although perhaps not quite as cheap as in 1974). This doesn’t mean they can’t go lower still over the next few weeks or months. But their historically low valuations, based on my analysis of market history over the past 138 years, suggests that stocks should provide returns far above their historical average over the next 10 to 30 years.
I know I can’t time the bottom, but stock returns’ current distance below their trend line, plus the extremely low valuations suggested by my analysis, make me comfortable that buying stocks (or continuing to hold them) around these prices will eventually prove to be a very lucrative move.
Tuesday, March 10, 2009
It's lonely at the bottom
Now that the major global market indices are all near or below their November lows, we’re hearing the pundits predicting ever lower market bottoms. Calls for “Dow 5,000” have become common, and there was even an article in today’s Wall St. Journal talking about this possibility. Jim Cramer, the chair-throwing investment guru on CNBC, did his own calculation and estimated that a “worst-case scenario” could bring the Dow down to 5320 (got to admire his precision).
Obviously, all of these numbers are total guesses, as there’s just no way to know where the market will go in the near term. But investors continue to sell nonetheless, concerned that stocks may still be far away from a bottom. The bulk of these sellers during the current downturn, as opposed to last fall, appear to be individual investors, who redeemed $71.2 billion from mutual funds in the 4 weeks ended March 4. While this is down from the record $137.9 billion withdrawn last October, it represents an historically huge number and a marked increase from December and January.
Meanwhile, institutional investors, including hedge funds, have dramatically curtailed their selling of equities since the fall. And many institutions and professional investors are buying stocks. Warren Buffett, the wealthiest man in the world (earned entirely through a lifetime of investing) went “all-in” to stocks with his personal fortune last October, and has been putting Berkshire Hathaway’s huge cash hoard to work recently. Peter Lynch, legendary manager of the Magellan Fund during its heyday, remains fully invested in equities. Marty Whitman of Third Avenue Value Fund is buying the deep value stocks that he loves (and that have been getting especially creamed recently). Even George Soros, one of the granddaddies of hedge fund management who publicly remains quite negative, has been seen recently buying $billions in stocks for his Quantum Fund.
All the the investors mentioned above have stellar track records going back 30 years or more. Why would these people, and others like them, be buying, while the general public is selling? Do they know something the average investor does not? History tells us that they do, as the bottom of every prior bear market has been accompanied by heavy individual selling, while insiders and pros start buying or at least stand pat. I know that this one will be no different, but knowing this does not help me identify the date or the level of the market’s bottom.
At the risk of wasting my time and yours, I will take my own stab at where the bottom of this bear might be. Although many analysts have tried to use valuations to do so, bear markets at this stage are driven primarily by sentiment (i.e., fear) and the need (or desire) for cash, not by a cold analysis of stocks’ value. Valuation analysis is, however, useful in determining whether one is at a propitious long-term entry point; we will examine this in a subsequent email.
One might, however, be able to look at prior bear markets to get an idea of where the bottom might be. At its current level, the Dow Jones Industrial average is 13.8% below its low of the previous bear market in 2002. It turns out there have been only 2 prior bear markets in the past 120 years when this has happened, that a bear market low is below the level set in the previous bear market: 1974 and 1932. In 1974, after that brutal 2-year bear market, the Dow was 8.5% below the price reached at the bottom of the bear market in 1970. At the market’s historic bottom in 1932, the Dow was 35% below the low reached in the prior bear market in 1921.
Using this particular metric, the Dow could bottom during the current bear market anywhere between 4,935 and 6,628. The index is now slightly below the higher number. So on a very simplistic level, if you think things now are about as bad as they were during the darkest days of the 1970’s, then the bottom should be right around here. If you think the economy will get as bad as it did during the Great Depression, then we’re talking about another 24.6% drop. Or maybe somewhere in between.
But the above analysis is actually severely lacking in at least one respect, as it looks at price only, and does not take dividends or inflation into account. Including both of these factors, and going beyond the Dow to the more inclusive S&P 500 index, the US stock market actually returned 57.6% from June 1921 until June 1932 (11 years). This is obviously very different from a –35% drop. In the 4.3 years from June 1970 to October 1974, stocks actually lost –22.8%, showing the effects of high and rising inflation. Today, on this basis, stocks have returned –16.9% since October 2002. Using this approach, then, it seems that the worst-case bottom should be another 7.1% below today’s close.
In reality, the numbers above are just guesses as well, and not supported by financial theory. But it’s interesting that very different approaches yield a fairly narrow range of results. Either the bottom is right around where we are, or it’s between 7% and 24% lower. Either way, with the S&P 500 already –57.1% below its 2007 high, the lion’s share of the drop certainly seems to be behind us.
I don’t know whether the above is encouraging or discouraging. But either way, it’s really the wrong question to ask (after all that, you say!). The near-term market bottom is not only unknowable, it’s irrelevant to a long-term investor (at least from a rational point of view; emotions are an entirely different thing). What counts is where stocks will be in 5, 10, 20, even 30 years. That’s because stocks are a long-term investment by definition. Even an 85-year-old couple has a joint life expectancy of over 10 years, and a 65-year-old retired couple could easily see one spouse live for over 30 years. So don’t say you’re too old to look that far into the future.
So let’s look into the future by looking at the past. Review the graph below, which shows total return after inflation for the S&P 500 from 1871 through today. (Don’t worry about reading the dates.)
The squiggly blue line is the actual return from stocks, while the straight black one is a trend line that shows the average return over a period of nearly 140 years, including the recent bear market. Note that while actual stock returns have strayed both above and below the trend line at various times, they never stray that far before “reverting to the mean.” The greatest drops below the line were in 1920 and 1932. Stock returns remained moderately below the line from 1974 to 1987, as well as for most of the period from 1932 until 1954. But the reversion to the mean during these periods resulted in some fabulous bull markets.
Note where we are today: about the same distance below the line as we were in 1982. Unlike 1982, it took only months, not years, to get there. In 2000, we were well above the line, but the 2000–2003 bear market took us back to trend. The current bear market started with stocks only a little above trend, far less so than in 2000, the 1960’s or 1929.
Could we go further below the line, either in the short term or sometime down the road? Of course we could, and there’s no way to know. But the more important point is that sometime in the next decade or so, we should get back to trend, and possibly rise above it again, at least temporarily. This would result in abnormally high returns for stocks during that period.
To get an idea of what that future return might actually be, I extended the trend line for 13 years past June 2008, when the market most recently dipped below trend. I used 13 years because that’s how long it took the market to recover to trend after first falling below it at the end of 1973. If the market recovers more quickly that that, returns will be higher; if more slowly, returns would be lower.
The trend line return, by the way, is +6.61% per year (remember, this is after inflation). Real purchasing power doubles in about 11 years at this rate. Now, if we return to trend from here over the next 12 1/4 years, that implies an average annual return, after inflation, of +12.23%. At this rate, real purchasing power doubles in less than 7 years; after 12 1/4 years, your purchasing power would have increased over 4 times.
Could such an optimistic scenario come true? We obviously won’t know for sure until more than 12 years have passed. But total real returns of this magnitude are not out of line with prior bear market bottoms: comparable period returns were +12.31% after 1932, and +9.72% after 1974. As you can see, inflation was a great drag on returns during the latter period, even though during and after the Depression it took much longer (22 years vs. 13) for stock returns to revert to trend.
Although I don’t know for sure whether +12.23% will be close to the actual return experienced over the next decade or so, I am sure that the path will be anything but smooth. There will be great rallies and bull markets, as well as scary corrections and probably at least one bear market during this period. But the overall trend should be decisively up, and at a rate that is both historically high and better than most other investments (cash, bonds, commodities, real estate, etc.). The price one pays for this higher rate of return is more volatility, which on rare occasions reaches the crisis proportions we see today. But no crisis lasts forever.
One other thing I know by looking at the graph above is that the bear market of 2007–2009 will go down in history alongside the great bear market of 1929–1932 as one of the 2 worst ones in US history. We’ve had other severe bear markets, but none as sharp and brisk (or as scary) as these two. But a further examination of the graph might give one hope: the sharpest bear markets have historically been followed by the strongest rallies. This one should, too. Now if only I knew exactly when it will start!
Obviously, all of these numbers are total guesses, as there’s just no way to know where the market will go in the near term. But investors continue to sell nonetheless, concerned that stocks may still be far away from a bottom. The bulk of these sellers during the current downturn, as opposed to last fall, appear to be individual investors, who redeemed $71.2 billion from mutual funds in the 4 weeks ended March 4. While this is down from the record $137.9 billion withdrawn last October, it represents an historically huge number and a marked increase from December and January.
Meanwhile, institutional investors, including hedge funds, have dramatically curtailed their selling of equities since the fall. And many institutions and professional investors are buying stocks. Warren Buffett, the wealthiest man in the world (earned entirely through a lifetime of investing) went “all-in” to stocks with his personal fortune last October, and has been putting Berkshire Hathaway’s huge cash hoard to work recently. Peter Lynch, legendary manager of the Magellan Fund during its heyday, remains fully invested in equities. Marty Whitman of Third Avenue Value Fund is buying the deep value stocks that he loves (and that have been getting especially creamed recently). Even George Soros, one of the granddaddies of hedge fund management who publicly remains quite negative, has been seen recently buying $billions in stocks for his Quantum Fund.
All the the investors mentioned above have stellar track records going back 30 years or more. Why would these people, and others like them, be buying, while the general public is selling? Do they know something the average investor does not? History tells us that they do, as the bottom of every prior bear market has been accompanied by heavy individual selling, while insiders and pros start buying or at least stand pat. I know that this one will be no different, but knowing this does not help me identify the date or the level of the market’s bottom.
At the risk of wasting my time and yours, I will take my own stab at where the bottom of this bear might be. Although many analysts have tried to use valuations to do so, bear markets at this stage are driven primarily by sentiment (i.e., fear) and the need (or desire) for cash, not by a cold analysis of stocks’ value. Valuation analysis is, however, useful in determining whether one is at a propitious long-term entry point; we will examine this in a subsequent email.
One might, however, be able to look at prior bear markets to get an idea of where the bottom might be. At its current level, the Dow Jones Industrial average is 13.8% below its low of the previous bear market in 2002. It turns out there have been only 2 prior bear markets in the past 120 years when this has happened, that a bear market low is below the level set in the previous bear market: 1974 and 1932. In 1974, after that brutal 2-year bear market, the Dow was 8.5% below the price reached at the bottom of the bear market in 1970. At the market’s historic bottom in 1932, the Dow was 35% below the low reached in the prior bear market in 1921.
Using this particular metric, the Dow could bottom during the current bear market anywhere between 4,935 and 6,628. The index is now slightly below the higher number. So on a very simplistic level, if you think things now are about as bad as they were during the darkest days of the 1970’s, then the bottom should be right around here. If you think the economy will get as bad as it did during the Great Depression, then we’re talking about another 24.6% drop. Or maybe somewhere in between.
But the above analysis is actually severely lacking in at least one respect, as it looks at price only, and does not take dividends or inflation into account. Including both of these factors, and going beyond the Dow to the more inclusive S&P 500 index, the US stock market actually returned 57.6% from June 1921 until June 1932 (11 years). This is obviously very different from a –35% drop. In the 4.3 years from June 1970 to October 1974, stocks actually lost –22.8%, showing the effects of high and rising inflation. Today, on this basis, stocks have returned –16.9% since October 2002. Using this approach, then, it seems that the worst-case bottom should be another 7.1% below today’s close.
In reality, the numbers above are just guesses as well, and not supported by financial theory. But it’s interesting that very different approaches yield a fairly narrow range of results. Either the bottom is right around where we are, or it’s between 7% and 24% lower. Either way, with the S&P 500 already –57.1% below its 2007 high, the lion’s share of the drop certainly seems to be behind us.
I don’t know whether the above is encouraging or discouraging. But either way, it’s really the wrong question to ask (after all that, you say!). The near-term market bottom is not only unknowable, it’s irrelevant to a long-term investor (at least from a rational point of view; emotions are an entirely different thing). What counts is where stocks will be in 5, 10, 20, even 30 years. That’s because stocks are a long-term investment by definition. Even an 85-year-old couple has a joint life expectancy of over 10 years, and a 65-year-old retired couple could easily see one spouse live for over 30 years. So don’t say you’re too old to look that far into the future.
So let’s look into the future by looking at the past. Review the graph below, which shows total return after inflation for the S&P 500 from 1871 through today. (Don’t worry about reading the dates.)
The squiggly blue line is the actual return from stocks, while the straight black one is a trend line that shows the average return over a period of nearly 140 years, including the recent bear market. Note that while actual stock returns have strayed both above and below the trend line at various times, they never stray that far before “reverting to the mean.” The greatest drops below the line were in 1920 and 1932. Stock returns remained moderately below the line from 1974 to 1987, as well as for most of the period from 1932 until 1954. But the reversion to the mean during these periods resulted in some fabulous bull markets.
Note where we are today: about the same distance below the line as we were in 1982. Unlike 1982, it took only months, not years, to get there. In 2000, we were well above the line, but the 2000–2003 bear market took us back to trend. The current bear market started with stocks only a little above trend, far less so than in 2000, the 1960’s or 1929.
Could we go further below the line, either in the short term or sometime down the road? Of course we could, and there’s no way to know. But the more important point is that sometime in the next decade or so, we should get back to trend, and possibly rise above it again, at least temporarily. This would result in abnormally high returns for stocks during that period.
To get an idea of what that future return might actually be, I extended the trend line for 13 years past June 2008, when the market most recently dipped below trend. I used 13 years because that’s how long it took the market to recover to trend after first falling below it at the end of 1973. If the market recovers more quickly that that, returns will be higher; if more slowly, returns would be lower.
The trend line return, by the way, is +6.61% per year (remember, this is after inflation). Real purchasing power doubles in about 11 years at this rate. Now, if we return to trend from here over the next 12 1/4 years, that implies an average annual return, after inflation, of +12.23%. At this rate, real purchasing power doubles in less than 7 years; after 12 1/4 years, your purchasing power would have increased over 4 times.
Could such an optimistic scenario come true? We obviously won’t know for sure until more than 12 years have passed. But total real returns of this magnitude are not out of line with prior bear market bottoms: comparable period returns were +12.31% after 1932, and +9.72% after 1974. As you can see, inflation was a great drag on returns during the latter period, even though during and after the Depression it took much longer (22 years vs. 13) for stock returns to revert to trend.
Although I don’t know for sure whether +12.23% will be close to the actual return experienced over the next decade or so, I am sure that the path will be anything but smooth. There will be great rallies and bull markets, as well as scary corrections and probably at least one bear market during this period. But the overall trend should be decisively up, and at a rate that is both historically high and better than most other investments (cash, bonds, commodities, real estate, etc.). The price one pays for this higher rate of return is more volatility, which on rare occasions reaches the crisis proportions we see today. But no crisis lasts forever.
One other thing I know by looking at the graph above is that the bear market of 2007–2009 will go down in history alongside the great bear market of 1929–1932 as one of the 2 worst ones in US history. We’ve had other severe bear markets, but none as sharp and brisk (or as scary) as these two. But a further examination of the graph might give one hope: the sharpest bear markets have historically been followed by the strongest rallies. This one should, too. Now if only I knew exactly when it will start!
Tuesday, March 3, 2009
The daughter of all bear markets?
The bear market of 2007–2009 is now officially the second worst in US history, exceeded only by the mother of all bear markets, the one from 1929–1932 that coincided with the initial years of the Great Depression. Thus, we have no viable model to use in estimating the trajectory of the current bear market, except for the “big one.” It’s for that reason we see more and more pundits throwing out numbers where they guess this one will bottom: Dow 6000, Dow 5000, etc. But these are really no more than wild guesses, and have no basis in either history or current reality. There’s just no way to know when or where the bottom will finally occur.
As much as I loathe to do it, however, I will draw some comparisons between today and those fateful years in the early 1930’s. First, I’ll model what would happen should things actually get that bad again. Then I’ll give a bunch of reasons why they almost certainly won’t.
The S&P 500 is now -55.8% below its all-time high from October 2007, and the Dow is down -52.9%. These are both greater falls than in any prior bear market other than 1929–1932. Overseas markets are down even more: the Nikkei average of Japanese stocks, for example, is down -61% from its high. These are big numbers by any measure.
If this were 1930, though, we’d be only about halfway done. The US market would have another -63% to fall before hitting bottom in mid-1932. That’s a frightening prospect! Certainly, few people held on during this period, with many of them selling out near the bottom in 1932 (most of the rest were forced out earlier because of margin calls and the need for cash to live on).
But suppose you had held on, not expecting the market to continue to plummet, and knowing that it would eventually recover. How long would you have had to wait to make your losses back?
Not as long as you might think. You would have recovered your money from that second sickening drop and be back to your 1930 balance by March 1934, or about 20 months after that final bottom. By February 1937, about 3 more years, you would have recovered 81% of your money from the 1929 peak. This, of course, assumes you stayed 100% passively invested in stocks the entire time, not trying to own the better stocks, countries or industries. (These numbers include dividends, which remain an important part of stock returns.)
In real terms, the numbers look even better, because the 1930’s were a time of significant deflation, which itself contributed both to the drop in the stock market and the downturn in the economy. That’s why governments are so intent on avoiding deflation today. So, after inflation, you would only have had to wait until May 1933, or 11 months, to earn back that second drop. And by February 1937, you would have earned back 99.5% of what you had in August 1929, before the “Crash.” So in the greatest bear market in world history, it took less than 5 years from the bottom to earn back everything you’d lost. Bad, but not the end of the world. (Not only that, but US GDP had actually reached 1929 levels by 1936.)
So now you know what the worst case looks like. Now I’ll tell you why, as bad as things seem, they are not even close to the 1930’s, and extremely unlikely to approach that level of economic or financial decline.
1. The economic decline is not even in the ballpark of the 1930’s: Even the worst-case scenario sees a 5% drop in GDP during this recession (it was -3.4% in 1973–75 during the oil embargo). From 1929–1932, real GDP dropped nearly 30%. Unemployment may well reach double digits this time (as it did in 1982); in the 1930’s, it exceeded 25%.
2. As bad as things are with the banking system, it’s in better shape than in the 1930’s: Remember, mark to market accounting makes banks’ financial status appear much worse than they would under 1930’s accounting rules. And in the 1930’s, there was no deposit insurance, so runs on banks made some sense. When a bank went under, depositors lost most or all of their money. Thousands of banks failed in the 1930’s because of bank runs, which obviously severely reduced the amount of cash the banking system had to lend. This fed on itself, until the banking system was near collapse. It was only stopped by FDR’s bank holiday, shutting all banks for a week and then gradually reopening only the solvent ones. Also, today we have all sorts of government guarantees on bank liabilities, along with government programs to replace some of the lost lending.
3. US government responses were either inadequate or counterproductive until 1933: They actually raised some taxes and increased trade tariffs, as well as cutting government spending. Today, we’re seeing tax cuts and massive spending increases relatively early on.
4. The Federal Reserve didn’t have a clue in the early years of the Depression: They kept credit tight, allowing the money supply to plummet. This caused deflation to embed itself in the economy, leading to a downward spiral in economic growth that was difficult to reverse. Today, the Federal Reserve has not only reduced interest rates to near 0 and greatly expanded the money supply, it’s also working to lower long-term interest rates such as mortgages and implementing several new programs to provide liquidity and increase lending.
5. The US was on a gold standard until 1933: The gold standard was a big reason the Federal Reserve had such trouble increasing the money supply. When a country is on the gold standard, the amount of cash in circulation is limited by Federal gold reserves. And when people start trading in their dollars for gold (which was permitted then), this further reduces the cash in circulation. When other countries went off the gold standard before the US, this further drained our gold reserves. One of FDR’s very first actions, along with the bank holiday, was to take us off the gold standard. The economy then started growing almost immediately.
6. Protectionism and trade wars made the Great Depression even worse: This time, as I’ve said, protectionism is minimal. Governments around the world have dramatically loosened monetary policy and put large stimulus programs in place. In addition, there is a fair amount of coordination and cooperation between countries. In the 1930’s, we had a massive trade war with punitive tariffs, along with the rise of fascism in Europe that eventually led to WWII, something that we thankfully don’t have to contend with today.
Thus, while this recession is turning out to be the worst since 1982, and perhaps even become the worst since 1932, stock declines have already discounted something very severe, having been greater than any bear market since the Great Depression. I’ve listed above several reasons why it’s highly unlikely that the economy will sink anywhere near as much as it did in the 1930’s, and thus neither should the stock market. But given all that, it may be somewhat comforting to know that even during the economic Armageddon of the 1930’s, investors made virtually all their money back in less than 5 years by just sitting tight.
So given that neither I nor anyone else can predict the future, and given how far stocks have already fallen, and given the history of past bear markets, it seems to me that the bigger risk now is missing the rebound, rather than suffering a further big fall. I may be wrong this time (as I have been for many months now), but the longer this bear market goes, the closer we must be to the end. And the end will come when no one expects it, seemingly out of the blue, as has the end of every other bear market. I’m sure even I will be surprised when stocks finally decide that they can go up as well as down. And believe me, no one is more anxious to see this bear market end than I am!
In future emails, I’ll look more closely at the question of valuation (are stocks really cheap now, or do they just appear to be?), and finally explain mv=py and how it governs many of the Feds actions.
As much as I loathe to do it, however, I will draw some comparisons between today and those fateful years in the early 1930’s. First, I’ll model what would happen should things actually get that bad again. Then I’ll give a bunch of reasons why they almost certainly won’t.
The S&P 500 is now -55.8% below its all-time high from October 2007, and the Dow is down -52.9%. These are both greater falls than in any prior bear market other than 1929–1932. Overseas markets are down even more: the Nikkei average of Japanese stocks, for example, is down -61% from its high. These are big numbers by any measure.
If this were 1930, though, we’d be only about halfway done. The US market would have another -63% to fall before hitting bottom in mid-1932. That’s a frightening prospect! Certainly, few people held on during this period, with many of them selling out near the bottom in 1932 (most of the rest were forced out earlier because of margin calls and the need for cash to live on).
But suppose you had held on, not expecting the market to continue to plummet, and knowing that it would eventually recover. How long would you have had to wait to make your losses back?
Not as long as you might think. You would have recovered your money from that second sickening drop and be back to your 1930 balance by March 1934, or about 20 months after that final bottom. By February 1937, about 3 more years, you would have recovered 81% of your money from the 1929 peak. This, of course, assumes you stayed 100% passively invested in stocks the entire time, not trying to own the better stocks, countries or industries. (These numbers include dividends, which remain an important part of stock returns.)
In real terms, the numbers look even better, because the 1930’s were a time of significant deflation, which itself contributed both to the drop in the stock market and the downturn in the economy. That’s why governments are so intent on avoiding deflation today. So, after inflation, you would only have had to wait until May 1933, or 11 months, to earn back that second drop. And by February 1937, you would have earned back 99.5% of what you had in August 1929, before the “Crash.” So in the greatest bear market in world history, it took less than 5 years from the bottom to earn back everything you’d lost. Bad, but not the end of the world. (Not only that, but US GDP had actually reached 1929 levels by 1936.)
So now you know what the worst case looks like. Now I’ll tell you why, as bad as things seem, they are not even close to the 1930’s, and extremely unlikely to approach that level of economic or financial decline.
1. The economic decline is not even in the ballpark of the 1930’s: Even the worst-case scenario sees a 5% drop in GDP during this recession (it was -3.4% in 1973–75 during the oil embargo). From 1929–1932, real GDP dropped nearly 30%. Unemployment may well reach double digits this time (as it did in 1982); in the 1930’s, it exceeded 25%.
2. As bad as things are with the banking system, it’s in better shape than in the 1930’s: Remember, mark to market accounting makes banks’ financial status appear much worse than they would under 1930’s accounting rules. And in the 1930’s, there was no deposit insurance, so runs on banks made some sense. When a bank went under, depositors lost most or all of their money. Thousands of banks failed in the 1930’s because of bank runs, which obviously severely reduced the amount of cash the banking system had to lend. This fed on itself, until the banking system was near collapse. It was only stopped by FDR’s bank holiday, shutting all banks for a week and then gradually reopening only the solvent ones. Also, today we have all sorts of government guarantees on bank liabilities, along with government programs to replace some of the lost lending.
3. US government responses were either inadequate or counterproductive until 1933: They actually raised some taxes and increased trade tariffs, as well as cutting government spending. Today, we’re seeing tax cuts and massive spending increases relatively early on.
4. The Federal Reserve didn’t have a clue in the early years of the Depression: They kept credit tight, allowing the money supply to plummet. This caused deflation to embed itself in the economy, leading to a downward spiral in economic growth that was difficult to reverse. Today, the Federal Reserve has not only reduced interest rates to near 0 and greatly expanded the money supply, it’s also working to lower long-term interest rates such as mortgages and implementing several new programs to provide liquidity and increase lending.
5. The US was on a gold standard until 1933: The gold standard was a big reason the Federal Reserve had such trouble increasing the money supply. When a country is on the gold standard, the amount of cash in circulation is limited by Federal gold reserves. And when people start trading in their dollars for gold (which was permitted then), this further reduces the cash in circulation. When other countries went off the gold standard before the US, this further drained our gold reserves. One of FDR’s very first actions, along with the bank holiday, was to take us off the gold standard. The economy then started growing almost immediately.
6. Protectionism and trade wars made the Great Depression even worse: This time, as I’ve said, protectionism is minimal. Governments around the world have dramatically loosened monetary policy and put large stimulus programs in place. In addition, there is a fair amount of coordination and cooperation between countries. In the 1930’s, we had a massive trade war with punitive tariffs, along with the rise of fascism in Europe that eventually led to WWII, something that we thankfully don’t have to contend with today.
Thus, while this recession is turning out to be the worst since 1982, and perhaps even become the worst since 1932, stock declines have already discounted something very severe, having been greater than any bear market since the Great Depression. I’ve listed above several reasons why it’s highly unlikely that the economy will sink anywhere near as much as it did in the 1930’s, and thus neither should the stock market. But given all that, it may be somewhat comforting to know that even during the economic Armageddon of the 1930’s, investors made virtually all their money back in less than 5 years by just sitting tight.
So given that neither I nor anyone else can predict the future, and given how far stocks have already fallen, and given the history of past bear markets, it seems to me that the bigger risk now is missing the rebound, rather than suffering a further big fall. I may be wrong this time (as I have been for many months now), but the longer this bear market goes, the closer we must be to the end. And the end will come when no one expects it, seemingly out of the blue, as has the end of every other bear market. I’m sure even I will be surprised when stocks finally decide that they can go up as well as down. And believe me, no one is more anxious to see this bear market end than I am!
In future emails, I’ll look more closely at the question of valuation (are stocks really cheap now, or do they just appear to be?), and finally explain mv=py and how it governs many of the Feds actions.
Monday, March 2, 2009
In like a lion....
March certainly started off with a bang, as worldwide equity indexes plunged over –4%. We now appear to be watching “Panic, The Sequel.” But unlike the panic selling that occurred in October and November, which was justified to some degree because of fear that the entire global financial system could collapse, no such risk exists today. Governments worldwide have gone to extraordinary lengths to rescue the banking system and restart lending, as well as stimulate the economy. There’s no longer any question that we’ll come out of this crisis; the only issue remains exactly when, and how much more pain we might have to bear in the interim.
Concerns about bank nationalization should not be an issue, either, as the stocks of banks most at risk of being nationalized (here or abroad) already trade at prices reflecting this. And if nationalization of one or more US banks were to occur, the experience of Sweden in the 1990’s with their banking crisis should provide solace that such an outcome does not portend disaster.
Yes, AIG reported a huge $60 billion loss, but this has been expected for several days. And HSBC (one of the world’s largest banks) said it plans to raise $17.7 billion in equity—but this will be private money, not from the government. It’s actually impressive that a bank feels it can raise private funds without a government backstop. Moreover, most of the economic news today was better than expected. The ISM manufacturing index came in higher than anticipated. Personal income and spending both rose in January, while most people were expecting it to fall.
Oil prices dropped 10% today after rising strongly last week. But paradoxically, copper prices (as I’ve mentioned before, one of the early indicators of economic recovery) fell less than 1%, and copper remains well above its December lows. Even stranger, gold prices fell slightly as well, which you wouldn’t expect if investors were preparing for Armageddon.
So we’re seeing panic selling when the economic environment does not justify panic, and when trading in other markets suggests the opposite. What’s going on here? Why the panic selling? And when might it end?
Interestingly, the last 2 bear markets (1990–91 and 2000–2003) also had a secondary panic phase. Not only that, but both primary panics occurred in October, with the secondary panics ending 3 to 5 months later. We’re now just under 5 months from the October panic and 3 1/2 months from the November one. Seems we’re right on schedule.
Why has this pattern repeated itself? I suspect it has to do with the rise of hedge funds. These highly-leveraged investors sell heavily during the primary panic to rapidly reduce their leverage and meet anticipated redemptions. Other investors, such as mutual fund owners, follow the hedge funds’ lead as they see stock prices tumble. The primary panic burns itself out when the hedge funds stop selling.
The secondary panic starts with a more orderly decline in prices, driven largely by individual investors (including owners of mutual funds) and less nimble institutions such as pension funds, with hedge funds largely sitting it out. This is because they’ve already raised a large amount of cash and no longer have an urgent need to sell. Finally, having endured a couple of months of steadily falling prices, an ever greater number of investors throw in the towel and head for the exits. While all kinds of investors participate in this final market “blow off,” the driving force is the individual investor, who is typically the last one out, both at market bottoms and at market tops.
Trading data from the past several months support this scenario. Individuals have been big sellers since mid-January, while hedge funds have backed away from selling. This is also in keeping with the adage that the individual investor has the worst possible timing, selling at the bottom and buying at the top. Why should this time be any different?
Selling during a panic such as the current one can be very dangerous, because reversals tend to be rapid and powerful, as well as unexpected. And panics tend to be short: the rapid declines of last October and November each lasted only 5 trading days. During these brief stretches, stocks fell 22% in October and 18% in November. The current panic is now 3 days old, and the S&P 500 has dropped about 10% during that time. Obviously, I can’t say exactly how many days this one will last nor how much stocks will fall, but 5 days and 15% is as good a guess as any. In any case, it’s likely to be over very quickly.
Recoveries after panics can be impressive. In October, the S&P 500 soared 23% in only 2 1/2 trading days. In November, the surge was 21% in 5 trading days. In other words, the losses can be recovered almost as quickly as they occurred. One has to be extremely nimble to take advantage of such rapid price movements as they occur.
Because of the rapidity and unpredictability of panics, I tend to sit them out, neither buying nor selling. Sometimes, I’ll make purchases on day 4 or 5, but one has to be very brave to do so. It’s usually safer, and certainly less nerve wracking, to do so after the first definitive up day.
Bear markets are always unpleasant. This one has been the most severe since 1932, so it’s certainly normal to feel worried (or even a little panicked along with other investors) during these rapid down moves. But they all do end and give way to new bull markets. Even the one in 1932 did so, and provided investors with some of the most impressive returns in US stock market history. Investors who stayed the course from the high in 1929 to the recovery in 1937 made back 99.5% of their money after inflation. This is pretty impressive after the mother of all bear markets. 2007–2009 has been bad, but not nearly as bad as 1929–1932. And the recovery, when it finally comes, should be very profitable.
I know the temptation to sell now may be very strong. Obviously, lots of people are giving in to that temptation, which is exactly what is driving prices lower. But it will be a long-term mistake to do so, and perhaps a short-term mistake as well. And I’m not recommending anything different from what I’m doing with my own money, as my personal accounts remain heavily in equities. I feel the pain of loss just as much as you, but I also know that acting on that pain can make for very bad decisions. Sometimes doing nothing is the best course of action. Now may be one of those times.
Concerns about bank nationalization should not be an issue, either, as the stocks of banks most at risk of being nationalized (here or abroad) already trade at prices reflecting this. And if nationalization of one or more US banks were to occur, the experience of Sweden in the 1990’s with their banking crisis should provide solace that such an outcome does not portend disaster.
Yes, AIG reported a huge $60 billion loss, but this has been expected for several days. And HSBC (one of the world’s largest banks) said it plans to raise $17.7 billion in equity—but this will be private money, not from the government. It’s actually impressive that a bank feels it can raise private funds without a government backstop. Moreover, most of the economic news today was better than expected. The ISM manufacturing index came in higher than anticipated. Personal income and spending both rose in January, while most people were expecting it to fall.
Oil prices dropped 10% today after rising strongly last week. But paradoxically, copper prices (as I’ve mentioned before, one of the early indicators of economic recovery) fell less than 1%, and copper remains well above its December lows. Even stranger, gold prices fell slightly as well, which you wouldn’t expect if investors were preparing for Armageddon.
So we’re seeing panic selling when the economic environment does not justify panic, and when trading in other markets suggests the opposite. What’s going on here? Why the panic selling? And when might it end?
Interestingly, the last 2 bear markets (1990–91 and 2000–2003) also had a secondary panic phase. Not only that, but both primary panics occurred in October, with the secondary panics ending 3 to 5 months later. We’re now just under 5 months from the October panic and 3 1/2 months from the November one. Seems we’re right on schedule.
Why has this pattern repeated itself? I suspect it has to do with the rise of hedge funds. These highly-leveraged investors sell heavily during the primary panic to rapidly reduce their leverage and meet anticipated redemptions. Other investors, such as mutual fund owners, follow the hedge funds’ lead as they see stock prices tumble. The primary panic burns itself out when the hedge funds stop selling.
The secondary panic starts with a more orderly decline in prices, driven largely by individual investors (including owners of mutual funds) and less nimble institutions such as pension funds, with hedge funds largely sitting it out. This is because they’ve already raised a large amount of cash and no longer have an urgent need to sell. Finally, having endured a couple of months of steadily falling prices, an ever greater number of investors throw in the towel and head for the exits. While all kinds of investors participate in this final market “blow off,” the driving force is the individual investor, who is typically the last one out, both at market bottoms and at market tops.
Trading data from the past several months support this scenario. Individuals have been big sellers since mid-January, while hedge funds have backed away from selling. This is also in keeping with the adage that the individual investor has the worst possible timing, selling at the bottom and buying at the top. Why should this time be any different?
Selling during a panic such as the current one can be very dangerous, because reversals tend to be rapid and powerful, as well as unexpected. And panics tend to be short: the rapid declines of last October and November each lasted only 5 trading days. During these brief stretches, stocks fell 22% in October and 18% in November. The current panic is now 3 days old, and the S&P 500 has dropped about 10% during that time. Obviously, I can’t say exactly how many days this one will last nor how much stocks will fall, but 5 days and 15% is as good a guess as any. In any case, it’s likely to be over very quickly.
Recoveries after panics can be impressive. In October, the S&P 500 soared 23% in only 2 1/2 trading days. In November, the surge was 21% in 5 trading days. In other words, the losses can be recovered almost as quickly as they occurred. One has to be extremely nimble to take advantage of such rapid price movements as they occur.
Because of the rapidity and unpredictability of panics, I tend to sit them out, neither buying nor selling. Sometimes, I’ll make purchases on day 4 or 5, but one has to be very brave to do so. It’s usually safer, and certainly less nerve wracking, to do so after the first definitive up day.
Bear markets are always unpleasant. This one has been the most severe since 1932, so it’s certainly normal to feel worried (or even a little panicked along with other investors) during these rapid down moves. But they all do end and give way to new bull markets. Even the one in 1932 did so, and provided investors with some of the most impressive returns in US stock market history. Investors who stayed the course from the high in 1929 to the recovery in 1937 made back 99.5% of their money after inflation. This is pretty impressive after the mother of all bear markets. 2007–2009 has been bad, but not nearly as bad as 1929–1932. And the recovery, when it finally comes, should be very profitable.
I know the temptation to sell now may be very strong. Obviously, lots of people are giving in to that temptation, which is exactly what is driving prices lower. But it will be a long-term mistake to do so, and perhaps a short-term mistake as well. And I’m not recommending anything different from what I’m doing with my own money, as my personal accounts remain heavily in equities. I feel the pain of loss just as much as you, but I also know that acting on that pain can make for very bad decisions. Sometimes doing nothing is the best course of action. Now may be one of those times.
Friday, February 27, 2009
The US government and Citigroup
I’ve been getting some good questions from clients lately that I will answer for everyone, since if one person is asking it, many more are probably thinking it. Today, someone asked what the US government’s new deal with Citigroup means, and whether it makes the stock a “buy” now.
Today, the government announced that it is converting some of the preferred shares that it acquired in 2 prior investments into common stock. As you should know, common stock (or “equity”) represents a “residual claim” on a company. This means that if the company goes under, everyone else gets paid ahead of the common shareholders. If the company grows, the common shareholders get most or all of the benefit.
Preferred stock, despite its name, functions more like debt: the holders are paid a fixed rate of interest and do not get additional financial rewards if the company grows. The difference between preferred stock and more conventional debt (such as bonds) is that preferred stock comes next in line in case of a bankruptcy, but still ahead of common stock. It also is typically “perpetual,” meaning it never matures (unlike a bond, which has a fixed term of years).
When the government initially invested in Citigroup and other banks, it bought preferred stock that paid a fairly high dividend (8% in the case of Citigroup). It has now agreed to convert up to $25 billion of those shares into common stock, provided that private investors who also own preferred shares agree to convert a similar amount. As of today, it looks like $27.2 billion of privately-held preferred shares will be converted, thus exchanging a total of $52.2 billion of preferred stock for common equity.
What this means for Citigroup: First, the company will save about $4 billion per year in preferred dividends (its annual common stock dividend is only $.04 per share). Second, Citigroup’s balance sheet now looks considerably different, with $52.2 billion more in common equity and that much less debt, giving it much more headroom to sustain losses in the future without putting its survival in peril. This has happened without any additional investment of cash by the government or private investors, and represents yet another move by the government to keep Citigroup from going under.
What it means to the US taxpayer: The government (and thus all of us) will now own a total of 36% of Citigroup. Our $25 billion investment will now bear the same risk as all the other common shareholders: if Citigroup goes under, that $25 billion will disappear. This obviously gives the government even more incentive to keep Citigroup afloat. On the flipside, if the company eventually recovers, taxpayers stand to make a lot of money.
What it means to current Citigroup common shareholders: They will be “diluted” by the issuance of a lot of new shares, reducing their stake in the company from 100% to only 26%. This is probably the main reason that Citigroup’s stock fell so much today, as the existing shares now represent roughly 1/4 as much ownership as before. On the other hand, 1/4 of a company that survives and may eventually thrive is worth more than 100% of a company that goes under.
What this means for the financial system and other big banks: For the financial system as a whole, this is a good thing because letting a bank the size of Citigroup fail would make a bad situation even worse. It also sends a clear message that the government intends to rescue all the big banks, but will avoid fully nationalizing them.
On the other hand, there are 3 real concerns here:
1. Will the government need to put in more money later, after Citigroup’s “stress test,” and potentially gain even more ownership, further diluting existing shareholders? (I suspect that any additional funds will be invested via preferred shares that don’t convert.)
2. Will the government need to convert preferred shares in other big banks, such as Bank of America, and thus end up with significant ownership in several big banks?
3. Will Citigroup have an unfair competitive advantage over other banks as a result of its actual or implied government guarantee?
Until these questions are more fully answered, expect the market, and bank stocks in particular, to continue to be volatile.
So does all this make Citigroup a “buy” or a “sell?” It’s pretty clear to me that the bank is not going to fail, but it could be broken up by the government, and existing shareholders could be further diluted. This makes its shares, even at their current price of $1.50, very risky. On the other hand, if things eventually work out for Citigroup, they could easily soar 10 or 20 times. So they make an attractive speculation, but no more than a speculation. As of today, I’m still staying away from these shares with so many other juicy, but safer, opportunities.
Next up: Is the stock market’s price/earnings ratio high or low? Are stocks really cheap or do they just appear to be?
Enjoy your weekend
Today, the government announced that it is converting some of the preferred shares that it acquired in 2 prior investments into common stock. As you should know, common stock (or “equity”) represents a “residual claim” on a company. This means that if the company goes under, everyone else gets paid ahead of the common shareholders. If the company grows, the common shareholders get most or all of the benefit.
Preferred stock, despite its name, functions more like debt: the holders are paid a fixed rate of interest and do not get additional financial rewards if the company grows. The difference between preferred stock and more conventional debt (such as bonds) is that preferred stock comes next in line in case of a bankruptcy, but still ahead of common stock. It also is typically “perpetual,” meaning it never matures (unlike a bond, which has a fixed term of years).
When the government initially invested in Citigroup and other banks, it bought preferred stock that paid a fairly high dividend (8% in the case of Citigroup). It has now agreed to convert up to $25 billion of those shares into common stock, provided that private investors who also own preferred shares agree to convert a similar amount. As of today, it looks like $27.2 billion of privately-held preferred shares will be converted, thus exchanging a total of $52.2 billion of preferred stock for common equity.
What this means for Citigroup: First, the company will save about $4 billion per year in preferred dividends (its annual common stock dividend is only $.04 per share). Second, Citigroup’s balance sheet now looks considerably different, with $52.2 billion more in common equity and that much less debt, giving it much more headroom to sustain losses in the future without putting its survival in peril. This has happened without any additional investment of cash by the government or private investors, and represents yet another move by the government to keep Citigroup from going under.
What it means to the US taxpayer: The government (and thus all of us) will now own a total of 36% of Citigroup. Our $25 billion investment will now bear the same risk as all the other common shareholders: if Citigroup goes under, that $25 billion will disappear. This obviously gives the government even more incentive to keep Citigroup afloat. On the flipside, if the company eventually recovers, taxpayers stand to make a lot of money.
What it means to current Citigroup common shareholders: They will be “diluted” by the issuance of a lot of new shares, reducing their stake in the company from 100% to only 26%. This is probably the main reason that Citigroup’s stock fell so much today, as the existing shares now represent roughly 1/4 as much ownership as before. On the other hand, 1/4 of a company that survives and may eventually thrive is worth more than 100% of a company that goes under.
What this means for the financial system and other big banks: For the financial system as a whole, this is a good thing because letting a bank the size of Citigroup fail would make a bad situation even worse. It also sends a clear message that the government intends to rescue all the big banks, but will avoid fully nationalizing them.
On the other hand, there are 3 real concerns here:
1. Will the government need to put in more money later, after Citigroup’s “stress test,” and potentially gain even more ownership, further diluting existing shareholders? (I suspect that any additional funds will be invested via preferred shares that don’t convert.)
2. Will the government need to convert preferred shares in other big banks, such as Bank of America, and thus end up with significant ownership in several big banks?
3. Will Citigroup have an unfair competitive advantage over other banks as a result of its actual or implied government guarantee?
Until these questions are more fully answered, expect the market, and bank stocks in particular, to continue to be volatile.
So does all this make Citigroup a “buy” or a “sell?” It’s pretty clear to me that the bank is not going to fail, but it could be broken up by the government, and existing shareholders could be further diluted. This makes its shares, even at their current price of $1.50, very risky. On the other hand, if things eventually work out for Citigroup, they could easily soar 10 or 20 times. So they make an attractive speculation, but no more than a speculation. As of today, I’m still staying away from these shares with so many other juicy, but safer, opportunities.
Next up: Is the stock market’s price/earnings ratio high or low? Are stocks really cheap or do they just appear to be?
Enjoy your weekend
Tuesday, February 24, 2009
Why it's risky to sell now
It sounds counterintuitive, but it may actually be riskier to sell now than to stay fully invested. This would be true even if the bear market still has many months to go. Why? Because of bear market (or “countertrend”) rallies, which tend to be both rapid and powerful. They also tend to be unexpected, seemingly coming out of nowhere when both news and sentiment are terrible. Kind of like now.
How powerful are these rallies? Very. Look at Japan since 1989, when its stock market last peaked. Since then, it’s been in a secular downtrend that’s lasted 19 years so far. There have been 7 countertrend rallies during that time, ranging from +21% to +135%, with a median gain of +48%. On average, 1/5 of that gain came in the first 5 days, so its pretty hard to just jump in when it starts. Each one lasted several weeks to a many months.
The picture in the US is similar. During the secular bear markets of 1929–1938, 1966–1980 and 2000–today, there have been 8 countertrend rallies. They median gain was +67%, even better than in Japan, with 1/5 of the rise coming in the first 13 days.
So big rallies do happen during extended bear markets, and we have yet to have one since the current downtrend began in late 2007. When it finally arrives, suddenly and without warning, it should be impressive. The question at that point will be: Is this a countertrend rally or a new bull market?
Unfortunately, it’s usually almost impossible to tell until well after the fact. But fortunately, it really doesn’t matter for most investors. If you are invested for the long term, you should stay that way during and after the rally. If you need to reduce the risk level of your portfolio, you’ll want to cut back on your equity holdings after they’ve recovered somewhat regardless of what you think the future holds. This is good, since the future is ultimately unknowable. The only thing I know for sure is that it won’t look like the past.
How powerful are these rallies? Very. Look at Japan since 1989, when its stock market last peaked. Since then, it’s been in a secular downtrend that’s lasted 19 years so far. There have been 7 countertrend rallies during that time, ranging from +21% to +135%, with a median gain of +48%. On average, 1/5 of that gain came in the first 5 days, so its pretty hard to just jump in when it starts. Each one lasted several weeks to a many months.
The picture in the US is similar. During the secular bear markets of 1929–1938, 1966–1980 and 2000–today, there have been 8 countertrend rallies. They median gain was +67%, even better than in Japan, with 1/5 of the rise coming in the first 13 days.
So big rallies do happen during extended bear markets, and we have yet to have one since the current downtrend began in late 2007. When it finally arrives, suddenly and without warning, it should be impressive. The question at that point will be: Is this a countertrend rally or a new bull market?
Unfortunately, it’s usually almost impossible to tell until well after the fact. But fortunately, it really doesn’t matter for most investors. If you are invested for the long term, you should stay that way during and after the rally. If you need to reduce the risk level of your portfolio, you’ll want to cut back on your equity holdings after they’ve recovered somewhat regardless of what you think the future holds. This is good, since the future is ultimately unknowable. The only thing I know for sure is that it won’t look like the past.
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