One of you asked how long one should keep tax returns, bank and brokerage statements, etc. Since I think this information will be of general interest to all of you, I decided to put it in one of my client emails. This information comes from a variety of sources, including my CPA wife, the IRS, the SEC and FINRA, the CFA Society and the AICPA, we well as KCS’s own practices. This is meant as a guide only and not the final word on the topic, as experts will often disagree (as they do in most things).
First, tax records. Backup for your tax returns, such as receipts, canceled checks for charitable contributions, bank and brokerage statements, 1099’s, W-2’s, etc. should be kept for 4 years after your return was filed (or the due date for the return if later). Thus, if you filed your 2008 taxes on April 15, 2009, you should keep all these records until April 14, 2013, at which point it is generally safe to shred them. If you had an extension and filed on Oct. 15, then you should keep your records until Oct. 14, 2013.
There are two exceptions to these guidelines: It’s usually a good idea to save the tax returns themselves forever, partly as proof of filing, and also for useful data in filing future returns. If this seems too long, then 10 years is a reasonable compromise. The second exception is evidence of the cost basis for investment property (stocks, bonds, real estate, etc.). These should be kept as long as you own the asset, then filed with the tax records for the year in which the asset was sold (and thus kept an additional 4 years). This can be a LONG time: I only recently sold shares of stock my father had bought in the 1950’s!
Evidence of the purchase cost of a financial asset can typically be found on your brokerage statement, as well as on the trade confirmation. The latter is usually easier to keep for a long period.
Insurance records, including policies and appraisals or purchase receipts for insured property, should obviously be kept at least as long as the policy is in force; it’s probably best to keep the policies themselves for at least 3 or 4 years after they’re canceled, along with the last year or so of policy statements. Purchase receipts should be kept at least as long as you intend to insure the property (if it’s also an investment asset, see above). Some say that old appraisals can be discarded once you have new ones, but others suggest keeping appraisals forever. The latter approach provides a history of the property’s value.
Lastly, there are things you should keep forever: copies of all versions of your living trust, other trust documents, wills, durable powers of attorney, healthcare advance directives, birth certificates, citizenship papers, medical records, diplomas and transcripts, marriage and adoption papers, divorce and separation agreements, and other really important papers. Note that regarding documents that are periodically updated (especially wills and living trusts), make sure that the latest version is always clearly indicated and readily available. You don’t want your executor mistakenly using an outdated document!
At this point, you’re probably thinking, “That a LOT of paper to keep!” And some of it should be stored in a safe place, such as in a safe deposit box. But for many documents, especially financial records and tax returns, there’s another option: electronic storage. That’s how we keep just about everything at KCS, including many of our clients’ records. As we look at expanding the kinds of client records we keep for your convenience, as well as how to make them readily available to you (such as over the Internet), here’s a rundown of what we currently keep on file and for how long:
Financial statements: For all accounts to which we have direct access, most obviously your Fidelity brokerage accounts, but also certain other types of investment accounts, we keep electronic versions of the statements for 7 years (as per SEC and CFA guidelines). Fidelity keeps 18 months accessible online through Fidelity.com (they also keep older statements, but we typically have faster access to them). We keep cost basis information as long as you own the asset, plus 7 years after you sell it.
In addition, we have transaction information in our portfolio management system back to when you first became a client of KCS. For those of you who were previously clients of Gay Abarbanell, we often have transaction information going back many more years. Access to this information can be surprisingly quick.
Any document that you have provided to us, either in electronic or paper form, is kept electronically for at least 7 years, and longer if it’s one of those “forever” documents listed above. Thus, if we don’t have the most recent copies of your living trusts, wills, insurance policies and other important papers, as well as tax returns going back several years, please don’t hesitate to send them to us for storage.
To get them to us, it’s obviously easiest if you have them in electronic format (PDF’s or TIFF’s are preferred). Some people are concerned that regular email could be intercepted, and we are looking into an easy and convenient means for you to email us encrypted documents. However, we host our own email server here, so that a hacker would have to grab an email during the brief time it’s in cyberspace, as our emails are not stored on any outside server that might be prone to hacking. So the odds of your email falling into the wrong hands, while not zero, are extremely low.
For paper documents, it’s best for you to send us a clean copy of the document that we can scan and then shred. We don’t recommend sending originals of important documents through the mail, but if you must do so, registered mail is best (we will return the documents by registered mail as well). Another option is to physically bring the documents to us, such as during one of your scheduled meetings; we can scan them and return the originals to you before you leave our offices.
Note that we’re not really a document storage service, so I’m not recommending that you discard originals of important records and documents just because we have them here. While we make frequent and multiple backups of all your data, I see having your documents at KCS more as an added failsafe and convenience to also keeping them yourself. On the other hand, if you have the ability to store electronic copies of documents that don’t necessitate keeping hard copy originals, we can provide you with PDF’s so that you can save storage space at home. (As always, back up your hard drives regularly, and also keep important documents on archival CDs or DVDs.)
So there you have it: more information than you probably ever wanted on record retention. But boring as it is, I’ll be this info will come in handy someday, perhaps when the IRS comes a-knocking.
Oh, by the way, the S&P 500 hit another new high for the year today. It’s now up about +6.5% so far in 2009. Not terrific, but a welcome change from 2008! Meanwhile, our benchmark, the MSCI ACWI [All-Country World Index], is up a much more impressive +17.2% so far this year, and a whopping +54% above its March 9 low. Yet despite these big recent returns, many are still denying that the bear market is over. What’s your opinion?
Monday, July 27, 2009
Tuesday, July 14, 2009
The time seems right‹Finally!
After a ferocious run through most of March, April and May, global equity markets stagnated for a while and then fell for about 5 weeks. The MSCI ACWI (All-Country World Index) peaked on June 2 at +48.6% above its March 9 low. It then spent most of the next 5 weeks drifting down, for a net loss of –7.6% from its recent peak as of last Friday. Investors became progressively more nervous during this period, with some measures of investor sentiment falling to levels not seen since mid-March, even though market indexes were at least 25% higher. Green shoots became brown weeds, and people again fretted over the speed and timing of an economic recovery. Several downbeat economic reports contributed to this feeling, and worries over earnings season, which began last week, added to the malaise.
Make up whatever reasons you want, the market just doesn't go up (or down) in a straight line. After a nearly +50% jump in just 12 weeks, stocks were due for a breather. A decline of 5–10% should have been expected. And that is the main reason I have been holding off investing cash and rebalancing portfolios recently, waiting for the correction to end, as I feel confident it will. And although it’s too early to know for sure, I suspect the end came yesterday, when the S&P 500 rose over +2% and erased its losses from the prior week.
Today, stocks edged up again, and after-hours action suggests another positive day tomorrow. The NASDAQ 100, for example, is up nearly +1.5% this evening, largely because of Intel’s positive earnings surprise. After the market closed today, the tech bellwether reported earnings and sales well above expectations; in fact, sales for the quarter were over $700 million more than analysts anticipated, and the company expects continued improvement in the third quarter. Intel stock is, not surprisingly, up over +7% after hours.
Yesterday’s powerful rally was ostensibly driven by the comments of Meredith Whitney, a prominent bank analyst who made a name last year by predicting hard times for banks. Far from her usual doom and gloom, yesterday she said that banks’ and other financials’ earnings in the second quarter would likely be much stronger than expected; Goldman Sachs’ announcement this morning that their earnings were +42% above expectations certainly added support to that view. Maybe the shoots are green after all.
Not surprisingly, the recently-ended second quarter of 2009 was one of the strongest for stocks in history, with the MSCI ACWI up +22.3% during those 3 months. Large numbers of investors who sold out of stocks in fear and disgust during February and early March ended up missing a history-making rally. These recent results are all the more impressive when you realize that the last time we had a positive quarter for stocks was way back in the third quarter of 2007 (when the MSCI ACWI was up only +3.5%)! It’s certainly been a long and horrific bear market!
But today I’m going to make three heretical statements, the kind I’ve been loath to make for well over a year now. Here are two predictions for the stock market and one for the economy:
1. The bear market that began on November 1, 2007 ended on March 9, 2009. Furthermore, the lows of that day will never be seen again (ever).
2. Stocks will continue to rise (in their usual irregular fashion) throughout this year and next. The MSCI ACWI will end 2009 at least +26% higher than today. 2010 should see another increase of +20% or more.
3. The recession that began in December 2007 is already over (at least as measured by changes in GDP). US GDP bottomed no later than June 2009. (We won’t know this “officially” until at least September.)
Many people will undoubtedly argue with me on these predictions, as well they should. But rather than giving me reasons why I might be wrong (or right), let’s just put these away until December 31 and see how I did.
Given the state of the markets and the economy right now, I think it’s finally time to buy stocks again. Those of you who have received your updated portfolios will start seeing trades in your accounts very shortly. Those who have not yet received your rebalanced portfolios will get them very soon. I wish I could do them all at once by computer, but because every client portfolio is a little different, and because I use a unique industry and country weighting approach, there is no software available that will do the trick (including those costing $100,000 or more). At some point, I hope to develop custom software to handle rebalancing; in the meantime, I will continue to use Excel and a lot of time and sweat!
Make up whatever reasons you want, the market just doesn't go up (or down) in a straight line. After a nearly +50% jump in just 12 weeks, stocks were due for a breather. A decline of 5–10% should have been expected. And that is the main reason I have been holding off investing cash and rebalancing portfolios recently, waiting for the correction to end, as I feel confident it will. And although it’s too early to know for sure, I suspect the end came yesterday, when the S&P 500 rose over +2% and erased its losses from the prior week.
Today, stocks edged up again, and after-hours action suggests another positive day tomorrow. The NASDAQ 100, for example, is up nearly +1.5% this evening, largely because of Intel’s positive earnings surprise. After the market closed today, the tech bellwether reported earnings and sales well above expectations; in fact, sales for the quarter were over $700 million more than analysts anticipated, and the company expects continued improvement in the third quarter. Intel stock is, not surprisingly, up over +7% after hours.
Yesterday’s powerful rally was ostensibly driven by the comments of Meredith Whitney, a prominent bank analyst who made a name last year by predicting hard times for banks. Far from her usual doom and gloom, yesterday she said that banks’ and other financials’ earnings in the second quarter would likely be much stronger than expected; Goldman Sachs’ announcement this morning that their earnings were +42% above expectations certainly added support to that view. Maybe the shoots are green after all.
Not surprisingly, the recently-ended second quarter of 2009 was one of the strongest for stocks in history, with the MSCI ACWI up +22.3% during those 3 months. Large numbers of investors who sold out of stocks in fear and disgust during February and early March ended up missing a history-making rally. These recent results are all the more impressive when you realize that the last time we had a positive quarter for stocks was way back in the third quarter of 2007 (when the MSCI ACWI was up only +3.5%)! It’s certainly been a long and horrific bear market!
But today I’m going to make three heretical statements, the kind I’ve been loath to make for well over a year now. Here are two predictions for the stock market and one for the economy:
1. The bear market that began on November 1, 2007 ended on March 9, 2009. Furthermore, the lows of that day will never be seen again (ever).
2. Stocks will continue to rise (in their usual irregular fashion) throughout this year and next. The MSCI ACWI will end 2009 at least +26% higher than today. 2010 should see another increase of +20% or more.
3. The recession that began in December 2007 is already over (at least as measured by changes in GDP). US GDP bottomed no later than June 2009. (We won’t know this “officially” until at least September.)
Many people will undoubtedly argue with me on these predictions, as well they should. But rather than giving me reasons why I might be wrong (or right), let’s just put these away until December 31 and see how I did.
Given the state of the markets and the economy right now, I think it’s finally time to buy stocks again. Those of you who have received your updated portfolios will start seeing trades in your accounts very shortly. Those who have not yet received your rebalanced portfolios will get them very soon. I wish I could do them all at once by computer, but because every client portfolio is a little different, and because I use a unique industry and country weighting approach, there is no software available that will do the trick (including those costing $100,000 or more). At some point, I hope to develop custom software to handle rebalancing; in the meantime, I will continue to use Excel and a lot of time and sweat!
Friday, June 5, 2009
You know we're in a bull market when....
You know we're in a bull market when....
General Motors, once the world’s largest corporation, files for bankruptcy protection, yet global markets rise 2.5%. That’s exactly what happened yesterday. At the same time, GM was kicked out of the Dow Jones Industrial Average after an 83-year stay, replaced by the much younger Cisco Systems. Perhaps even more a sign of the times, Citigroup is also getting the boot, to be replaced by Travelers Cos., its former subsidiary. (How’s that for poetic justice?)
That stocks rose strongly on such news continues to suggest that investors are looking forward rather than back. The demise of once mighty GM is being taken as a sign of progress, as old industries mature and downsize, while newer ones (as embodied by network router maker Cisco) continue to blossom. “Creative destruction” is necessary for economic progress, and it tends to accelerate during times of economic turmoil.
So in the midst of the worst recession since 1982, and perhaps since 1932, stocks continue to rally. Even after the strongest March and April in memory, stocks maintained their upward march in May, with the MSCI ACWI (All-Country World Index) adding another +10.0%. Stocks’ rise from their March bottom has been nothing short of impressive: the MSCI ACWI has surged +45.8% in the 59 trading days from March 9 through yesterday, and it’s actually up +9.5% for the year. Quite a turnaround from being down -24.9% year to date on March 9!
The skeptics abound, and that is good for stocks. Many investors still think the worst is ahead of us, and are waiting for this rally to fizzle and take stocks down a lot before committing their money. They are likely to have a very long wait. Even many of those who believe we’ve seen the lows for this cycle (as I do; in fact, I believe we’ve seen the lows for this century!) don’t expect stocks to rise much from here. They’ve got plenty of good reasons, too, from the slowing economy and the fragile financial system to the overleveraged consumer and surging unemployment. Many of their arguments are sound, yet stocks just keep going up. What gives?
I think that the current surge in stock prices comes from the realization that the Armageddon scenario, in which the world financial system melts down and we enter Great Depression II, is now off the table. 2009 is likely to be characterized by “just” a very severe recession and credit crunch, but nothing of the magnitude of the 1930’s or what many were imagining just a couple of months ago. And in that context, the current rapid rise in the stock market makes sense.
We’ve come down so far from the highs of 2007 that they now seem like meaningless numbers: investors have “anchored” to the recent lows rather than the more remote highs. In fact, just to bring stock prices back to where they were before the collapse of Lehman Bros. and AIG, before the Armageddon scenario first started to be priced into stocks, the MSCI ACWI would need to rise another +29% from here. At that level, stocks would again be pricing a severe recession, which is what we’re experiencing today.
So absent any new and unexpected economic shocks, it looks to me that stocks could rise another 30% or so before being fully priced. No real improvement in the economy or financial system is necessary; just the gradual adjustment of investors expectations to the current reality. Once we make it back to that level (perhaps by the end of this year), further progress will depend on the economy actually improving. Most agree that this will happen next year, and the pace of improvement will help determine the rate at which stocks continue to rise.
The biggest risk to a persistently rising stock market over the next year or so is a “double dip” recession, in which the economy improves for a few months but then starts to contract again. This has happened before and it could happen again. While such an an occurrence would almost certainly cause stocks to fall, history suggests that they will remain well above their recession lows (as they did in 1933, for example.)
I’m not expecting the double-dip scenario, but one must be prepared just in case. Such preparation does NOT mean getting out of stocks now, because that risks missing what could be a roaring bull market. Rather, it means being watchful and doing one’s best to spot a double dip early. But most important, it means not panicking should one occur and abandoning stocks just before the best part of the bull market. Those who did so in 1933 missed out on four of the best years in stock market history, and a real return of +436% over that period. I’m sure they felt pretty stupid in retrospect!
Let’s be smart and realize we can’t predict the future. But we can learn from the past, both recent and more distant. I’ve certainly learned a lot recently, and have adapted my investment style in response. Not huge changes, but incremental ones, because successful investing is an endurance contest, not a sprint.
General Motors, once the world’s largest corporation, files for bankruptcy protection, yet global markets rise 2.5%. That’s exactly what happened yesterday. At the same time, GM was kicked out of the Dow Jones Industrial Average after an 83-year stay, replaced by the much younger Cisco Systems. Perhaps even more a sign of the times, Citigroup is also getting the boot, to be replaced by Travelers Cos., its former subsidiary. (How’s that for poetic justice?)
That stocks rose strongly on such news continues to suggest that investors are looking forward rather than back. The demise of once mighty GM is being taken as a sign of progress, as old industries mature and downsize, while newer ones (as embodied by network router maker Cisco) continue to blossom. “Creative destruction” is necessary for economic progress, and it tends to accelerate during times of economic turmoil.
So in the midst of the worst recession since 1982, and perhaps since 1932, stocks continue to rally. Even after the strongest March and April in memory, stocks maintained their upward march in May, with the MSCI ACWI (All-Country World Index) adding another +10.0%. Stocks’ rise from their March bottom has been nothing short of impressive: the MSCI ACWI has surged +45.8% in the 59 trading days from March 9 through yesterday, and it’s actually up +9.5% for the year. Quite a turnaround from being down -24.9% year to date on March 9!
The skeptics abound, and that is good for stocks. Many investors still think the worst is ahead of us, and are waiting for this rally to fizzle and take stocks down a lot before committing their money. They are likely to have a very long wait. Even many of those who believe we’ve seen the lows for this cycle (as I do; in fact, I believe we’ve seen the lows for this century!) don’t expect stocks to rise much from here. They’ve got plenty of good reasons, too, from the slowing economy and the fragile financial system to the overleveraged consumer and surging unemployment. Many of their arguments are sound, yet stocks just keep going up. What gives?
I think that the current surge in stock prices comes from the realization that the Armageddon scenario, in which the world financial system melts down and we enter Great Depression II, is now off the table. 2009 is likely to be characterized by “just” a very severe recession and credit crunch, but nothing of the magnitude of the 1930’s or what many were imagining just a couple of months ago. And in that context, the current rapid rise in the stock market makes sense.
We’ve come down so far from the highs of 2007 that they now seem like meaningless numbers: investors have “anchored” to the recent lows rather than the more remote highs. In fact, just to bring stock prices back to where they were before the collapse of Lehman Bros. and AIG, before the Armageddon scenario first started to be priced into stocks, the MSCI ACWI would need to rise another +29% from here. At that level, stocks would again be pricing a severe recession, which is what we’re experiencing today.
So absent any new and unexpected economic shocks, it looks to me that stocks could rise another 30% or so before being fully priced. No real improvement in the economy or financial system is necessary; just the gradual adjustment of investors expectations to the current reality. Once we make it back to that level (perhaps by the end of this year), further progress will depend on the economy actually improving. Most agree that this will happen next year, and the pace of improvement will help determine the rate at which stocks continue to rise.
The biggest risk to a persistently rising stock market over the next year or so is a “double dip” recession, in which the economy improves for a few months but then starts to contract again. This has happened before and it could happen again. While such an an occurrence would almost certainly cause stocks to fall, history suggests that they will remain well above their recession lows (as they did in 1933, for example.)
I’m not expecting the double-dip scenario, but one must be prepared just in case. Such preparation does NOT mean getting out of stocks now, because that risks missing what could be a roaring bull market. Rather, it means being watchful and doing one’s best to spot a double dip early. But most important, it means not panicking should one occur and abandoning stocks just before the best part of the bull market. Those who did so in 1933 missed out on four of the best years in stock market history, and a real return of +436% over that period. I’m sure they felt pretty stupid in retrospect!
Let’s be smart and realize we can’t predict the future. But we can learn from the past, both recent and more distant. I’ve certainly learned a lot recently, and have adapted my investment style in response. Not huge changes, but incremental ones, because successful investing is an endurance contest, not a sprint.
Wednesday, May 20, 2009
The bull keeps on running....
After last week’s –5% drop in the S&P 500, many were already calling an end to this rally. But I don’t think it’s over yet: far from it. This move up is likely to continue—with inevitable pauses such as the one last week—for many more months and even years. I suspect that before the new bull market is finally over, and stocks again suffer a –20% or greater decline, we’ll not only have reclaimed the highs of October 2007, but should be well beyond them. With very rare exceptions, bull markets are much bigger than the bears that precede them. The main risk to I see now isn’t losing money, but missing out on big profits.
Of course, I could be wrong. But I’m not seeing any economic or financial signs that disturb me. Most of the latter are hugely positive; for example, 3-month LIBOR (the rate at which many banks lend to each other) is now 0.78%. This is the lowest level ever, and it has fallen from 1.10% only one month ago. If LIBOR were to drop to about 0.50%, that would mean the inter-bank lending market was back to normal. It’s possible we could see this in just a couple of months.
Investor sentiment, while way better than it was in early March, remains tepid. And last week’s market drop was enough to convince many that the bear market is not yet over. As recently as last night, few expected a rally today. Tokyo was down –2.4%, as were several other Asian markets. But India changed all that when it rocketed +17% shortly after the open, apparently giving strong approval to the winning party in the just-completed election. Almost immediately, other Asian markets that were still open (Tokyo was closed) turned strongly positive, and the bull was reinvigorated. All this shows that markets can shift suddenly for little apparent reason.
Some of you are still waiting to see your re-allocated portfolios; most who have received them so far have had no comment (either you think they’re terrific or I’ve totally confused you). To all of you: don’t worry about missing the bull, we’ve got plenty of upside ahead of us. Just returning to the old highs on the S&P 500 would give us a +73% rise from here, and that’s without dividends. Allocating wisely among countries, industries and individual securities could provide even better results: non-US developed markets need to rise +87% (without dividends) to reclaim their 2007 highs, for example, and many individual stocks (such as GE) need to triple (that’s +200%) just to reach their old highs.
What’s driving the rally? There’s just too much cash out there, and cash isn’t earning squat. After inflation and taxes, nearly all so-called “risk free” investments are earning negative returns. If investors want to make a reasonable return in this environment, they simply have to take some risk. And in a nearly perfect reversal of the bear market, since their recent lows, riskier investments have provided higher returns than less risky ones. The risk-return relationship is again positive, as it has typically been over the long term.
Here’s a note from STIR Research on how institutional investors are dealing with their mounds of cash (written just before today’s big jump):
“According to this week’s Barron’s, growth stock managers have been left behind the last two months. Only 33% beat the benchmarks in March and only 25% in April. They want to catch up, and with high levels of cash, they are looking to buy on any dip.
“But the market has not been very accommodative. Last week we had 4 down days for the S&P 500, NASDAQ, the Russell 2000 and others. But on three of those down days volume was below normal. Even with Friday’s option expiration, which normally leads to a spike in volume, it was below average.
“We are interpreting that to mean, that even when the buyers pull back, sellers are not panicking and dumping stocks. Instead the selling has been drying up. Therefore, institutional investors wanting to deploy some of their excess cash, have to bid stocks higher to find willing sellers: a formula for a market moving higher.
“In a bullish report sent out Friday by Goldman Sachs, they noted that following the 18 largest bear markets in history, the initial rally lifts stocks 43% and lasts 180 days. And that is just the average.”
The last point is interesting. Given that the recent bear market was at least 50% worse than average, one could expect the initial rally to be roughly 50% stronger than average. This would imply that 6 months after its low, the S&P 500 would rise +65%, which translates into a level of 1,100 (compared to 910 today, or another +21% gain over the next 3 1/2 months). I’m not saying that this is what will happen, but it wouldn’t be out of line historically. Of course, if the global economy and credit markets are in decent shape by September, stocks should continue to move upward.
Remember that stocks are not the only “risky” asset. Corporate and municipal bonds, commodities, and real estate all fall into the risky asset category, and should also do well as the financial markets improve. They, too, deserve a place in most portfolios (and my model portfolios do include them). The only assets I would avoid right now are US Treasuries, CD’s and other “risk-free” assets. They should lag severely, and could even provide negative returns going forward.
Of course, I could be wrong. But I’m not seeing any economic or financial signs that disturb me. Most of the latter are hugely positive; for example, 3-month LIBOR (the rate at which many banks lend to each other) is now 0.78%. This is the lowest level ever, and it has fallen from 1.10% only one month ago. If LIBOR were to drop to about 0.50%, that would mean the inter-bank lending market was back to normal. It’s possible we could see this in just a couple of months.
Investor sentiment, while way better than it was in early March, remains tepid. And last week’s market drop was enough to convince many that the bear market is not yet over. As recently as last night, few expected a rally today. Tokyo was down –2.4%, as were several other Asian markets. But India changed all that when it rocketed +17% shortly after the open, apparently giving strong approval to the winning party in the just-completed election. Almost immediately, other Asian markets that were still open (Tokyo was closed) turned strongly positive, and the bull was reinvigorated. All this shows that markets can shift suddenly for little apparent reason.
Some of you are still waiting to see your re-allocated portfolios; most who have received them so far have had no comment (either you think they’re terrific or I’ve totally confused you). To all of you: don’t worry about missing the bull, we’ve got plenty of upside ahead of us. Just returning to the old highs on the S&P 500 would give us a +73% rise from here, and that’s without dividends. Allocating wisely among countries, industries and individual securities could provide even better results: non-US developed markets need to rise +87% (without dividends) to reclaim their 2007 highs, for example, and many individual stocks (such as GE) need to triple (that’s +200%) just to reach their old highs.
What’s driving the rally? There’s just too much cash out there, and cash isn’t earning squat. After inflation and taxes, nearly all so-called “risk free” investments are earning negative returns. If investors want to make a reasonable return in this environment, they simply have to take some risk. And in a nearly perfect reversal of the bear market, since their recent lows, riskier investments have provided higher returns than less risky ones. The risk-return relationship is again positive, as it has typically been over the long term.
Here’s a note from STIR Research on how institutional investors are dealing with their mounds of cash (written just before today’s big jump):
“According to this week’s Barron’s, growth stock managers have been left behind the last two months. Only 33% beat the benchmarks in March and only 25% in April. They want to catch up, and with high levels of cash, they are looking to buy on any dip.
“But the market has not been very accommodative. Last week we had 4 down days for the S&P 500, NASDAQ, the Russell 2000 and others. But on three of those down days volume was below normal. Even with Friday’s option expiration, which normally leads to a spike in volume, it was below average.
“We are interpreting that to mean, that even when the buyers pull back, sellers are not panicking and dumping stocks. Instead the selling has been drying up. Therefore, institutional investors wanting to deploy some of their excess cash, have to bid stocks higher to find willing sellers: a formula for a market moving higher.
“In a bullish report sent out Friday by Goldman Sachs, they noted that following the 18 largest bear markets in history, the initial rally lifts stocks 43% and lasts 180 days. And that is just the average.”
The last point is interesting. Given that the recent bear market was at least 50% worse than average, one could expect the initial rally to be roughly 50% stronger than average. This would imply that 6 months after its low, the S&P 500 would rise +65%, which translates into a level of 1,100 (compared to 910 today, or another +21% gain over the next 3 1/2 months). I’m not saying that this is what will happen, but it wouldn’t be out of line historically. Of course, if the global economy and credit markets are in decent shape by September, stocks should continue to move upward.
Remember that stocks are not the only “risky” asset. Corporate and municipal bonds, commodities, and real estate all fall into the risky asset category, and should also do well as the financial markets improve. They, too, deserve a place in most portfolios (and my model portfolios do include them). The only assets I would avoid right now are US Treasuries, CD’s and other “risk-free” assets. They should lag severely, and could even provide negative returns going forward.
Friday, May 15, 2009
Don't moor yourself to the wrong anchor
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.
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 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!
Subscribe to:
Posts (Atom)