Three Important Questions
• What to do now in 2009
• How to get a decent return without so much risk!
• What to hold and what to sell
Before answering these three questions please allow me to recount how we got to this point in the first place.
2008 began like any normal year. The economic outlook was good as was the health of the stock and bond markets. I felt there would be some economic slowing throughout the year and bumpier ride in the stock market so I raised cash in advance. It was like the mood you’re in on a beautiful day 20 minutes before your house disappears in a Tornado.
The tornado that comes out of the blue then bam! all hell breaks loose.
First, oil rises to $148 per barrel, and everyone’s paying 4 bucks and over for a gallon of gas. Experts start predicting a rise to $200 per barrel and most other commodity prices start going up dramatically causing inflation to rise with no end in sight. (We start seeing videos of masses of people from China and India switching from bikes to cars). Then, as fast as oil prices rise, the price drops to $40 and gas at the pump is $1.80 again.
Now we hear that housing prices are declining faster than expected and many homeowners are unable to make their payments and foreclosing, so the banks start losing billions and the economy experiences a credit panic not seen in 75 years. This scares the heck out of everyone causing the stock market to unravel which is followed by a huge government bailout as banks continue to weaken. Then, established investment companies start merging or going out of business and interest rates rise dramatically on everything but Treasury obligations. The final icing on the cake for 2008 is the uncovering of the most diabolical Ponzi scheme in history. What a mess.
But just as seems it could get no worse, the panic subsides, and credit markets start to improve. (See my commentary: The Great Thaw, week of January 12, 2009)
Here we are today, bewitched and bewildered, sitting on a pile of uncertainty wondering if the storm has passed, wondering if this hellish ride is over. Hoping it is safe to come out of the bunker to assess the damage.
In order to know if it is safe, let’s look at the current state of affairs and the important numbers to ponder:
Interest Rates:
• Rates are falling. Mortgage rates are 5+% but they want to go even lower.
• T-bills are at .2% and you would only get 3% if you loaned the Government money for 30 years!
• Prime is at 3.25% so if you have a home equity line of credit you are only paying a pittance.
• CDs are at 2-3%
• Many stocks are paying higher dividends than Treasury bonds which we haven’t seen since the 50’s.
This is good news.
Inflation:
Declining, and expected to stay low for a while.
Good news.
Unemployment:
Rising and rising fast. The economy basically shut down in November and December and companies are adjusting to the situation.
A strong negative, especially since consumer spending makes up 70% of our GDP.
Real Estate:
Still declining but at a slower rate. Housing is affordable once again and low interest rates will help too. Homebuilder stocks are up 40% in the last 2 months. Maybe the market sees something new brewing
Look for some positives later this year.
Oil:
Low and likely to stay low as the economy remains weak. A lot of the banks and hedge funds are no longer driving prices wildly up and down. Typical supply and demand dynamics have returned putting some sanity back into pricing.
This is good.
Banks:
Still reeling and not ready to come out of the woods for a while.
A big negative.
Corporate Earnings:
Corporate earnings are soft and won’t move until credit becomes available once again to the consumer. We need the banks to improve dramatically before that happens.
Not good.
Government Spending:
A trillion is the new billion. A lot of stimulus and economic support is coming our way and our new president is committed to getting the economy back on track by investing in infrastructure and public works programs. It will be interesting to see how well this works, but the old saying: “don’t fight the fed” means you don’t want to bet against this huge amount of stimulus.
For the economy this is good right now. For the future????
Stock Prices:
Stocks are valued as a function of future earnings and current interest rates. Low rates make stocks more valuable. So this is a positive. Future earnings are also important. With rates this low and earnings expected to grow, on average, 6-8% per year, stocks are currently a good investment and will probably yield double digit returns in the next 10 years.
Prices are attractive
Bonds:
• Investment Quality Bonds yield over 6%
• Preferred Stocks yield over10%
• Low quality (junk) bonds are yielding 15-20%. This is a risky category but you are, in my opinion, getting paid to take the risk.
Bonds are very attractive.
Three Important Questions Answered
• What to do now in 2009
Keep a decent amount of cash in your accounts but don’t sell out of your stocks entirely. Get rid of the weakest companies and replace them with high quality companies. Look for so-called “fat-pitches”. These are the pitches you get in a game of softball that you just know you can hit out of the park. Wait patiently to buy any stock and then “swing” when ready. That is what we’re doing.
• How to get a decent return without so much risk!
Bonds are a very good way to do this. Picking individual corporate bonds is getting trickier, so for the time being buying mutual funds or index funds is a better way to go. Let the manager decide on which bonds to buy.
• What to hold and what to sell.
Today, picking the right individual stocks is more risky than ever so I would invest in either larger index funds that invest in the S&P 500, RUSSELL 2000, overseas markets and the like. This will help you get broad access to the market without the risk associated with owning just a few stocks. When this market turns, these funds will do very well.
Add some gold to the mix and some funds which can hedge against market downturns.
Summary:
All in all, I’m not entirely negative right now. The news will continue to be mixed with a negative slant, and it may get scary once again, but stock prices are reflecting most of what is already known. If there are any positive surprises, the market may rise strongly, if the surprises are worse than expected, be ready for more turmoil. Hopefully you have planned for this and you will survive to fight another day.
Finally, regarding very short-term market conditions:
We did get a cautious buy signal about four weeks ago and started to invest some sideline cash on a stepped-in basis adding 20% at a time. That signal has failed to follow through so I am currently in a holding pattern waiting to see what we will do next. I will keep you informed.
All investors are compelled to guess the future direction of the economy and the stock market. Whether by gut feeling or the use of sophisticated mathematical algorithms, the future is not predictable and any attempt to forecast it is a futile enterprise. Past performance will give us no more insight into the future than crystal balls or astrology. Warren Buffett quips that if past performance were all that was required to be successful, all of the rich people would be librarians. Furthermore, Wall Street types who forecast the market really have no more clue than you or me; however they compound their problem by giving pin-pointed forecasts which are wrong most of the time.
It is far better to approach this question by coming up with a list of reasonably valid scenarios that include the full range of economic outcomes and then try to attribute a rate of return for the market over the next 5 years. While not perfect, this can be done with some accuracy, due to the fact that we are forecasting a range of returns over a longer time horizon (5 years).
Scenario 1: “Muddle Through”
Scenario 2: “Stagflation”
This also suggests an economic recovery in late 2009 or early 2010 and a less that normal recovery for several years. However it is followed by STRONG INFLATION in the 5-8% range near the end of the five year period.
Scenario 3: “Severe Recession Accompanied by Deflation”
This is a bitter scenario because it forecasts an extended and deep recession causing prices to spiral downward through 2010. The recession does end but the following economic growth is very anemic.
Scenario 4: “Goldilocks”
Everything is just right because the Government’s “kick-start” gets the economy growing in late 2009, followed by average growth with moderate inflation.
Since these are the four scenarios most likely to occur, the next question we need to ask is: What are the possible returns of the stock market under each scenario?
Before examining the chart, let’s get a little knowledge about a few of the numbers that appear in the first two rows.
First we want to add up all of the companies’ earnings that make up the S&P 500 and compare them to the price of the S&P. In 2008 the S&P’s earnings added up to about $501. As of this writing the index of the S&P stands at just under 900, therefore a simple math calculation puts the price as a multiple of earnings to (PE) around 17. Just to reiterate, this means the average company in the S&P 500 sells at 17 times its earnings.
Now this PE multiple thing is not a static number. A lot of things like interest rates and inflation among other things can affect it, but our research forecasts the following earnings and PE ratios under each of the four scenarios. The chart below organizes all of this and forecasts possible returns based on a given price level of the S&P 500.
Realistically, we don’t know which scenario is going to work out so to be extra careful, we would want to buy the S&P 500 at a lower price just to build in a margin of safety.
Move up to 800 on the left hand column and the numbers start to look better, but not ideal.
During the latest sell-off which occurred in March of ‘09, the S&P 500 dipped to 680. I don’t think we will see the 680 lows again but I do think 750 is a good possibility, so let’s look at that.
The possible future returns at 750 range from .05 to 18.5%. If we eliminate the extremes of deep painful recession and a goldilocks economy, we are left with returns in the 7% to 12% area. This is a decent return and one that will create real wealth for those with the patience and fortitude to stay invested. This return won’t come easy, however. Remember I’m forecasting an average annual return. The word average sounds safe, but it is one of the most dangerous words in the investment vocabulary.
The same is true for investing. To get an average rate of return of 10% you will probably have to experience annual volatility of 20% and maybe more. That means that the range of returns in any one year could swing by 40%. This is not for the faint of heart and as we saw last year, many were not able to stomach it and keep their faith about the future.
There we have it; an idea of possible future returns under four economic scenario at numerous price levels of the S&P 500. This is not crystal balling, nor is it wild guessing. In my opinion, since one of these four events will actually occur, we can choose our entry back into the market accordingly. We can control our investing destiny rather than having the market or our emotions control us.
This is the essence of successful investing and the essence of wealth creation.
Steve…
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