Business Cycle & Expected Returns

Well, 2 positive weeks back to back in the market and perhaps starting on week 3 today. The momentous amount of government intervention and tinkering makes it difficult to properly analyze what part of the business cycle we are in at present. On most levels it appears we are late in the contraction but the medicine prescribed by the government may be masking some additional ills...not sure. What we do know is that generally speaking, the sharper the decline ...the stronger the recovery.

David Booth , President of Dimensional Funds (DFA) published a brief article last week on expected returns in the market. He says in part " we believe expected stock returns are now higher than before the drop, rather than lower". The math leads one to think this is likely so.

The worst real estate market in the country (California) saw a 42% year over year increase in sales during February . Prices were almost 40% lower than the year prior. Over half of the transactions were foreclosures with a median sales price of $373,000. The real estate market seems to be trying to find a bottom .

Speaking of market bottoms, almost every interaction these days seems to contain the query of "is this the bottom?" Really, it doesn't matter much. Few have made money "finding the market bottom". On the contrary, many have lost $ trying to time the markets ins and outs. 

Best 7 Days

While we of course don't put much credence in short term market movements in either direction, I heard a stat this morning that bears repeating. The S&P 500 Index has increased 17% over the past 7 trading days. This represents the best 7 days since 1939!

Investing vs. Banking

The stock market posted good returns last week (up about 11% in 4 days) which of course is welcome news. Even if it does not retrace the downward path in an uninterrupted sequence, it certainly helps investors look ahead. Even so, we don't like to look at day to day or week to week price movement since we are involved in  investing not banking. Your investment account is different at a fundamental level than your bank account. Investing consists of exchanging one asset (cash) for another asset (in this case ownership in businesses). A bank account is  simply a place to store cash . The downdraft in the market has led investors to look at the short term movements in their account values as one would look at a bank account statement. The two are different and really should not be viewed in the same way. Remember investing is long term by definition. Continue to stay focused on your long term planning goals. More later.

Clarity=Confidence

A lot has been made of Warren Buffett's comments a couple days ago about "the economy going off a cliff". I saw some of the 2 hour long interview and he was actually quite upbeat. He did say that clarity (by the political forces primarily) will transform into confidence. Declining confidence is more of a symptom of what is wrong vs. the cause of our travails. Confidence is derived from improvements (forward looking) in what we see as economic activity. 

Buffett also said that he is convinced that over the next 10 years owning a basket of American companies (equities) will do considerably better than fixed income. Further, he pointed out that U.S. Treasury  securities are guaranteed ...to lose purchasing power over time. Indeed. He went on to describe the late 19th century and early 20th century economic struggles and said we have always come out of these troubles and will again this time. Final tidbit ...he mentioned that the Dow Jones Industrial Average went from about 66 to 11,000 during the 20th century. Keep the faith and stay tuned.

Things to Consider

The first couple months of 2009 have been anything but kind to investors . I thought you might benefit from a list of a few things to consider as we continue to work our way through this bear market. This list is certainly not comprehensive but is a start. 

1. Fear and hysteria are blinding investors to long term market values

2. No one knew in advance this was coming and for the most part there has been no where to hide.

3. The past is the past . Don't focus on how much you portfolio or net worth  has "lost" (unless you have cashed out you have not realized any losses ). Focus on what you nave now.

4.It is okay- normal- to have some fear and anxiety.

5. Focus on what you can control- diversification, low expenses,etc. A recent study reports that index (passive) funds outperform active funds by 4%  per year over time when considering tax efficiency,costs,turnover etc. 

6. Keep decisions in context of your long term financial planning goals.

7.Be an "adult" investor- one not ruled by emotions which can lead to poor decisions.

8. Cash is not a long term investment- it is a returns "smoother" . You can't accomplish long term planning objectives with cash.

9.Don't think that a decision to capitulate( to sell) will relieve your anxiety/fear. You will just transfer this to the decision of when to get back in the market. There is no bell that rings at the bottom . Remember that the average 12 month return from market bottoms is 32.4%.

10.Despite all the negativity and concern about the direction of the economy/country, optimism is the only realism. 

David Brooks-NYTimes on the budget

David Brooks 

Where we are/Where we stay

It is important in a fear driven market rout (like the present) to acknowledge that fear could drive the market lower still. That being said, do you really believe that the current market level (plus or minus a little) is where the market will stay? With almost 50% of investor cash on the sidelines( an all time high), we think the momentum will eventually reverse and head higher once again. As Larry Kudlow likes to say "free market prosperity will return" and hopefully soon.

The negative tenor of the market is to a large extent due to the unwillingness of the new administration to acknowledge market stability as even a tangential objective. Hopefully this will change as early as today when the Treasury Secretary visits Capitol Hill . Valuation levels are bordering on ridiculous levels  for most stocks.

Bear markets end when investors give up hope (capitulate). Looks like we are getting close to that point. 

Monday Morning Musings

I read Warren Buffett's  annual letter this weekend and even "the oracle of Omaha" has not been able to dodge the worldwide contagion impacting financial markets. Looking forward he proffers that 3 out of 4 years will bring positive returns for stocks (just as through the observed history to date) and that he is enjoying "buying quality stocks at low prices".

I also heard an interview with Wharton School Professor Jeremy Siegel where he discussed the earnings of the market at present after adjusting for the negative performance of the large banks. He said the multiples are near all time lows once the adjustments are made. I was curious and looked back at an interview he did in early January where he predicted -7% 4th quarter GDP and -5% 1st quarter 09 GDP. As we now know, the recently revised 4th qt 08 GDP was -6.8%. Anyway, at that time he was looking for a +20% year in 09 for stocks . Let's hope that he is even half right.

So far, the financial markets have not signed on to the government sector expansion planned by the new administration. Markets know that there are but 3 methods for paying for these huge expenditures: grow/innovate our way out (unlikely given the disincentives in the tax policies); tax our way out ; inflate our way out. The market is guessing the latter two will carry most of the weight.

For perspective we are sending out to clients a chart showing the worst 3 year periods for the S&P 500 and subsequent returns. The 3 year timeframe ending in February ranks 35th worst . Of the 40 periods portrayed on the chart , the subsequent 3 year annualized returns were in double digits in 36 . The average 3 year returns were 19.56% per year.