Recently,
a long-term associate was talking about his morning routine when it came
to getting his morning news. He gets up, turns on his computer in his study,
goes down and gets his newspapers and a cup of coffee, then comes back to
the computer. Once he logs onto his favorite internet news sites, he throws
his newspaper away. “It’s already old news…I might as well
be reading a paper from a few days ago.”
Major economic news has indeed been flowing that fast and furious
in recent weeks. Larger than normal boldfaced headlines in major
newspapers at 5 am already seem dated. This really isn’t a
comment on old versus new media, but more a comment regarding the
onslaught of news flow that has been unsettling and unpredictable.
Getting quality information quickly, ideally before others, has
always been a key element of successful investing. Another way to
attain an edge, however, is by conducting superior analysis of that
information. This has been increasingly important as information
has become more widely accessible to investors in recent years.
A third way to find an advantage, however, and often the most important,
is behavioral. This is the ability to maintain discipline in various
market environments, the ability to go against the crowd, and the
ability to be patient.
What does all this have to do with the current environment, especially
a real estate/credit/liquidity/confidence crisis that many have called
the worst crises of their lives? First, we recommend that investors
cut down on their information intake. In the current environment,
where financial and emotional stress is high, and sensational opinion
and conjecture are easy to find, sifting through the river of information
to discern what is important and what is just “noise” can
be difficult, especially when most of it is, in fact, just noise.
For those who are investing for longer-term goals, the key is to
maintain discipline and patience. What is going on now is indeed
serious and has been financially painful – for all of us. Nonetheless,
the market has been through crises before. The markets will eventually
stabilize. The markets will, at some point, resume their ascent.
Perhaps the recovery starts this month. Perhaps it starts next year;
perhaps even later. For the long-term investor though, there are
indeed stronger reasons to buy now than to sell.
In this month’s commentary, we will talk about three things.
First, we will provide our quick take on the government’s rescue
plan. Second, we will talk about the incredible market volatility
that we have seen, and why it actually suggests higher returns moving
forward. Lastly, we will talk about the basic building blocks of
long-term equity returns – and why expected returns for stocks
look better now than they have in a long time.
Rescue Package
The reason the economy is in this current mess really began with
the real estate bubble. There were many contributing factors to
the bubble, including low interest rates, government incentives,
excessive debt, and good old human nature. Bubbles happen. Bubbles
also burst.
As a result of the real estate bubble bursting a few years ago,
prices have fallen, foreclosures have risen, and credit conditions
have deteriorated. This in turn has resulted in reduced demand for
mortgage-related securities. Lending standards then tightened, which
translated into fewer mortgage loans written, which meant less demand
for housing, pushing housing prices lower still, and the cycle has
continued to repeat. We are still in that vicious cycle.
A key aspect of the current situation is the lack of liquidity.
Market participants simply don’t want to transact business
right now. While on one hand deleveraging and cleaning up messy balance
sheets is healthy economic behavior in a micro sense, on the other
hand, with banks less willing (and less able) to lend, many organizations
and individuals who need access to capital can’t get it. This
is negative for the economy.
This contraction in liquidity and its negative impact on the economic
system became much more prominent in September. Many household names
in the financial sector ran into trouble. Just to name a few; Lehman
Brothers filed for bankruptcy, Merrill Lynch was bought out by Bank
of America, and AIG was bailed out by the Federal Reserve. The stock
and bond markets captured the angst in the markets, with sharp volatility
and sharp price drops. Serious dislocation occurred in the fixed
income markets, including U.S. Treasury bills plummeting to essentially
zero yields. The lack of liquidity ripple effects started to turn
into waves of fear and a loss of confidence in the system. The damage
on Wall Street was starting to spill over onto Main Street.
This is where the federal government stepped in and became much
more involved. While nobody thinks the rescue package passed by Congress
is perfect, it stands a good chance of restoring some confidence
and liquidity back to the markets. We believe that this is an important
first step toward an eventual turnaround, even if a full economic
recovery is still months or quarters away.
Regardless of one’s political persuasion, it should be recognized
that in an environment where industry and consumers are deleveraging,
the U.S. government has the ability to leverage up and offset some
of the economic contraction. While many think that Warren Buffett
is the ultimate example of a patient, long-term investor (by the
way, he is buying in this environment), the government has advantages
that even Warren Buffett doesn’t have. Who has a larger war
chest? Who has a lower cost of funds? Who is going to be around a
lot longer? The government, love it or hate it, is perhaps the only
entity that has the ability to stabilize the situation.
An important reminder is that according to the International Monetary
Fund, the past quarter century has seen at least 124 banking crises
around the world. This also isn’t the first time that the U.S.
financial system has experienced a financial crisis, and it won’t
be the last. Nonetheless, the markets and economy have always recovered
and moved onto new highs.
Volatility
Market volatility has been nothing short of intense in recent weeks.
Whether one looks at point moves or percentage point moves, the
volatility has been dramatic and historic. When volatility gets
extremely high, many investors simply abandon ship and move to
what feels like safer ground. Abandoning an investment plan during
times of high volatility is generally not healthy investor behavior.
One common way to measure volatility is the VIX or Volatility Index
which reflects the market’s expectation of what price volatility
will be like over the next 30 days and is often considered a way
to measure investor fear. A typical VIX level is below 20 (meaning
an expectation that annualized volatility will be less than 20%).
A level above 30 is a signal that investors are fearful. Levels above
40 typically suggest panic.
Studies have shown, however, that investors should “be greedy
when others are fearful.” The table below shows the handful
of times that the VIX spiked over 40 over the last ten years. For
the most part, buying the market during periods of such extreme stress
has produced positive returns moving forward.
| |
VIX |
1-Month |
3-Month |
12-Month |
3-Year |
| 8/31/1998 |
44.28 |
6.41 |
22.03 |
39.86 |
7.14 |
| 9/17/2001 |
41.76 |
3.80 |
9.58 |
-14.65 |
4.55 |
| 7/22/2002 |
41.87 |
17.62 |
9.06 |
22.74 |
16.64 |
| 9/19/2002 |
40.65 |
5.02 |
5.35 |
25.16 |
15.48 |
| Average |
-- |
8.21 |
11.51 |
18.28 |
10.95 |
High market volatility often pushes investors get off course when
it comes to their long-term investment portfolios. The irony is
that those high volatility periods tend to be more closely associated
with market bottoms, than market tops.
Long-Term Return Expectations
Warren Buffett, among others, is fond of saying that he is a lot
more comfortable with his approximate return expectations over
the next 5-10 years than his expectations for the next 5-10 months.
The reason he can say this is that while fickle investor sentiment
tends to dominate short-term market activity, valuations tend to
determine long-term results.
Currently, the outlook for the stock market is the best it has been
in quite some time. Let’s review the basic building blocks
of long-run equity returns:
1. Dividend yields
2. + earnings growth
3. + or - any change in valuations (P/Es)
First, let’s look at dividend yields. Currently, the dividend
yield on the S&P 500 is 2.6%. This favorably compares to the
25-year average of just under 2.5%. It is also the highest dividend
yield since the mid-1990s. Investing in the S&P in the mid-90s
would have generated an annualized return over the next ten years
of approximately 10%. And compared to Treasury bills, stock yields
are the most attractive they have been since the 1950s!
Second, what can we expect in terms of earnings growth? Going back
to the 1920s, annual earnings growth has been about 6% per year.
While this number obviously has significant short-term cyclicality
associated with it, the long-run trend of earnings growth has been
very stable.
In recent years we had been in favor of reducing long-term return
expectations due to above-average valuations, but we no longer maintain
that view. While the current price/earnings ratio for the S&P
500 is 21 times the last twelve month reported earnings, about in
line with its 25-year average, the P/E ratio using expected earnings
over the next twelve months is 14 times. The typical price/earnings
ratio when the economy troughs is about 19 times.
When interest rates and inflation expectations are low, as they
are now, they are supportive of higher valuations on stocks. Valuations
also tend to be higher when transaction costs and tax rates are low.
This is also currently the case.
All in all, an argument can be made that stocks today are relatively
cheap. At worst, they are fairly valued. To be fairly conservative,
let’s say that our expected ten year return for the stock market
gets only a slight boost, say approximately +0.5% per year, from
changes in valuations.
Putting the three components together; a yield of approximately
2.5%, a 6% earnings growth rate, and +0.5% increase in valuations
(P/Es), we come up with an expected return of 9% in the coming years.
While this isn’t the 10%+ that many investors have come to
expect from the stock market, it is better than the 3% annualized
return that we actually saw from the S&P 500 over the last ten
years that ended on September 30th.
That compares to ten-year Treasury bonds yielding less than 4% and
cash closer to 2%. Bottom line, this is the best that expected returns
for stocks have looked in absolute and relative terms in a long time.
Don’t Wait for the Wind and the Weather
to Be Right
Periods of high volatility, just like periods of low investor confidence,
thankfully tend to be fairly short in the grand scheme of things.
Even though the information flow is heavy and emotions are running
high, long term investors should continue to make investment decisions
primarily due to long-term factors such as valuations. Starting
valuations drive long-term returns.
Besides, there is a saying that if you wait for the wind and weather
to be just right, you will never plant anything or harvest anything.
Many investors now are waiting for the market to stabilize or some
other sign that the wind has stopped blowing. However, numerous studies
have shown that waiting until after the market begins to recover
means that you will miss much of the market’s long-term returns.
You have to be in the market to earn its return.
Sincerely,
