Last month was nearly the worst ever January for the stock market.
It sure looked that way on the morning of the 22nd when, with the
market already down about 9% for the month, the Federal Reserve announced
an emergency rate cut of 75 basis points sending the Dow down over
400 points in the opening minutes.
But by the end of that day, the Dow made up nearly 300 points of
that loss, and rose nearly 300 points the next day. And the final
week of the month (including the first day of February) turned out
to be one of the best for stocks in years. Still the losses for the
month were painful with the Dow dropping 4.5%, the S&P 500 losing
6% and the Nasdaq falling 9%.
Losses like that amid such high volatility can make one agitated
and nervous. How do you keep your bearings amid such sharp changes
in direction?
By keeping your focus where it belongs: on the longer-term.
In such volatile times, it is important to remember our guiding
principles: we treat the money you entrust to us as carefully as
if it were our own; we manage appropriately balanced, diversified
portfolios targeted to produce solid risk-adjusted performance and
accomplish long-term client objectives; we do not speculate in an
attempt to capture short-term gains.
While the current market may be making you uneasy, here are some
other voices with timeless advice on keeping a long-term focus:
The investors cited above were all very successful. They had long-term
investing orientations. They didn't shake out of positions.
If anything, when the market was down, they bought more as stocks
were "on sale." Remember, in time, all bear markets end.
But beyond that philosophical support for a long-term view to investing,
we believe that hidden in today's turmoil are the seeds necessary
to produce returns over the next 10 years that are higher than those
of the previous 10 years.
Let's start with valuations. At the beginning of 1998, the
P/E (price/earnings) ratio of the S&P 500 stood at 22.1. With
the S&P 500 closing at 1378.55 on January 31, 2008, the P/E ratio
was 16.3 based off 2007 operating earnings, and 14.1 based on forecasted
2008 earnings. While we think current 2008 earnings forecasts may
be too high, the point remains the same - valuations are not
as expensive as they have been in recent years. In fact, the P/E
for the S&P is at its cheapest levels since the end of 1995.
In addition to more attractive valuations, dividend yields are back
around 2% - compared to 1.6% at the beginning of 1998.
Why is all this important? Let's do a "back of the envelope" calculation.
A simple method of forecasting a "long-term expected return" for
the stock market is to calculate the "earnings yield" (which
is the inverse of the P/
E) and add in the dividend yield. As
shown in the table, applying that formula to the S&P 500 in 1998, we
get an earnings yield of 4.52% (1/22.1). Add in the dividend yield
of 1.60% and we get a forecasted return of 6.12% per year. The actual
10-year average annual return (1998-2007) was 5.97%.
Using current valuations and dividends we get a forecast of 8.16%.
While that is still below the historic long-term average (primarily
due to dividend yields still being lower than their long-term average)
it is a very respectable return, significantly better than the
6% of the past 10 years, and one that an investor can begin to
build a long-term program upon.
The Short-Term
While the future looks promising, the short-term promises to remain
difficult. There is likely to be a lot of bad news in front of
us yet. Given current economic and market conditions, corporate
executives have every incentive to put out all the bad news that
they can find now. This is fairly typical behavior during periods
of corporate earnings weakness. Earnings are expected to be negative
for the last two quarters of 2007 and stand a good chance to be
negative for the first two quarters of 2008 as well.
Remember though, that the news is "history," while the
markets are always looking ahead. The markets don't look back
at what happened like the news does. They don't react to historic
data like the Federal Reserve does. The markets are pro-active. While
media commentators are filling a perceived need for investors to
have short-term market behavior constantly "explained,"and
while the Federal Reserve and government are often reacting to political
pressures to do something about the current situation, the markets
are already moving on to the "next thing."
Looking ahead is healthy and rational behavior. Making an investment,
as a reward for past behavior is not the way to invest, nor is waiting
to invest until "things look better." It makes sense
for investors to commit funds based on what they think will succeed
in the future. Making an investment to achieve future objectives
is the right way to go about building a successful long term investment
program.
Nobody knows for certain where the markets will go over any time
period, but that is especially so in the shorter time periods. If
you take money that will eventually be used to fund some goal in
the next few years, and put it in the stock market, that’s
not investing, it's called gambling. Over short periods, the
markets are simply too uncertain to risk failing to achieve your
goals.
Volatile times like this can sometimes make the stock market feel
like "gambling." However, investing and gambling really
have only one thing in common: uncertain outcomes in the short-term.
In the longer-term, however, the difference couldn't be more
dramatic. In Vegas, your long-term expected return is negative. The "House" always
wins over time. That's why they buy the drinks. But the stock
market has historically provided a positive long-term return. Investing
in the stock market is participating in the growth of the global
economy. Even investors who follow a long-term, balanced approach
that may not "beat the market," certainly fare better
than "betting it all on red."
If you have been unsettled by the last few months, and our words
here haven't done enough to soothe your frazzled nerves, by
all means reach out to us. Maybe we need to re-visit your risk tolerance.
Maybe your long-term objectives have been modified. While we may
have discussed these issues with you recently, sometimes things look
and feel a little differently after the market has a significant
correction. Our aim is not just to deliver a satisfactory long-term,
risk-adjusted return, but to give you sound investment counseling,
as well.
Making Lemonade
In sum, for the long-term investor, periods of market weakness are
times to take positive action. When the markets are "on sale," it
is not only a great time to invest, it's also a good time
to clean up portfolios. In fact, at Kobren Insight Management,
January was one of our most active months trading client accounts
ever. The trading was primarily client-specific related, especially
for taxable accounts. We re-balanced some positions on the market
movement. We took tax losses which can be used to offset future
gains. We were able to get other investors fully invested. Each
of these situations was unique, but it's important to note
that positive actions can be made to investment portfolios even
if values are temporarily sliding the wrong way.
In addition, after talking to many of the portfolio managers of
the underlying mutual funds that we currently use, and including
managers of funds that we are contemplating using in the future,
we have heard lots of fresh optimism. There is opportunity out there.
