There’s an old saying that “the market is most dangerous when it looks best and most inviting when it looks worst”. Given the downturn we’ve experienced, the market certainly couldn’t look much worst. Add in the fact that this is October with a mid-term election next month, and we have the perfect recipe for fear and panic.
Although we’ve had our short rebounds here and there, the decline in the stock market as of the end of September had finally reached – even surpassed by some estimates – the horrible 1973-74 bear market. Many of our politicians, taking a lesson from James Carville’s “It’s the economy, stupid” play book, have donned their fright wigs and begun painting a picture of doom and gloom in the hopes of winning their elections. At their very best, they tell us that the economy is weak, and at their worst we’re told that a second recession has actually begun. What’s missed in all this political posturing is the fact that our economy is actually growing at about 2.5% this year (that’s not a recession) and will produce about $10.5 trillion of goods and services – 20% of the planet’s total output (that’s not historically weak).
Nonetheless, most investors are worried, and some have even made large strategic moves “to safety” in their portfolios. The lack of real dividends for most stocks and the disbelief in management-reported earnings have convinced many that the sky is falling. In reality, I believe these concerns are rooted more in psychology than anything else and major strategic changes at this time ill advised.
To understand how we’ve reached this state, it’s helpful to consider what’s missing from the mix. Throughout most of our history, and specifically in past bear markets, the dividend paid by stocks provided a way to measure the stock’s value and formed a natural cushion for falling prices. As long as the stock was actually paying a dividend, the price only went so low. Investors had confidence in the actual cashflow into their pockets via the dividends they received. Until recently, about three-quarters of a stock’s total return was determined by this dividend; capital appreciation accounted for the other quarter.
Tax law changes discouraged dividends and changed managers’ incentives. When CEOs of public companies realized that dividends were no longer tax-deductible, but interest expense was, they stopped paying dividends and started borrowing more. Without substantial dividends, stock prices became almost entirely dependent on reported earnings to justify their price. As long as company management was “reporting” positive – and especially growing – earnings, then investors continued to bid up the price of the stock.
All this then served to mask some outlandish fraudulent manipulations by a very small, but hugely visible, minority of CEOs. Not only did they fudge their numbers, but they conspired to corrupt their auditors and supposedly independent analysts. When these transgressions came to light, there were no dividend payments to fall back on. Investors couldn’t determine what income stream their stocks would generate, and they certainly didn’t trust reported earnings anymore. Throw in the current winds of war in the Middle East, and stock prices across the board were bid sharply down, and our current crisis occurred.
While some deflation of prices was in order, I believe that the current level of the Dow and S&P 500 are too low. My belief was first prompted by the underlying growth (even if it is only 2.5%) in the economy. Stock prices should reflect this fact. My belief was confirmed by an analysis of taxable earnings maintained by the Department of Commerce.
Based on the reasonable assumption that companies do not inflate earnings on their tax returns in order to pay more in taxes, we can look at the Commerce Department’s quarterly earnings data for every US corporation as a measure of true economic activity and profitability. This data can be readily adjusted to reflect true replacement costs where appropriate. Furthermore, stock-option costs can be incorporated and capital gains/losses in pension funds eliminated. The result is a set of numbers which are accurate and comparable over time.
These adjusted “true” earnings tell us two important things. First, they indicate that the sum total of all corporations in the US are profitable. Secondly, this data indicates that current P/E ratios, taken as a whole, are not high. In fact, they are low by historical standards. The market P/E, based on these true earnings for corporate America, is at the lowest level of the last 23 years. Accordingly, I believe the market is substantially underpriced and a correcting rally is likely.
Despite this evidence, I know there are some bears out there who will argue that long bull markets are often followed by long declining or at best stagnant periods. I believe the relevant history of past bear markets argues for a strong recovery. In the last 100 years, there have been 6 major peaks and subsequent crashes. In every case after the market has fallen 40%, the following 5-year returns have averaged 8.6% per year above inflation.
More comforting is the knowledge that none have been negative. Even extending this period to 10 or 15 years after a major crash, the subsequent returns have been above the 7% long-run average real return for stocks.
For those investors who actually flew to bonds for safety, there is an even more important message. Watch out! Bonds have done exceedingly well these last 10 years or so because interest rates have fallen from approximately 14% in 1982 to 4% today. It is ridiculous to think that this will happen again in the near term. Remaining solely in bonds may – and I emphasize “may” – generate a consistent, albeit low, income, but bonds will not outperform a diversified portfolio of stocks over the next 10 years.
There is another old saying that “market recoveries only begin when there’s blood in the streets”. Of course everyone always hopes that the blood is from someone else’s portfolio. The only way to insure that is by maintaining a well-diversified portfolio with both bonds and stocks. Blood is spilled in greatest abundance by those who place substantial bets on one category over another. Trying to time the market or invest heavily in a “winning” sector may work over short periods. Inevitably, all sectors have their downturns. We can never predict when they will occur. By spreading your investment assets between both stocks and bonds, you can prevent a meltdown in your portfolio and still achieve your financial objectives. For the wise investors who have remained in stocks, simply stay the course. For those who have abandoned them, you need to get back in as soon as possible. Diversification may be psychologically taxing, but it is eminently profitable.