How low can you go?

A lot people are wondering how bad the stock market can get.

I don’t know how low it will go, but I have a pretty good idea of how low it can go.

Before I outline my reasoning, let me forewarn you: the answer is ugly.

I’m not trying to predict what the market will do or when–no one really can. I’m just trying to prepare you for the worst case scenario just in case it happens.

You don’t want to sell at the bottom. Nothing will hose up your long term goals as much as going to cash in hopes you can sell at the top and buy at the bottom. The odds are highly in favor of you doing just the opposite–most people do. Knowing how bad things can get may help you avoid selling at the bottom, and that’s what I’m trying to do in this blog.

The reality is I’ve never been as bullish as I am now. I’m projecting the highest returns going forward I’ve seen in 13 years! I’m terribly excited about the returns I believe I’ll get over the next 5 years. But, and there’s always a but, the stock market could go a lot lower before it goes back up again.

How low? History indicates the market can get as low as 7 times normalized earnings. I’ve talked about normalized earnings in the past, but let me explain it again briefly.

The stock market’s per share earnings have grown quite steadily at around 6% a year over the last 50+ years. In boom times earnings are above this trend, and in bust times earnings are below. But, over time, the earnings always return to trend.

Such earnings are like true north to a navigator. They point the way in all circumstances and provide a ready reference for where you are and where you’re going.

That’s why I use normalized earnings–it’s a steady guide. In boom times, the stock market sells at over 20 times earnings. In bust times, it tends to go down below 10 times earnings. In the worst times, it gets down to around 7 times normalized earnings.

What would 7 times normalized earnings mean for the S&P 500? Normalized earnings in the next year for the S&P 500 will be around $67 a share. 7 times that gives you a value of $469 for the S&P 500, roughly 52% below today’s closing price of around $970 on the S&P 500. That would correlate to a Dow Jones Industrial Average of $4,500.

I’m not saying we’ll get that low. In fact, I consider that quite unlikely. I’m not saying I want to see it go that low–I’d feel terrible if it did. But, I am saying be prepared for it to go that low just in case it does.

Benjamin Graham, the father of value investing, once said you shouldn’t invest in the stock market unless you’re ready to see your investment cut in half and double in value. I agree with that sentiment. Be prepared for the worst, hope for the best.

On a brighter note, the stock market usually trades at an average of 15 times normalized earnings. That would mean an S&P 500 of around $1,000 and a Dow of $9,600. In other words, the market is already below fair value.

The problem is the stock market almost always goes below fair value after boom times. It already has, but could go lower still. Be prepared for how low it can go and don’t sell at the bottom.

Like I said above, I’m finding the best values I’ve found in years. Great companies are selling at prices that are likely to generate very high returns over the long run. Even if things go significantly lower, this is an absolutely great time to invest!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Hanging in there is tough, no doubt about it

October has been a brutal month.

I saw this crisis coming years ago, and my returns have benefited from that foresight, but this hasn’t kept me from feeling the pain.

I was feeling pretty good about myself at the end of September. Having beat the market by more 8% over the last two years and by more than 4% over the last three years (annualized, after fees), I was feeling pretty cocky.

But, that was before October. In October, my returns have paralleled the market’s path down. I haven’t enjoyed the ride, even if I started from a higher place.

This has been particularly frustrating because I’ve invested in some of the strongest companies around. You’d think the strongest businesses would be untouched, or much less touched, by recent turmoil.

That hasn’t been the case. When people are under a lot of pain, they do crazy things, like selling great companies at huge discounts to underlying value. Many of those investors were probably buying on margin. Some were hedge funds that were forced to sell long positions and cover short sales after the SEC banned shorting certain companies.

What’s been happening is the usual capitulation you tend to see when markets are bottoming. People are under so much pain that they’re selling everything, regardless of the price they’re getting.

This isn’t fun for a value investor like me because I hate to see my clients’ money or my own money decline in value. I work hard to be sheltered by the storm, even though I know some markets are so brutal that everything goes down.

What’s a person to do? I’m on a buying spree.

I’m taking the opportunity to sell strong performers and buy poorly performing great companies. I’m finding some absolutely astounding bargains and, most likely, boosting future returns. And, although it’s no fun to see the market and portfolios go down dramatically, I’m having a lot of fun putting things in place to benefit when the market does recover.

When will the market recover? No one knows. The market could go down by another 33% to hit historical lows reached in the past, or it could rally by 67% (a 40% decline requires a 67% increase to get back to break even) as it’s also done in the past.

You don’t need to be a fortune teller or have a crystal ball to make money from here, you just need the gut wrenching fortitude to buy great companies at great prices–now. As long as you believe our economy won’t permanently collapse, this is a great time to invest.

Although it’s no fun to live through, I’m quite confident that buying at times like this make for very high long term returns in the future.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Warren Buffett is buying American stocks

I’m not the only one feeling more bullish lately–so is Warren Buffett (yeh, I’m flattering myself).

Warren Buffett is the richest man in the world and probably the best investor alive today. To top it off, he seems like a grounded, happy guy. He still lives in the house he bought in his 30’s, still drives himself around town, and has good relationships with his kids. Pretty amazing for a multi-billionaire.

Buffett wrote a letter to the editor of the New York Times that was published today titled “Buy American. I Am.” You can access it here to read the whole thing.

Buffett’s basic argument is that because the financial world is a mess, this is a historic time to buy American stocks.

He cautions that unemployment will rise, business activity will slow and headlines will be scary. Despite these issues, he’s buying stocks in his personal account (not just for Berkshire Hathaway, the holding company he runs). Up until recently, his personal money was all is U.S. government bonds. But soon, he will be 100% invested in U.S. equities.

As Buffett has said many times before, “Be fearful when others are greedy, and be greedy when others are fearful.” In other words, buy when everyone is scared and sell when everyone is euphoric. This is very difficult to do, but it is also very profitable.

He cautions against investing in highly leveraged companies and businesses with weak competitive advantages. He also cautions that he can’t predict short term movements in the stock market. Let me let you in on a secret–no one can!!! It may keep going down over the next year or two, but in 5 years, it’s the best place to invest (especially at today’s low prices).

Buffett is seldom if ever outright bullish. But, when he says, “What is likely…is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up,” I stand up and listen. What he’s saying is you can’t wait until things look good to invest, because by then you’ll have missed significant gains. I’ve rarely, if ever, heard Buffett say something so bullish. The last time he seemed to be this optimistic was 1982, and that was an outstanding time to invest.

He goes on to give examples of why waiting doesn’t work. During the Great Depression, the stock market bottomed in the summer of 1932, long before the economic picture improved. During World War II, the market bottomed in the spring of 1942, long before it was clear the Allies would defeat Axis powers. In the early 1980’s, when inflation was double-digit and the economy was in a deep, double-dip recession, the time to buy was in 1982, long before the economy’s recovery was clear in 1983 and 1984.

The lesson from a guy who has generated 20%+ returns for over 50 years is: you buy when everyone is pessimistic, and that time is NOW!

He warns that buying stocks only when you feel comfortable leads to poor results, so does selling because you feel scared.

He also warns against sitting in cash. Holding cash now feels comfortable, but it’s an unwise investment decision. Cash doesn’t pay much of a return, especially now, and it will depreciate in value. As he warns, government policies directed at alleviating the current crisis will probably prove inflationary and make cash an even worse investment.

He believes that “[e]quities will almost certainly outperform cash over the next decade, probably by a substantial degree.” You should invest for where things are going, not for where they are today.

At a time when people are looking for something to hang their hopes on, Warren Buffett is a voice of clarity in the maelstrom. I’m listening, and so should you.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It’s normal to worry, but this is not the time to panic

Below is a slightly altered version of an email I recently sent to clients:

Dear Clients,

As you’ll see next week, my client letter was written at quarter end and doesn’t address recent market volatility. With that in mind and considering the recent market drop, I decided to throw together a quick email to all clients giving my opinion of what is happening and what my response is.

I’ve summarized my thinking in quick bullet points for those short on time or not as interested. Then below, I go into more detail on each point for those who want more info. Finally, my intent is to try to answer your questions as well as I can and to get a dialogue going if you are concerned. Please feel free to contact me at any time if you want to talk to me about what is going on. I will be available or quickly return your calls. This is a stressful time, and I’m here to answer your questions.

1. It’s natural to be worried, but panic selling now will lead to regret in the long run.
2. Historically, this decline is not out of the ordinary.
3. I believe recent government action will work, although it will take some time and it will lead to higher inflation in the long run.
4. It’s not possible to time the market, so trying to sell now and buy at the “bottom” almost always leads to worse results than holding on.
5. The market is throwing the baby out with the bathwater.
6. Our underlying businesses are strong even though their prices are going down.
7. This is a historic time to invest!
8. One of the reasons you hired me is to let me worry about the market for you. That’s what I’m trying to do for you now.

Now, the details.

1. It’s natural to be worried, but panic selling now will lead to regret in the long run.

Being worried is normal–I’m having no fun watching your and my portfolios decline. It’s easy to anchor on recent market tops and expect the highs to continue–there was a lot of media coverage about the Dow hitting 14,000 this time last year. People are panicking because they are scared, but reacting by selling is the worst investment plan and will lead to tremendous regret when the market does rebound. Temporary highs and lows can make you feel better and worse than you want to. The market swings up and down dramatically, so it’s best to focus on longer term averages. A wise person once said that courage is not the lack of fear, it’s the ability to act in the face of fear. Right now, not selling is taking a lot of courage.

2. Historically, this decline is not out of the ordinary.

The stock market tends to decline an average of 40% when recessions hit, which is about every 5-10 years. We’re down around 40%, so this decline is in line with history. As Mark Twain said, history doesn’t repeat, but it sure does rhyme. Sometimes the market goes down by 20%, sometimes it goes down by more. No one knows where this one will bottom, and trying to pick the bottom is a fool’s errand. Our economy and financial sector are facing the worst period since the Great Depression, but that doesn’t mean it will look just like the Great Depression. Comparisons to history are useful, but expecting the same outcomes in the same way is a mistake.

3. I believe recent government action will work, although it will take some time and it will lead to higher inflation in the long run.

Current government plans have flaws, but I believe they will get credit markets and the economy going, eventually. The cost will be higher long term inflation and more regulation, but I do think it will work. The market tends to bottom 6-9 months before the economy does. Economic data comes out months and years after the economic bottom is clearly reached. Waiting for the economy to improve will lead you to miss the huge stock market rebound that will occur. It’s hard to see past our current turmoil, but a long term focus helps.

4. It’s not possible to time the market, so trying to sell now and buy at the “bottom” almost always leads to worse results than holding on.

Like the search for the Holy Grail and a perpetual motion machine, people are always trying to time the market by buying at the bottom and selling at the top. Unfortunately, this isn’t possible, and every attempt to do so ends in tears. I remember buying a company called JLG in 2000 at $8.88 per share, watching it decline to $3.95, and then selling it when it climbed above $17. I had doubled my money when the market was doing terribly, so I felt good about myself. But then JLG climbed to $60. It’s easy, in hindsight, to think I should have known that JLG was worth a lot more than $3.95 at the bottom and buy more. It’s easy to think I should have waited for $60 to sell at the top. Having been through that ride, though, I know very well that it’s not possible to pick the tops and bottoms. Instead, I focus on the underlying value of the business and buy when it goes down and sell when it goes up. I never pick the exact bottom or top, but over the long run, I’ve had very good results.

5. The market is throwing the baby out with the bathwater.

When the market panics, everyone feels so much pain they sell no matter what price they get. This leads people to throw the baby out with the bathwater, and that is what I’ve been seeing since Oct 1st. People are selling good companies and bad ones, small and big, everything. When that happens, it’s very unprofitable to join the crowd and sell, too. This is a sign of how much pain people are in, not the underlying value of businesses. In the long run, the market will recognize underlying business value, even if it takes a while and some pain to get there.

6. Our underlying businesses are strong even though their prices are going down.

When I look at our underlying businesses, I feel very confident. Software companies will continue to sell software and make money, even in a down market. People will still subscribe to cable, even if they don’t pay for HBO anymore. Smart insurance companies will continue to write insurance. Discount retailers are doing better than ever as people look for bargains. Europe’s lowest cost airline is still lowest cost and, and with little debt, can continue doing business and make more money than competitors, smart holding companies have investment money on the sidelines and the inside scoop on the best deals in the market when everyone else has no cash to invest, well capitalized insurers are writing more insurance now that AIG and other insurance companies are in severe trouble, big pharmaceutical companies will continue to sell drugs to people who need the medicine to live longer, happier lives, great banks are expanding by buying competitors at a fire-sale price because most other banks are on the ropes, auto insurers will continue selling car insurance because people have to buy it to drive, smart chemical companies will continue to make vital chemicals and pay lower prices for gas and oil inputs, large integrated oil companies will continue producing and refining fuel for people who will continue to heat their homes and drive their cars, large international banks will continue to grow their international banking franchises and will be able to buy up competitors because they are more conservatively financed than competitors. Many companies are strong and exploiting the downturn–but their prices are going down! Why? Because people are panicking, not because the businesses are going bankrupt.

7. This is a historic time to invest!

If you look back at market history and see 2002, 1998, 1991, 1987, 1982, 1974, 1962, 1953, 1942, 1938, 1932, etc., you will see market bottoms where things were awful. 2002 was the bottom of the tech blowout. 1998 was the bottom of the Asian Contagion. 1991 was the Saving and Loan bailout and recession. In 1987, the market dropped over 20% in one day! 1982 was a sharp recession and the Time magazine article of the “End of Equities.” 1974 was a terrible recession, extremely high inflation, the pullout of Vietnam, etc. And so on and so forth. They were each excellent times to invest and extremely tough moments to do so. What made them great times to invest? Because some people panicked and others didn’t. The people who didn’t panic made out like bandits. If you have extra cash to invest, put it to work now. If you don’t, hold on for now. The roller coaster is on the way down, our stomach is in our throat, we know it will go back up again but can’t think about that because we feel awful. But, holding on is the most profitable route.

8. One of the reasons you hired me is to let me worry about the market for
you. That’s what I’m trying to do for you now.

An important part of my job, in addition to researching and picking investments, is to take the pain for you of watching the market go down. If you can, turn off the TV, get off the Internet, put down the business section of the newspaper. Go out and do something fun. Spend time with loved ones. I remember watching TV for 48 hours after 9/11 and after Hurricane Katrina, and I managed to convince myself that more doom was right around the corner. It wasn’t, and it probably isn’t now. Let me focus on this stuff for you, let me take the pain for you. That’s what you pay me for.

I don’t want to short change current events. These are tough times.

I don’t want to undercut how miserable it is to watch our portfolios decline in value–I’m agonizing because I feel responsible for your money.

If you still have concerns, please call or write me. I’m standing by and waiting to talk to anyone who calls.

Take care and have a great weekend,
Mike

Michael Rivers, CFA
Athena Capital Management Corp.
719-761-3148
www.athenacapital.biz

Visit my blog: www.mikerivers.blogspot.com.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It’s ugly out there

The economy is getting to look downright ugly.

The reason why the U.S. government was working so hard on the bailout is because credit markets are frozen. For those who don’t know, our economy operates mostly on credit. When most companies buy inventory, purchase property, plant and equipment, or pay wages and salaries, it’s frequently done with credit.

So, when credit markets are frozen, businesses (and municipalities) can’t keep operations going, they can’t expand, and they can’t pay their employees.

It’s unclear that the government bailout will unfreeze credit markets. Banks aren’t lending because their balance sheets are either close to or insolvent. They can’t lend. Having the government purchase illiquid securities may facilitate the rebuilding of bank balance sheets, but it won’t rebuild bank balance sheets directly.

The credit freeze has been slowing the economy remarkably over the last two months, and precipitously over the last two weeks. That is why Secretary of Treasury Paulson and Federal Reserve Chairman Bernanke have been running around like chickens with their heads cut off trying to get the bailout going.

Warren Buffett says this is the worst he’s seen in his 50+ years of investing. The situation is being touted as the worse financial crisis since the Great Depression.

It’s going to get worse before it gets better, but, if free markets are left alone to work, it will get better. The U.S. economy is the most dynamic and resilient in the world.

We may be over-leveraged with debt, we may have too much debt, we may not save enough, but we have the best protection of property rights and a relatively sound rule of law. That’s all it takes, and individuals will do the rest.

It’s always darkest before dawn. Things look pretty dark out there now. Believe it or not, that can be a great time to invest. By the time things look better, you will have missed the upswing.

I’m not saying investing at a time like this is easy, but it is smart. In the long run, investments made today will do very well, even if it’s looking ugly out there right now.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.