After a financial crisis, recessions are worse than average

Not all recessions are the same. Most recessions are a manifestation of the business cycle. But, when a recession is the result of a crisis in the financial sector, things get much worse.

What does that mean for investors? It means this is a once or twice in a lifetime opportunity to buy equities at very low prices. This opportunity may exist for some time, but trying to predict when markets will recover is a losing proposition. Get invested now and keep some cash on hand in case things get significantly worse.

A recent paper by Carmen Reinhart and Kenneth Rogoff, called “The Aftermath of Financial Crises,” provides support for the view that recessions following a financial crisis are worse than average.

In their paper, they show that asset markets collapse more deeply and for a longer time period. Real (after inflation) housing prices collapse an average of 35% over 6 years. Equity prices collapse by 55% over 3 1/2 years. Unemployment rises an average of 7% over 4 years. Output falls 9% over 2 years. The real value of government debt explodes.

The average recession lasts 10 months. Using that average, we would have come out of this recession last October because we entered it in December of 2007. As I’m sure you know by now, that didn’t happen. In fact, the recession hit high gear around that time.

Averages are not a proper expectation for what will happen. If you stuck your head in an oven and your feet in a freezer, your average temperature would be comfortable, but I guarantee you’d be miserable. Averages can be deceiving and misused.

But, averages can be useful for gauging what could happen. My intention here is to prepare you for the downside and how rough this ride will be, not to predict what will happen or when.

Asset markets have been down around 40%, so getting to down 55% would require another 25% decline from the down 40% level. I wouldn’t be surprised to see markets go significantly lower, but that’s impossible to predict. A decline to the 55% level, or even the 90% level like the Great Depression, is likely to be very short lived. The best thing to do is be prepared for the downside while acknowledging that the upside for equities from here is extraordinarily good. Try to pick the bottom is a fool’s errand.

We’re only a year and a half into the housing price decline, but this market was unusually over-valued at the top, so I expect it to end up more than 35% down. I also wouldn’t be surprised to see this last shorter than it has historically because of how rapidly it declined and how actively the government is intervening.

Unemployment bottomed around 4.4%, so it would have to get over 11% to reach historical average. The rate is around 7.2% currently, so we are well on our way there. Remember, unemployment is a lagging indicator. It will almost certainly hit its peak long after the markets and economy are recovering.

Output has only started to fall, and getting to the down 9% level will be painful. Like with employment, this will be a lagging indicator. By the time we see it recovering, markets will almost certainly be up significantly.

Government debt is already ballooning and will continue to do so. Government officials are already calling for a $1.2 trillion deficit this year, and that is only the tip of the iceberg. When an institution issues a lot of debt, even the U.S. government, their cost of debt will go up. Be prepared for higher interest rates and inflation. This may take years to develop, but when it does it will be truly life-changing.

Recessions following financial crises are deeper and longer lasting than average. It looks like we’re in such a situation. Be prepared for the downside. Be prepared for a lot of negative news going forward. But, most importantly, get invested to take advantage of the recovery and be prepared for even lower prices–in case they happen–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.

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.

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.

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.

Jeremy Grantham “has almost never been this dire”

Jeremy Grantham heads one of the best quantitative, value-oriented firms out there, Grantham Mayo and Van Otterloo (referred to as GMO for short). In his quarterly letter (www.gmo.com, you have to register to read their letters, but it’s worth it and I’ve never received a bit of unsolicited email from them), Grantham puts forward the same message he’s been delivering for some time: the market is grossly over-valued.

Grantham has been preaching this for some time, but his record in being right, though almost always early, is excellent. Heeding his words back in the late 1990’s would have saved you a lot of heart-ache if you were invested in the tech and telecom bubble.

Grantham’s theme in the past focused on a reversion to the mean of corporate profit margins. In this letter, he doesn’t spend much time on that subject, but he does take private equity, corporate tax rates, global financial markets, subprime mortgages, etc. to task. He simply sees too much risk taking out there and predicts it will end poorly.

I’ll just quote Grantham here because he says it best, “To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.”

Wow, that’s quite a prediction!

He goes on to say, “I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.”

He’s not mincing words there, either.

What’s his suggested solution? In a word, “anti-risk.” He doesn’t take much time explaining what that means, but I think I can guess. Some investements will do a lot better than others if or when risk becomes a four-letter-word again. That may include shorting the market, buying commodities or gold, buying Treasury securities, or finding business managers who can benefit greatly in a market situation characterized by a lot of risk aversion.

In this last category, I’d put companies like Berkshire Hathaway, Leucadia and Fairfax Financial, companies that have a lot of cash on hand or are short the market and are waiting for a risk averse market to put their money to work. In the interest of full disclosure, I own positions in all three of these companies both personally and for clients.

A more risk averse market like we are facing usually scares people to death. In contrast, I see such situations as golden opportunities to buy when blood is running in the streets. In addition, I’ve purchased securities that I believe will do well even if the market does fair poorly.

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.

Will China Tank?

The Chinese stock market has been on a tear over the last 2 1/2 years. My question is: how long will it last?

The Chinese economy has been growing at over 10% for many years, so the fundamentals seem strong. But, has any market gone straight up without temporary setbacks along the way? Not that I know of.

Chinese investors have been piling into the market any way they can. Some are even borrowing against their homes to participate in the frenzy. Does that type of mania end well?

In addition, China is not fully a market economy, and it’s still run by a communist party which doesn’t fully recognize human rights, much less voting rights. And those government folks are trying like crazy to slow down the stock market now. Do you think they’ll just give up and join the party? Not likely.

Timing the market seems like a fools errand to me, but markets in that type of frenzy seldom end well. I’m neither long nor short Chinese stocks, but after the 10% drop in the Chinese stock market last February, I can’t help but wonder how the Chinese stock market may impact other world markets. I don’t know when, but at some point, we’ll find out.

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.