The long road back

The stock market has rallied strongly since March, and this has a lot of investors feeling optimistic again.

A lot of the numbers touted by the press (with Wall Street’s careful nudging) foster this cycle of optimism. For example, the S&P 500, on a price-only basis, is up 56% from its ominous intra-day bottom of $666.79 (March 6, 2009). 56% sounds very impressive, indeed!

But, the context of that 56% number is important. If you bought a company for $100 a share and it fell to $1 (99% decline), and then rallied to $1.56 (up 56% from the bottom, but down 98% from purchase price), you’d have a 56% “gain.” Not as impressive when put that way.

The same context should be included in any analysis of the S&P’s meteoric 56% increase.

The S&P 500 peaked on 10/9/2007 at $1,565.15. That means, on a price-only basis, the S&P 500 is down 34% even after it’s 56% increase. It’s not very impressive to have gained 56% when 1/3 of your wealth is still missing in action.

This is where most investors get confused because percentage changes aren’t intuitively obvious (why, oh why, do teachers spend so much time on trigonometry and calculus and so little on the math of compounding!?). Percentage changes must be put in context and looked at over longer time periods, otherwise they can give an incomplete impression and perhaps even deceive.

Let me illustrate. My clients’ growth accounts were down 24% from the end of October 2007 (the month when the market last peaked) through the end of August 2009 (including fees and dividends, consult my notes on performance for full disclosure). Down 24% sounds bad, but not when you compare it to the S&P 500 total return (includes dividends): down 31%.

Down 24% may not sound much more impressive than down 31% because they are both down a lot. But, when you’re down 24%, it takes a 32% gain to get back to breakeven; when you’re down 31%, it takes a 45% gain to get back to breakeven. It will likely take less time to climb 32% than 45%.

Stretching these number out over time illustrates why a broader context and longer time periods are important.

My clients’ growth accounts are up 5.76% since inception (4/30/05) versus down 3.30% for the S&P 500. If “big-whoopledeedoo” is your response, I don’t blame you–it might not sound impressive at first glance.

But, from a broader context, that means my clients were 9% ahead of the S&P 500 after 4 years and 4 months, and that’s worth a lot over the long run where even small out-performance adds up. 2% out-performance (which I am by no means promising) means 50% more wealth over a 20 year period. That can really make a difference.

Even with its recent climb, the market still has a long road back.

Another factor in thinking about the 56% climb is valuation–what is the market likely to do going forward? If the market were dramatically under-valued, then that 56% climb may keep going. But, what if that 56% climb started from fair value or over-valuation? Then expecting the dramatic rise to continue wouldn’t make sense.

By my calculations, the S&P 500 is very close to fair value right now. Assuming underlying growth of 3%, inflation of 3%, and a 3% dividend yield, the expected return going forward is around 9% a year. At 9% a year, it would take the market another 5+ years to climb another 56%. Just because the market has risen a lot doesn’t mean it will continue to do so.

I’m not making a market prediction. I’m just trying to illustrate that the market’s recent rise must be kept in context, must be looked at over a broader time span, and must be looked at with respect to underlying fundamentals.

Given that, the market could rise, fall or remain flat. I have no idea what it’ll do. But, it would not be reasonable to take the 56% rise and extrapolate that performance going forward.

It’s a long road back, and it’ll likely take some time to cover the distance.

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.

Selling low and buying high

Sometimes the stock market seems like a machine designed to produce regret.

When the market goes down, most people hang on until they reach a point of maximum pain and they sell. That’s when the market starts to climb back up again.

When the market goes back up, most people wait for the market to pull back (so they can “buy back in”). When the pull back doesn’t occur and the market continues to climb, they reach a point of maximum regret and buy back in. That’s when the market starts to tank again.

And so the story goes on and on over time. People end up buying at the top and selling at the bottom, en masse, because they invest using their psychological inclinations instead of their heads. That’s what allows calmer minds to make money over time.

The financial press is full of articles about those who sold at the bottom and are now regretting it and buying back in at the top. Why don’t people learn that trying to time the market doesn’t work?

This fear and regret cycle has repeated twice over the last 6 months. As the market tanked in October and November of last year, people sold at the bottom. As the market climbed out of those lows, the same people bought back in only to see the market tank again in March. Guess what happened from March to May? Rinse and repeat.

Why don’t people just accept that their psychological inclinations are almost always wrong when it comes to investing in the stock market? I don’t know. Tons of studies have shown that people make bad investing decisions using their psychological reactions. And yet they continue to do so.

The stock market will go up and down, I guarantee it. When it feels awful to hold on, you should be buying. When it feels wonderful because things are going up, you should be selling. Do almost the exact opposite of what you feel, and you’ll be a better, more successful investor.

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.

Dumbfounded

It first started to occur to me around 5 years ago that the housing market would probably crash and that it would almost certainly drag credit markets down with it along with home builders, mortgage insurers, bond insurers and several financial institutions.

But, if you had asked me 5 years ago what the Dow Jones Industrial Average (DJIA) would trade at given that:

1) 3 of the top 5 investment banks in the US would no longer be independent and the final 2 would be tottering
2) the US government would take over Fannie Mae and Freddie Mac because they were insolvent
3) the US government would own 80% of AIG’s equity because it was also insolvent

I would have said the DJIA would be at $5,000, not $11,388.

What color is the sky in most investors’ world? Does anyone really believe all these bailouts will be cost free?

I’m dumbfounded.

Don’t get me wrong, my investors and I are doing very well both absolutely and relatively to the market.

But, isn’t the US economy entering what could be the worst recession since the early 1980’s? Isn’t government intervention on a scale not seen since the Great Depression an indication of how bad things are? Isn’t the world economy entering the first widespread slowdown in a generation?

Then, why is the market down so little?

I have no idea. In fact, I’m dumbfounded.

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.

What’s beating the market down?

A lot of things are coming together to cause the market to go down, recently.

One issue is lower earnings forecasts for the 3rd and 4th quarter. Companies reporting 2nd quarter earnings are saying things don’t look that great for the rest of the year. This is knocking down stock prices. As investors optimistically begin to look forward to 2009 this fall, I expect the stock market to rally.

Another issue is uncertainty over upcoming elections. Markets hate uncertainty, and until it becomes clear who will win upcoming elections (both Presidential and Congressional) and what those elected will do, the market will do poorly. As that uncertainty clears up this fall, I expect the stock market to recover.

A third issue is the housing market. Housing inventories are very high, home sales volumes are low, and home prices continue to decline. Not only is housing an important part of our economy, it’s also a major part of most consumers’ wealth. Depressed consumers spend less, and that is reducing stock prices. When the housing market shows concrete signs of recovering, and I have no idea when that will happen (although I’m guessing late this year or early next), I expect the stock market to resume its climb.

A fourth issue, strongly related to the third, is the financial services sector. Banks are seeing their loans to consumers and businesses sour. At the same time, consumers and businesses need the money they put with banks as deposits to cover their needs as the economy slows. This perfect storm is hurting banks in a major way. After the housing market, and thus consumers and businesses, begin to recover, so will the banks.

A fifth issue is energy prices. Although energy prices have pulled back, no one is certain whether they will continue down or climb again. My guess is that high energy prices have both brought more supply online and reduced demand, so I expect energy prices to continue to decline in the short run. If such a decline becomes more clear, I think the market will rebound.

The way I see it, there are both short and long term issues at hand.

One short term issue is the market’s transition from looking at 3rd and 4th quarter earnings to looking forward to 2009 earnings. Another short term issue is election season. Those two issues are relatively easy to predict and should tend to lift market prices some time this fall.

Two long term issues are the housing market and financial services sectors. I don’t know when these two will recover, but when they do it will be a major and longer term lift to market prices.

Energy is both a short and long term issue. In the short run, I believe energy prices will come down and tend to support the economy and market prices, especially this fall. In the long run, I don’t believe it will be easy to find supply to keep up with growing demand, and higher energy prices will tend to undercut the economy and market prices. This dynamic is very difficult to predict.

I expect market prices to continue to decline into early fall, as investors focus on current economic conditions and election uncertainty. Such a decline will be tempered by declining energy prices and accelerated by rising energy prices.

In the longer run, the market will not begin a long term climb until the conditions in the housing market and financial sector improve. I can’t predict when this will happen, but it may happen this fall or some time next year.

In the much longer term, as the economy recovers and demand picks up, so will energy prices. This will dampen the market’s rally to some degree.

Although I don’t use market predictions to time the market, I believe an understanding of market dynamics are useful for investors who are trying to understand what is happening and when it will improve.

The best time to buy is when things look terrible, and the best time to sell is when things look great. Whether the market rallies this fall, next year, or 3 years from now, I believe this is a 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.