Not “All-Clear” but Not All Bad!

Tuesday’s rally was most welcome. Citgroup’s positive news is very important because it is the first pause we’ve had in a stunning, deteriorating trend. It was good news for Citi and hopeful for the rest of the banks and financials. While the media are gleeful and breathlessly suggesting DOW 20,000, the ALL-CLEAR has NOT been sounded yet. We WILL have more down days, but back and forth trading activity is necessary to build a base. We’ve pointed out many times that the1974 Bear and the 2002 Bear each made three distinct bottoms over a period of several months. We believe that this is the second leg down, that we will rally from here and have a third leg sometime later this year. So, should you buy now? Sure if you’re a long-term investor and can endure more volatility and have the strength to look at your holdings at a loss at different points in the near-term. We don’t have any idea if the market has in fact bottomed. Could it go down 20% from here? Of course. Could it go up 20% from here? Of course. Remember, 20% up takes us to about 8,500 on the DOW. Keeping in mind that we DON’T know, we find the universally negative sentiment and historically reasonable valuations as attractive.

In our last email (March 4) we broached the topic of stock valuations for long-term investors. I said that our view is that stocks are relatively attractive at today’s levels based on low P/E multiples, a 4% dividend yield (on the S&P 500), low interest rates, and a conservative assumption that it takes 10 years for S&P 500 operating earnings to get back to 2006 levels. Based on our assumptions, we said it would not be unreasonable for investors to expect a 9% total return from stocks over the long term even if we assume no multiple expansion – attractive given the current level of interest rates.

This week’s Barron’s magazine featured two articles offering further evidence that valuations are attractive at today’s levels. The cover story, entitled “Ouch That Hurt”, argues that low interest rates, extremely negative sentiment, and high levels of liquidity are three factors that could keep the market from falling to the trough P/E level of 10x experienced in the 1974, 1982 and 1987 downturns. Trough P/E multiples experienced in the 9 other bear markets since 1929 came at much higher levels. The article goes on to say that stocks are inexpensive relative to GDP, book value and gold. While none of these relationships, taken in isolation, is especially compelling, they do seem more compelling if viewed collectively.

The second article, by Gene Epstein, presents an argument that we at Farr, Miller & Washington have always supported: “The historical record shows that for 20- and 30-year periods, inflation-adjusted returns on stocks have never been negative.” In other words, if you take any 20- or 30-year period since 1871, returns on stocks were positive in every case even after subtracting inflation. Epstein goes on to say, “With this consistently strong performance over long periods, it stands to reason that below-par returns over five- and 10-year intervals would tend to be followed by much better results over the subsequent five- and ten-year intervals.” Given that returns on stocks over the past five- and ten-year periods have been negative, it is reasonable to assume the next five- to ten-years will be solidly positive. In fact, this is precisely what the data show. After examining the worst-performing quartile of 10-year stretches since 1971, Siegel found that the subsequent 10-year periods, without exception, produced positive returns with a median annual total return of 8.17% (adjusted for inflation). And finally, Siegal provides data comparing long-term returns on Treasuries to long-term returns on stocks. “Assuming buy-and-hold strategies in Treasuries over 20- and 30-year intervals, how often did the inflation-adjusted income and possible capital gains from bonds prove superior to the returns on stocks? Answer: Through 2008, stocks have always done better than Treasury bonds over 30-year periods. And over 20-year periods, stocks bested Treasuries in all but a little over 5% of the cases.”

Importantly, Epstein also makes the point that trying to time the markets is an exercise in futility. Investors should not only buy, but also sell stocks over time to finance their retirement. Those of you that know me have probably heard me use the phrase “do what feels bad.” What I mean is basically that times of crisis frequently provide us with the best opportunity to buy stocks, and times of euphoria have often proven to be the best times to sell. While I recognize that this rule in and of itself seems like a timing strategy, my best advice to the novice investor is to smooth out purchases and sales using a methodical process. Moreover, given today’s valuations and widespread negative sentiment, we believe those fleeing the market altogether will ultimately look back on a mistake. As Warren Buffett says, “beware the investment activity that produces applause; the great moves are usually greeted by yawns.” This could be roughly translated as “buy low and sell high.”

Our view at Farr, Miller & Washington is simply that the overwhelming majority of evidence suggests that investment in stocks over long time horizons is the best way for individuals to meet their financials goals. In fact, we would go far as to say that investing in stocks is a NECESSARY component of an investment strategy for many people to succeed in realizing their retirement goals. Essentially, as Epstein points out, an investment in stocks represents an investment in the growth of the US economy. We do not believe the US economy is dead, but rather believe that the country’s best days are ahead. In this, we agree with Warren Buffett.

Hang in there.