Economic Forecast - Do Not Panic!

For the twenty year period ending on 12/31/2010, individual equity investors earned an average annualized return of 3.83% while the S&P 500 returned 9.14% (1). For a $100k initial investment, this is the difference between having $212k and $575k at the end of that period. The explanation for this divergence is simple: typically individual investors buy and sell equities at the exact wrong time. While we can not say for sure that we have reached the bottom of the market, we believe that now is a bad time to be selling equities.

Famed investor Benjamin Graham noted, "In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand." We take great pride at Weston Financial in knowing our clients and understanding their individual cash flow needs. Your asset allocation was carefully constructed to meet your personal financial goals, with equities representing the long-term investment bucket. As demonstrated in the below chart, we believe that when viewed as a long-term investment, equities are a strong component of a client's portfolio (the below chart shows the best and worst stock market performance over increasing time frames from 1950 through 2010):

Source: JP Morgan Guide to the Markets

As demonstrated above, the longer the time frame, the more predictable equity returns become. We believe that building portfolios based on time-frames has served our clients well during many volatile market cycles over the past thirty years. Therefore, we feel that Graham's prerequisites of investing - knowledge and judgment - are in place. If we add in a dose of courage, we believe that clients will ultimately reap the benefit of equity investing and not be left behind like the majority of those who try to time the market.

In this edition of the Weston Observer, we will discuss the factors influencing the market and explain the ongoing battle between the extremes in fear and uncertainty versus the extremes in valuations.

Fear and Uncertainy:

The largest factor influencing the downward movement of the markets is the Euro-Debt situation. We continue to believe that Greece has an unsustainable debt burden that will only be rectified through the write-down of debt or a bailout. The key for the European Union is to build a firewall around Greece so that the issues do not spread. Greece is a small economy with a relatively small debt burden, which by itself should not have large negative implications on the global economy.

However, the situation in Greece has had a spill-over effect beyond its borders. The capital markets now perceive a higher risk of default with other European sovereign debt, which has driven up the borrowing costs for countries like Italy, Spain, Ireland and Portugal. Due to the higher borrowing costs, Fitch recently downgraded Spain's credit rating from AA+ to AA- and Italy from AA- to A+. If Greece has a disorderly default, this problem could be exacerbated. The borrowing costs of many European nations are disturbingly high, as shown in the below chart:

Sources: Yield Data from the European Central Bank as of October 12th. Credit ratings from Fitch.

There have been positive developments in providing liquidity to these nations. Governments around the world, including China's, Japan's and the United States' have indicated a willingness to buy European debt. Additionally, the Euro-Zone has agreed to increase the European Financial Stability Fund (EFSF), which has already provided liquidity to Greece, Ireland and Portugal, from approximately €440 billion to €780 billion. While many analysts believe this Fund is still too small to put a floor under larger nations, such as Italy and Spain, its increase is a step in the right direction.

European banks have also been negatively impacted by the higher perceived risk of the European sovereign debt. For years the European banks have bolstered their balance sheets with European sovereign debt that they considered safe investments. This is very similar to American banks bolstering their balance sheets with mortgage backed securities prior to 2008. Now that cracks are showing in the credit-worthiness of the sovereign debt, the balance sheets of these banks are being questioned. This stress has been seen in the borrowing rates between European banks. The Euribor-OIS spread is a measure of the premium that European banks charge one another to borrow funds compared to prevailing rates. The Euribor-OIS spread peaked at 0.83% on September 23rd, which was the highest spread since the beginning of 2009. While this Euribor-OIS spread remains well below the panic level recorded after Lehman Brothers collapsed in 2008, when it spiked to over 5%, it has reached a level that is beginning to raise concern.

While politicians in Europe (as well as at home) have given us reason to doubt their effectiveness in tackling complex issues, we believe that a reasonable solution will be reached to quell the Euro-Debt fears. The European Union has sufficient resources, but there have been ongoing questions on their willingness to take the difficult steps necessary to solve this problem. However, the European politicians have already seen this act play out in the United States in 2008 and it is very difficult to imagine that they would allow history to repeat itself. No matter how expensive this ordeal becomes, they are aware that the costs of inaction are considerably more expensive than the costs of action. Thus, we believe that in the end the European Union will take the necessary steps to restore confidence back into the credit worthiness of European sovereign debt.

Update: On October 27th the European Union struck a significant deal that accomplished the following:

• A 50% write-down of Greek debt for private bond-holders
• A new financing program with the International Monetary Fund for €100 billion
• Leveraging the EFSF to approximately €1 trillion and supplementing that Fund with special investment vehicles, which will be open to private investors and sovereign wealth funds
• Requiring European banks to raise capital reserves to 9% by June 2012

Fear of Recession - 

 

The risk of recession in the United States has added additional fear to the equity markets. Economic data continues to show sluggish growth and little improvement in the unemployment rate. Political risks as well as dropping consumer confidence are the primary reasons stated for this increased risk of recession. Weston Financial agrees that both of these issues are threats to the economic recovery. However, to date we have seen few signs of deterioration in the recovery.

Cyclical industries typically push the United States into recession. In a typical economic cycle, these industries will ramp up production to meet growing demand. As this demand ultimately slows, companies have excess slack, including high levels of employment and inventory. This slack needs to be absorbed through slower production and layoffs, which potentially creates a recession. This recovery has been different as we have not seen periods of high demand in the cyclical sectors. For example, the housing industry is the largest cyclical industry and a reduction in housing starts is generally a sign of a slow-down in the economy. However, housing starts have been bouncing along the bottom and have seen very little recovery from the 2008 collapse. Therefore, there is very little ground for the housing industry to lose. In general corporations are running very lean with low levels of inventory and employment. This makes it less likely that a recession is imminent. In fact, many of these cyclical industries, including auto sales and capital goods orders, have shown increased demand in the 3rd quarter.
 

Opportunity:
 

After discussing the risks present in the economy, now is probably a good time to remind you of Benjamin Graham's required ingredients for successful long-term investing; adequate knowledge, tested judgment and courage. The prevailing risks in the market are prime examples of why courage is needed to withstand the downturns in the market and execute a long-term financial plan. But there is a more concrete reason not to sell equities today - they are historically cheap.

JP Morgan introduced a statistic called the lagged P/E ratio, which compares the value of all U.S. equities to their after-tax corporate profits over the previous 12-months. Their findings were as follows:

Source: JP Morgan Guide to the Markets

Bloomberg did a similar study and found that even if earnings fell by 12% next year, which is the average drop in earnings during the last nine recessions, then the September 30th value of the S&P 500 Index would be trading at a 12.9x the forward looking multiple. This is notably cheaper than the average price to earnings multiple during past economic recessions (13.7x forward looking earnings) (2).

Comparing the S&P 500 Index to Treasury Bonds makes an even more compelling argument to invest in equities. The earnings yield for the S&P 500 Index is 9.80% (the inverse of price to earnings) compared to the10-year Treasury yield at 1.92% as of September 30th. This represents a spread of 7.88%. The volatility of equities suggests that there should be a risk premium for investing in stocks. However, historically a spread wider than 6% would indicate significant relative cheapness in equities. The current spread of 7.88% would suggest historical cheapness relative to Treasuries.

These extremes in valuation are not surprising based on the pervasive fear in the markets. We are not far removed from the events of 2008 and investors' appetite for risk is low. However, this fear has created the potential for a significant valuation bounce. We believe that the depressed valuations have been caused mostly by the fear of the Euro-Debt contagion and therefore positive developments in Europe could offer a quick and substantial boost to the markets.
 

Recommendations:

The number one recommendation at this time is not to panic. We do not know the timing of when equities will recover their recent losses, but history suggests that they will. While downside risks remain, we believe that the upside potential of the market is substantial and attempting to time the markets will likely result in missed opportunities.

Warren Buffett's quote "Be fearful when others are greedy and greedy when others are fearful" is an appropriate citation for the current market conditions. However, unlike Mr. Buffett, few of us have tens of billions of dollars of cash sitting on the sideline to invest during these difficult times. Therefore, simply holding onto the equities that you have is likely more apropos for most clients. If we combine Mr. Buffett's wisdom with Mr. Graham's advice, perhaps "be courageous when others are fearful" may be a more appropriate recommendation. Nevertheless, for clients with cash, we do believe that now is an appropriate time to implement a dollar cost average strategy. Furthermore, we recommend that clients continue to invest savings into 401(k) plans and other investment portfolios.

We believe that if fear does subside, most risk assets will perform well. Equities are our most favored risk class at this time. As shown in the below chart, all equities are cheap relative to their 10-year average:

Source: JP Morgan Guide to the Markets

We recommend U.S. equities on a risk/reward basis as compared to the developed international sector, which has significant exposure to Europe. European equities not only have more exposure to the European Debt Crisis, but the European economy appears to be in worse shape than the economy in the United States. Furthermore, while emerging market equities are closest in valuation to their 10-year average, we feel that the long-term growth prospects of the emerging economies and their isolation from many of the problems that are hampering the developed economies warrant a continued allocation. Within U.S. equities, we continue to recommend large cap equities over small cap stocks.

For clients looking for assets with risk profiles that have historically been less risky than equities, high yield and convertible bonds currently look attractive. Another recommended strategy, which is likely less familiar to clients, is an option hedged portfolio. These strategies typically buy a portfolio of equities, sell an index call option, and buy index put options. Selling call options can produce additional income, but will also limit upside potential. Call options become more valuable as volatility increases, which may result in additional income for this strategy. Therefore, the recent spike in volatility makes these types of strategies more appealing. Purchasing the put option should reduce the downside potential of the strategy. The option hedge strategy will likely still lose value in a decreasing market, but it should provide more stability than equities, and add an additional income return element.

Please do not hesitate to call if you wish to discuss anything mentioned in this report.

Update: Please note that October has been a strong month for global stock markets. The recent recovery in equities does not change our overall view that stocks remain under-valued. However, equities also remain fraught with risk, and volatility will likely remain at an elevated level. The velocity of the recovery over the past few weeks is a clear reminder of why timing the markets is such a dangerous game. Overall, we believe that a thoughtful, long-term plan that is not subject to the emotions of the market is the only way to invest in volatile assets.

Footnotes:

(1) Dalbar, Investors Can Manage Psyche to Capture Alpha, April 1, 2011
(2) Bloomberg, S&P Valuations Below Average Recession Level, October 3, 2011

The views expressed here are those of Weston Financial Group, Inc. and are subject to change based on market and other conditions. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is neither representation nor warranty as to the current accuracy of such information, nor liability for decisions based on such information. Past performance is not a guarantee of future results.

It is important to remember that investing entails risk. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. The value of a portfolio will fluctuate based on market conditions and the value of the underlying securities. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio.

All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice.

You can also read past editions of the Weston Observer by going to the Suggested Reading Section on our web site.