I’ve Fallen…And I Can’t Get Up

March 5, 2009

As of Monday, March 2nd the S&P 500 is already down about 22%, including dividends, in 2009 – more than half of 2008’s loss of 37%. The market is now down over 50% from the peak in late 2007.

We used this downward spiral to make some more changes to the portfolio, detailed in our portfolio commentaries a few days ago. The goal of this trade was to sell our successful inverse commodities ETF (after an over 300% return), cut back on some recently added closed-end funds that are no longer a bargain, and to increase our overall stock allocation slightly.

This is not our last move up the down market. We could see our stock allocation increase significantly in our more conservative portfolios if the market continues to fall and hits S&P 500 levels last seen in the mid 1980s instead of just the 1990s. Don’t laugh (or cry). It’s possible.

On a plus side, stocks are now officially cheap. The trouble is, that value could quickly evaporate if the economy goes into a true Depression-like death spiral. It’s worth noting that in the last real depression the GDP dropped around 25% adjusting for inflation, but fell closer to 50% in current dollars. This is like the current GDP going from 14.2 trillion to around 7 trillion. It may not seem like a 50% slide when you adjust for a huge drop in prices (we had massive deflation in the Great Depression) but stocks more closely follow nominal GDP than real GDP, which partially explains the near 90% wipeout in the Dow from the peak in 1929 until 1933. The other explanation was the massive run-up in stocks in the years immediately preceding the crash, something we didn’t see before this crash but did see before the 2000 crash.

While the market has plenty of upside for the next 10 years from the S&P 500 below 700 and the Dow below 7,000, it is entirely possible that this could be the once-in-a-lifetime market event that truly destroys wealth and the business of wealth management. In our opinion, there were too many fund companies, exchange-traded funds, private equity firms, venture capitalists, hedge funds, and other brilliant money management companies appearing on the scene during the last 30 years of largely up markets. Something had to clean all the fee collectors out of mix, and a 50%-80% correction in asset prices could do the trick. 

The negatives are largely fear itself at this point. The economy and stocks are going to exist on confidence for the next few years, and it is a variable that is difficult to manipulate this late in the collapse of confidence, even with trillions of dollars stimulus. 

One reason we may not be at the absolute bottom – the Shangri-La for contrarian investors like ourselves – is fund investors are still adding money when the market seems to rebound, as they did in January (just in time to lose big in the following few weeks). We would still like to see a mega liquidation of perhaps even $200 billion or more in a month by fund investors for us to put all our chips in.

On a quite positive note, doomsaying is now a growth industry, a sure sign close to a bottom. Harry Dent Jr, futurist and publisher of The Roaring 2000s (Oops) recently penned the The Depression Ahead. Apparently these people are optimistic at Dow 14,000, pessimistic at Dow 7,000. Go figure. Making money from hot sellers is a rare feat. Even Peter Schiff’s timely book, Crash Proof  should be called Crash Prone when you consider his actual advice of buying foreign stocks and precious metal mining shares was a recipe to underperform the S&P 500 since the peak, a problem noted in a recent Wall Street Journal article.

You could make a fortune doing the opposite of successful investment books. If Dow 36,000 was a good sell signal, consider “Hot Commodities” as another. All these depression scenario books mean investing for a depression is not much of an idea going forward.

What is likely happening is the stock market (and housing market) is returning to low valuations. Over much of the last three decades stocks have had elevated valuations – relative to book value, earnings, sales, GDP what have you. This was the anomaly. Through most of recorded investment history stocks were cheap, like they are now. 

Mathematically stocks have historically been probably a little too cheap, but this is why investors earned roughly 11% a year in stocks. Expensive investments lead to poor returns. Cheap investments yield solid returns. Over the last 30 years investing has become too popular – everybody was in on the game, with thousands of intermediaries offering their expert advice and products for a fee. 

In theory stocks should be more expensive. They grow earnings and dividends, they can get bought out or merge at higher prices, are good long-term inflation hedges, and generally outperform all other investments (until everybody realizes how great stocks are like in 2000 and then you have a decade of destruction). 

What is wrong with this theoretical valuation model for stocks – promoted in the last bubble by Dow 36,000 and Harry Dent, and in the more recent bubble by experts like economist Jeremy Siegel, Ph.D in  The Bullish Case for Stocks? The problem is the economy is risky and susceptible to panic. Moreover, there are outright frauds that scare investors, and sometimes companies do such flagrantly stupid things that they can wipe out a 100+ year old institutions in a few months. Sometimes the hardest hit companies will start out looking cheap with low P/E ratios and high dividend yields. 

Throughout much of our nation’s investing history people were scared of stocks (and to a lesser extent real estate). Gradually their fears subsided to the point where stocks and homes got expensive. Most professionals will tell you real estate is low risk/high return, and that over time buying always beats renting. The same economists recommending stocks in 2007 will tell you real estate wasn’t overpriced in 2005 Housing Still Has Sturdy Foundation

The great mistake is that real estate may be a better deal than renting over a lifetime at almost any price, but in the real world there are a number of risks that may make homeowners sell at inopportune times at prices 10-50% below where they should theoretically be. This ‘chaos’ risk means some caution should apply and homes should be cheaper then they mathematically are worth to reward taking on this risk. Stocks can be equally destructive. There are now scores of retirees who just took 50%-70% hits to their all-stock portfolio because stocks supposedly were always the smart move at any price.

The correct answer is somewhere in the middle of irrational exuberance and irrational pessimism towards investing. We recently passed through this middle ground in valuations and may be on the express train to irrationally cheap valuations. From here on down it doesn’t matter when you get in, if you have the time you will be rewarded – though the same risk of losing significant money in the short-run applies.

Why then didn’t we hold off and go all cash in 2007 rather than buy on the way down? Sure we fell much less than the S&P 500, but we still fell. The answer is we could have remained at elevated valuations for the next 30 years, all the while complaining about prices and earning nothing after taxes in cash. The only solution in our opinion is to be conservative near the top and aggressive near the bottom, since you never know exactly when this means you will lose some money on the way down.

This current environment could scare investors out of the market for ‘the long run’. We should now enter a period of a decade or more of valuations on the lower side of history. The game is about to get a whole lot more rewarding now that others are quitting or just have less money to invest. We are more excited about the potential future returns than at any time since the lows in 2002.