Monday, June 7, 2010

Fear of the Unknown

The March-May quarter first appeared to be a period of growth when suddenly sentiment of professional traders, hedge funds, and institutional investors turned 180 degrees from very optimistic to very negative. This shift fed on itself, leading to the dramatic one month drop of 8.2% in the S&P500 and an 11.8% fall in the MSCI World Index. May produced the worst drop of the DOW JONES Index since 1940. The S&P500 drop was the worst since 1962.

The big question: What comes next?

I have written that “It is important for “investors” to weigh in the balance the opposing risks of being too conservative versus the risk of a possible short term decline.” and “Market action since August has been driven by trading rather than investing---Market action is dominated by “traders” who bid up prices and sell quickly.” as well as “There is still a tremendous amount of cash on the sidelines.” All of these statements still apply.

Nobody knows, with certainty, what markets will do in the short term. Short term movements tend to be based on emotion versus logic. Rather than a certainty that markets are likely to fall, there seems to be general feeling by traders of “let’s wait and see”. In other words this is a period of significant risk for short term investors and a time that requires patience and commitment for longer term investors.

Nothing illustrates this market “nervousness” and the markets moving from fear to greed and back to fear again, better than action during the first week of June. Based on comments from our President that employment was improving, the DOW rose 285 points Wednesday and Thursday, falling back by 323 points on Friday after it was reported that most of the employment “improvement” was temporary government census workers.

I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time. Continue to diligently monitor the situation, searching for any such indication.

On the other hand, there are significant indications of a very oversold market situation. Many estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or an 8.8% increase from the end of May level. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)

The most important thing for investors to consider is not what the S&P500 will be in 2010, but rather, what will it be in 2015. The important questions are: “If markets drop, are they likely to recover within 12-18 months?” and “Are we on track to achieve annualized returns of 8-12% over the next five years?” as well as “How should my portfolio be positioned to achieve my long term financial goals?”

A word about Europe..the “worldwide financial crisis” started in 2007-2008 as a result of a fear that high levels of debt would result in defaults and huge losses by lending institutions—leading to a decline in economic activity. This fear subsided in part because of an expansionary monetary and fiscal policy implemented by governments all over the world. Because of the unique structure of Europe’s monetary policy, it became unclear how Europe could sustain the expansionary fiscal policy of government deficits. And, almost simultaneously, because the policy worked so well in the US and China, fears surfaced that these governments might also move to a less expansionary policy in order to alleviate risks of inflation. This caused a nearly perfect storm of fear—not fear of the known, but fear of the unknown.

Is Europe going to reduce fiscal stimulus, perhaps even causing an economic slowdown as they cut government spending and deficits? Will this cause an economic slowdown everywhere, causing the dreaded “double dip”? Well, that is the question that is causing the fear and uncertainty.

First, will a reduction in deficit spending in Europe cause an economic slowdown? By itself, this is probable, but when it is considered that the Euro is likely to have fallen by 15-20%, it is not so probable. Consider that every enterprise in Europe is now 15-20% more competitive—this is a large off-setting stimulus.

Second, will a more competitive Europe mean less economic growth in the US and China? This is probable. On the other hand, with a more competitive Europe, selling to the US for lower prices, it is likely that the US will be able to sustain it’s expansionary monetary policy for a longer period.

When traders and gamblers are fearful and uncertain, predicting the “bottom” or the lowest point that markets reach is a futile exercise—it is unknowable.

Prudent portfolio management in periods like this is a bit like sailing a ship in the middle of the North Atlantic during a weather storm. It is seldom wise to return to port and abandon the long term plan of the voyage. It is wise however to be increasingly vigilant to ascertain if any adjustments to the course or rigging may be prudent…and increasingly vigilant for evidence of any new approaching storm.

I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time.

What comes next?

My best estimate at this time: (subject to change with changing conditions.) In the near term expect very high levels of uncertainty and therefore volatility. Be prepared for 2-3% changes in market levels---daily. Be prepared for short term declines in reaction to bad headlines. Longer term: (barring an unexpected geopolitical event) A) The global economy and corporate profits will rise, albeit at a slower rate than in previous expansions—Market prices will rise accordingly; B) The retirement of debt will be a drag on economic growth; C) Global commerce will increase; and D) Inflation, taxes and interest rates are ALL likely to rise. In my opinion, the best thing to own: a very diversified, income producing portfolio of worldwide stocks and intermediate term bonds issued by “solid” entities/companies that gain from such an environment—with “enough” cash to cover your short term needs.

I continue to advise a cautiously optimistic outlook, being alert and staying prepared for opportunities as well as risks. This means a diversified portfolio consistent with your long term goals and sufficient cash/income to insure that good quality investments do not need to be liquidated at low prices.

Considering that a 44% rise in the market would be required, to get back to the October 2007 “peak” levels, there is a lot of room for markets to rise—moving toward a “fully invested” status between now and September is probably advisable for long term investors with a normal risk tolerance. (Those with a lower tolerance for short term risk and market fluctuation are advised to hold a higher than normal cash level.)

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.