 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
|
To Clients and Friends: Given the ongoing market turmoil and the stress we are all experiencing, we want to share our views and responses to common concerns that everyone has regarding the recent market downturn. We trust that you will find this helpful, and we encourage you to call us if you have questions. How Low Might The Stock Market Go? In an emotionally driven market there is no way to know for sure. When greed was out of control, the popular stock market averages (e.g. the S&P 500) went far beyond what rational analysis would have forecasted. We must be cognizant of the possibility that the same irrationality can work on the downside. The trouble is that emotion is not so easy to analyze. And just as there were optimistic analysts who stepped forward to defend even higher stock levels, there are now pessimistic analysts making the case in support of much lower levels. That they are there making the case doesn't make them right. As for us, we are more comfortable analyzing economic fundamentals than assessing market psychology. So, in attempting to provide some perspective on this question, our approach is to make historical comparisons of several types of data in order to provide a frame of reference. Valuations: As we write this on Tuesday July 22nd, our basic valuation model suggests stocks are 53% undervalued. At the end of the last big bear market (1973 and 1974), stocks bottomed at a 55% undervalued level. We also took a look at the Fed's stock valuation model. It currently shows the stock market as 36% undervalued, exactly where the 73/74 bear market ended. Absolute Decline: As we write this on Tuesday, the S&P 500 Index has declined by 47% on a price basis. During the 73/74 bear market, the S&P 500 dropped by 48% (but it did have a higher dividend yield). Before that, it was the 1930's depression period when we last saw declines larger than the current decline in the S&P. As you know the NASDAQ has fared worse and is now down 75%. Length of Decline: The current bear market started two years and four months ago. That makes it longer than any U.S. bear market since the depression years. Technical Factors: We do not rely on technical analysis in our decision-making. However, it is true that the end of most bear markets is characterized by large declines on very high trading volume. On Friday, July 19, the market was down big on very high volume and on Monday it was also down on high volume. How low might the market go? We can't say for sure but by all the above measures we can argue that this bear market should be nearing an end. Moreover, it's true that the overvaluation was at a record level suggesting the possibility of an equally strong overreaction on the downside. We can't say with certainty that stocks won't decline and become even more undervalued. Nevertheless, valuation levels are now attractive based on our analysis. There Is So Much Bad News Out There - Isn't It Possible That This Bear Will Be Much Worse Than In 73/74? This bear market is now within a whisper of surpassing '73/74 so at this point we'd say there is a good chance it could be worse, at least for the S&P 500. The real worry is whether it will be much worse. Again, we can't say for sure. But the fact that there is lots of fear based on real problems (economic risks and the terrorism wildcard) doesn't necessarily foreshadow much more downside. Remember, bear markets end at the point of maximum pessimism, when fear is greatest. And at a bottom it will always feel like the stock market is about to drop another 20%. Doom and gloomers will get lots of exposure in the media. Remembering 1974 is useful. We had Watergate and Nixon's resignation, the Middle East oil embargo, surging inflation and recession and a discredited Fed that all combined to create a massive pessimism. A Business Week writer wrote in the 9/14/74 issue "…the flight of individual investors and the breakdown of the markets foreshadows the end of the capitalistic system as we have known it." (During the fourth quarter of 1974 the stock market delivered a positive return and the bear was over.) Certainly it is possible the pummeling could intensify even more. One of the worst-case scenarios we can imagine would involve a reversal in the housing market, consumers cutting back on spending and businesses holding off on new capital investments, all contributing to a debt-induced deflationary period which would justify even lower stock prices. But that does not seem to be a high probability outcome. The banking system is very healthy given where we are in the economic cycle, loan delinquency rates are not high and corporate profits are recovering. There are always risks that could result in temporary losses in the stock market. But in bear markets investors tend to see the glass as half empty just as they see it as half full in bull markets. What should we take from all this? When stocks were in a bubble we resisted greed-driven thinking and instead focused on rational analysis of valuations and underlying economic fundamentals in each asset class. Similarly, we are now resisting fear-driven thinking and focusing on the same rational analysis of valuations and underlying economic fundamentals. If there is one thing that we can say we always believe, it is that this approach pays off in the long-term. Prepare yourself as best as you can - if we don't see a turnaround in the next week or so, your July statements are likely to show meaningful declines. We are sensitive to your fears but want to remind you that when we're finally at a bottom it will still feel like the worst is yet to come. We may be pushing up against our defined loss thresholds. We've never guaranteed our ability to protect against violating these thresholds. We've believed that it would probably take a secular bear market to push us up and past our risk limits. Now this may happen, so we must warn you of the possibility. We are hopeful that we will see a rebound before the end of the year and that for the full year we will avoid violating risk limits. The tough thing about the risk threshold is that in a scary market like this one, the point where we get close to our thresholds is also likely to be close to the point at which we reach a bottom. With some of our portfolios nearing their risk thresholds, are we contemplating changes? We are always thinking about many options and there are other possible strategies we may employ. However, no new asset classes are on the verge of being added and the biggest driver of change in the near-term is likely to be the stock market. If it declines much more it may become so attractive that we will have to shift money from other asset classes back into stock funds. Now is not the time to be selling stock funds. Remember Having said all of the foregoing, remember that there are some positive considerations:
The most frustrating times lead to the best results. The economist H.S. Dent observed that "Our human tendencies cause us to perceive low risk near market tops when risk is greatest and high risk at market bottoms when risk is lowest." Consider that many investors who were anxious to buy shares when the NASDAQ was at 5000 are now concerned that the index is too expensive at 1300. From a historical, valuation, and sentiment basis, the market is sending a clear signal to invest now. When the disconnect between the improving economy and market psychology ends, a major buying opportunity will have passed. Now may be a good time to begin investing cash.
We are confident
that we will be rewarded for staying the course. That being said,
we may be in for a volatile next few months and we encourage you
to call us if you have any questions regarding your portfolio and/or
our most recent market outlook. Very truly yours, ZRC Financial
Services, LLC By:
|
About Us | Investment
Philosophy | Client
Services |
| Business Relationships | Investment Outlook | Articles of Interest | Web Resources | Why ZRC | Account Access | Contact Us |
|
