Investment Postcards from Cape Town

Stock market movements over the past few months have been characterized by increased volatility as uncertainty became paramount. And as new pieces of the economics puzzle are added every day, investors are increasingly grappling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Are we still in a bull market, or perhaps experiencing a counter-trend rally in a bear market? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with very few investors actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns. The study covered the period from 1871 to November 2007 and used the S&P 500 (and its predecessors prior to 1957). In essence, a total real return index and coinciding ten-year forward real returns were calculated and used together with PEs based on rolling average ten-year earnings.

In the first analysis the PEs and the ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

The cheapest quintile had an average PE of 8,5 with an average ten-year forward real return of 11,0% p.a., whereas the most expensive quintile had an average PE of 22,0 with an average ten-year forward real return of only 3,2% p.a.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3).

This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham’s GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Based on the above research findings, with the S&P 500 Index’s current ten-year normalized PE of 23.7 and ten-year normalized dividend yield of 1,6%, investors should be aware of the fact that the market is by historical standards not in cheap territory, arguing for luke-warm long-term returns. Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would be irrational to bank on above-average returns from these valuation levels. As a matter of fact, there is a distinct possibility of some negative returns.

It is easy to understand why Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns”.

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Global stock markets, and the US markets in particular, have displayed a large degree of volatility since the middle of last year and daily fluctuations are now back at levels last seen in 2003. This is shown clearly by the following graph of the daily change in the value of the S&P 500 Index.

Source: StockCharts.com

In the nature of stock markets, some investors seem ready to turn tail at the first sign of bad news. On the other hand, there are those who are only interested in knowing whether the current bear phase has bottomed so that they can buy stocks again.

This begs the question: When is the right time to buy stocks? Unfortunately there is no straightforward answer, irrespective of the amount of analysis thrown at the issue. But let’s step aside from trying to time the market by simply considering what the chances would be of losing/making money on the stock market over different holding periods.

I have asked the research team of my investment firm, Plexus Asset Management, to conduct an analysis of the returns of the S&P 500 Index for different holding periods over the past 51 years (i.e. from the inception of the “new-look” S&P 500 Index in 1957 through 2008). Both price movements and dividends were included in the return calculations.

The following graph and table summarize the research results:

The analysis of the one-month holding periods indicated that 36.3% of all the periods resulted in a negative return and that 63.7% of all the periods therefore recorded a positive return. The best one-month period (September 1982) showed a return of 12.1% and the worst month (October 1987) a return of -21.6%, while the average monthly return was 0.9%.

It therefore seems as if the likelihood of a profit over the one-month period is better than the likelihood of a loss, but in view of a probability of 36% investors will still have a tough time knowing how the situation will play itself out.

Unless you have the proverbial crystal ball, why take the risk of investing in the stock market? It is for the simple reason that the situation looks significantly different over longer periods – the longer the investment term, the less chance of ending up in the red.

By increasing the investment term to one year, the picture already starts improving. 76.9% of all the one-year periods showed a positive return, i.e. 23.1% of these periods registered negative returns. Furthermore, the best one-year period (August 1982 to July 1983) showed a return of 60.2% and the worst (November 1973 to October 1974) a return of -34.2%. The average return was 11.9%.

As can be expected, investors fared much better over the five-year holding periods. A loss was made in only 8.0% of the periods, while the average return amounted to 10.8% per annum. The best period (September 1982 to August 1987) showed a return of 29.7% per annum, whereas the worst period (April 1998 to March 2003) recorded a return of -3.8% per annum.

Stretching the holding period even longer, not a single one of the 493 rolling ten-year periods produced a negative return. The average return for staying invested for ten years was 11.1% per annum.

The research results are not offered as an alternative to sound fundamental and technical models (or perhaps an experienced “gut”) with a track record of having accurately identified entry or exit levels over time. It merely serves the purpose of alerting investors to the stock market’s return profile over different holding periods in order to (1) know what they are “up against”, and (2) properly match their investment personalities with investment periods that are optimal for allowing them a good night’s sleep en route to an improved lifestyle.

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The past week witnessed mounting uncertainty as investors digested news regarding the ongoing credit market problems and deepening gloom about the global economy. In the words of Richard Russell, author of the 50-year old Dow Theory Letters: “If you’re standing on the railroad track and the train is bearing down on you at 90 miles per hour, don’t stand there trying to decide whether the oncoming train is the ‘Midnight Special’ or the ‘Wabash Cannon Ball’. Just get the hell off the tracks. Which train was coming at you can be determined later – right now that’s not the problem.”

In a speech on Thursday (January 10), Fed Chairman Ben Bernanke acknowledged a weaker economy and the need for further relaxation of monetary policy. He assured the American public at large, that the Fed would “take substantive additional action as needed to support growth and to provide adequate insurance against downside risks”.

However, this was cold comfort for The Street as Stock Trader’s Almanac pointed out that 11 of the last twelve easing periods have proved to be tumultuous times for the markets. It certainly does not inspire confidence when considering that the S&P 500 Index registered its worst performance on record (i.e. since 1950) for the first five trading days of 2008. Also, the fact that the Dow Jones Industrial Index closed below its December closing low (on January 2) and continues to trade below it, points to further weakness. Since 1950, 27 of 29 such occurrences saw continued declines with and average loss of 10.1%, according to Stock Trader’s Almanac.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
Philadelphia Fed President Charles Plosser said on Friday (January 11) that the Fed’s biggest worry was potential weakness in consumer spending. Many investors fear that consumer weakness could push the US economy into a recession, a concern exacerbated by overall disappointing retail sales. Rising energy prices, weakening housing markets and slower job growth are all weighing heavily on consumer moods.

The annualized growth rate of the ECRI Weekly Leading Indicator continued on its way down, with Moody’s Economy.com remarking that the trajectory was increasingly looking similar to past periods preceding a recession.

With a barrage of economic data coming from all corners of the world, perhaps the more insightful information was the ECB and BOE decisions to leave their benchmark interest rates unchanged at respectively 4.0% and 5.5%. Although growth in the Eurozone is slowing, inflation remains of greater concern to central bankers than a slowdown in economic activity.

On the other hand, the US seems to be heading towards a half-percentage rate cut at the FOMC’s next meeting on January 30. Fed funds futures indicated an 88% chance of a 50 basis point rate cut, up from the pre-Bernanke speech level of 74%. Goldman Sachs sees three further rate cuts after January of 25 basis points each, bringing the Fed funds rate to 3.0% by mid-year.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, January 11, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following:

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 13, 2007.

Equities rallied on the back of Bernanke’s assurances, but it did not take long for subprime fears to resurface and most stock markets closed sharply lower on Friday. The MSCI World Index declined by 1.9% during the week, with Japanese stocks (-4.0%) falling to a 26-month low and European stocks (-2.4%) to a 13-month low.

Friday’s sell-off marked the third straight weekly decline for the US stock markets, with the Dow Jones Industrial Index suffering its steepest first-eight-sessions-of-the-year slide in 17 years.

The S&P 600 Small Cap Index (-2.8%) underperformed the larger caps of the S&P 500 Index (-0.8%). Defensive areas that are more resistant to an economic downturn, such as Pharmaceuticals (+3.3%) and Utilities (+1.5%), were among the few sectors registering positive returns for the week.

The depth of the problems faced as a result of the subprime fallout was underscored by Bank of America’s rescue of troubled mortgage lender Countrywide Financial, Merrill’s expected additional $15 billion write-down, and Citigroup’s second capital-raising effort ($14 billion) in as many months.

Government bond yields fell further around the world as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class. However, fears that inflation could become a problem slowed the decline in long-dated maturities.

On the currency front, the US dollar fell somewhat against the euro as expectations of aggressive cuts in US rates increased. Worries about the deteriorating prospects for the UK economy resulted in the British pound hitting a record low against the euro.

The precious metals complex, however, was propelled higher by inflation jitters, with both gold ($898) and platinum ($1 564) recording all-time highs. Silver played catch-up and rose by 7.1% for the week compared with gold’s 3.8% and platinum’s 2.5%.

Base metals and agricultural commodities also performed strongly. A report by the US Department of Agriculture warned of extremely low inventories and pushed wheat prices to an all-time high, corn prices to an 11-year high and soyabean prices to a 34-year high.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist to make sense of financial markets’ shenanigans during the week ahead.

Source: Steve Sack, Slate, January 8, 2008.

Moody’s Economy.com: Survey of business confidence for world
“US business confidence fell to a new record low at the start of 2008 and is consistent with recession. Sentiment is stronger elsewhere across the globe, particularly in Asia, although it is down everywhere since the subprime financial shock began this past summer. Expectations regarding the first half of 2008 are especially bleak, plunging to another new low last week. Businesses have also become notably cautious with respect to their inventories and office space needs. Hiring and fixed investment are soft, but holding up better. Pricing pressures have risen with oil prices near $100 per barrel, but remain very subdued compared to the pressures that prevailed during previous oil price spurts.”

Source: Moody’s Economy.com, January 7, 2008.

BCA Research: Global economy – the oil tax
“The surge in oil prices toward the US$100 threshold adds to growth risks for many of the world’s economies. At US$100 per barrel of WTI, the world’s oil bill will approach US$3 trillion, equivalent to roughly 5% of GDP. That would mark a 1% increase compared with last year and comes at a time when growth in the advanced economies is already moderating in response to the US housing collapse and tightening credit conditions. US consumers in particular will feel the pinch, increasing downside risks for the American economy.

“While strong oil demand – especially in China and the Middle East – is contributing to the surge in crude prices, the rising world oil bill is bearish for global growth. This ‘tax’ on growth adds to pressure for major central banks to ease monetary policy. While rising oil prices have temporarily push up headline inflation, the impact of crude on price pressures may already be peaking. Bottom line: High oil prices will require more aggressive stimulus from policymakers in order to support economic growth.”

Source: BCA Research, January 7, 2008.

James Quinn (Telegraph): US recession is already here, warns Merrill
“The US has entered its first full-blown economic recession in 16 years, according to investment bank Merrill Lynch. Merrill, itself one of Wall Street’s biggest casualties of the sub-prime crisis, is the first major bank to declare that a recession in the world’s biggest economy is now underway.

“David Rosenberg, the bank’s chief North American economist, argues that a weakening employment picture and declining retail sales signal the economy has tipped into its first month of recession. Mr Rosenberg, who is well-respected on Wall Street, argues: ‘According to our analysis, this [recession] isn’t even a forecast any more but is a present day reality.’

“His comments are the strongest sign yet that the gloom on Wall Street over the US economy is deepening as the sub-prime mortgage crisis and the credit rout show little sign of easing.

“Mr Rosenberg points to a whole batch of negative data to support his analysis, including the four key barometers used by the National Bureau of Economic Research (NEBR) - employment, real personal income, industrial production, and real sales activity in retail and manufacturing. … he believes that all four of these barometers ‘seem to have peaked around the November-December period, strongly suggesting that we are actually into the first month of a recession.’”

Source: James Quinn, Telegraph, January 8, 2008.

Ambrose Evans-Pritchard (Telegraph): Bush convenes Plunge Protection Team
“Bears beware. The New Deal of 2008 is in the works. The US Treasury is about to shower households with rebate cheques to head off a full-blown slump, and save the Bush presidency. On Friday, Mr Bush convened the so-called Plunge Protection Team for its first known meeting in the Oval Office. The black arts unit – officially the President’s Working Group on Financial Markets – was created after the 1987 crash.

“It appears to have powers to support the markets in a crisis with a host of instruments, mostly by through buying futures contracts on the stock indexes and key credit levers. And it has the means to fry ‘short’ traders in the hottest of oils.

“The team is led by Treasury chief Hank Paulson, ex-Goldman Sachs, a man with a nose for market psychology, and includes Fed chairman Ben Bernanke and the key exchange regulators.

“Judging by a well-briefed report in the Washington Post, a mood of deep alarm has taken hold in the upper echelons of the administration. ‘What everyone’s looking at is what is the fastest way to get money out there,’ said a Bush aide. Emergency measures are now clearly on the agenda, apparently consisting of a mix of tax cuts for businesses and bungs for consumers.

“‘In terms of any stimulus package, we’re considering all options,’ said Mr Bush. This should be interesting to watch. The president is not one for half measures. He has already shown in Iraq and on biofuels that he will pursue policies a l’outrance once he gets the bit between his teeth.”

Source: Ambrose Evans-Pritchard, Telegraph, January 8, 2008.

(more…)

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