October 20, 2008

Perspective on the bear market
Five reasons for optimism

The decline in stock prices triggered by the U.S. financial crisis has been frightening at times. Most shocking has been the sheer velocity of the decline, which rivals that of the crash of 1929. And despite a recent rally, there is enough bad news to push stock prices back down. But unless you believe the global economy will grind to a halt; I see five reasons why investors should be optimistic today.

Governments are taking action

Many have been comparing today's crisis to the Great Depression and the Japanese deflationary spiral to gain insight into how things may unfold. But a key difference between what happened in those two previous instances and the current crisis is the extent, speed, and coordination of government action. During the Great Depression, the government responded much too slowly. The many bad loans that brought down Japanese banks were covered up.

Today we're not only seeing the U.S. government move aggressively to unfreeze credit markets; we're also seeing a coordinated global effort by central banks and governments across the globe to prevent this crisis from turning into a depression. You can point out imperfections in the solutions proposed thus far, but I'll take an approximately correct solution over inaction any day.

History is on our side

Peak-to-trough losses from the current bear market are clocking in anywhere from -40% (North American stocks) to -56% (emerging markets stocks). And, at the time of writing, prices have bounced up a bit from there. But viewing those losses in the context of history reveals that this is a very typical bear market.

I studied the monthly returns of U.S. stocks (in U.S. dollars) from January 1926 through September 2008. There have been seven distinct instances of U.S. stocks losing 20% or more from peak-to-trough. U.S. bear markets have posted average losses of 39% and took 16 months to reach their respective lows. After touching bottom, U.S. stocks took an average of 43 months (about 3.5 years) to recover to previous highs.

Also, previous instances of 40% declines in U.S. stocks were followed by decades of handsome returns. More specifically, the subsequent ten-year annualized returns clocked in at a median of 9% annually. The 1929 Crash (which saw U.S. stocks lose almost 90%) drags down that average but investing in U.S. stocks after losing 40% or more has - so far - never been a losing proposition when measured in ten-year increments.

Balanced portfolios are doing okay

Much of my analysis over the past month has focused only on stocks. But, with few exceptions, we simply do not recommended 100% stock portfolios for anybody. (One exception I've made to this rule in the past, for example, has been for someone with a very small RRSP who has a generous pension plan.)

Looking, then, to what the past tells us about balanced portfolios is instructive. While a portfolio of 60% U.S. stocks and 40% U.S. 5-year Treasury bonds still lost 62% at the worst of the Great Depression, it recovered from that punishing loss in 45 months. That's a gain of 168% from the low (almost 15% annually). The entire trip, from peak-to-bottom-to peak took a total of 6.5 years. A portfolio of 100% U.S. stocks spent more than 15 years under water, in large part because it lost so much more.

Today's balanced portfolios have surely been dented but not irreparably. A portfolio of 60% stocks and 40% bonds is showing a loss of about 23% through October 17. I know that's not pretty but it's not without precedent. Almost exactly six years ago, a similar portfolio would be showing a 21% loss. Not great, but not terrible.

Stocks are cheap

The most encouraging sign I see today is the abundance of cheap stocks that are available today. True, stocks could get cheaper. But close to half of the stocks in the S&P/TSX 60 Capped Index trade at 10 times their latest annual earnings, or less. There are hundreds more U.S. stocks trading at similar prices, including stocks of almost two hundred medium and large companies.

Another by-product of falling prices is higher dividend yields. Indeed, there is a proliferation of stocks offering a dividend yield of 4% and higher. Broad market indexes - like the S&P 500 - are trading at composite dividend yields not seen since the early 1990s. So, unless you think the economy will vanish and earnings will disappear, today's prices are very attractive.

Legendary investors are buying today

Several legendary investors have spoken publicly about their personal investing in recent weeks. Perhaps the most widely circulated article of late was Warren Buffett's Op-Ed piece in the New York Times. The title, 'Buy American. I am.' says it all. But other seasoned investors, such as Marty Whitman and John Neff, are adamant that a rare buying opportunity is before us. I wouldn't bet against these legends.

Links
Buy American. I am.
Those With a Sense of History May Find It's Time to Invest
Former Vanguard guru is buying stocks