Where To Now? A Rational Assessment

An ugly September closed out the worst quarter since the market crash in the fourth quarter of 1987. The damage was widespread, with growth, value, large-cap, small-cap and foreign stocks all experiencing double-digit declines. High-yield bonds were also hammered, though they declined much less than stocks. The only winner on the quarter was investment-grade bonds, as interest rates plunged in the face of a stalling economy and war fears.

As this torturous environment hits the 2½ year mark, I know it’s trying the patience of most investors. I empathize because my patience is also wearing thin. Our decisions have allowed us to protect substantial capital relative to our benchmarks during this bear market. However, this year the message has been that we’ve outperformed by losing less. While our clients have been amazingly supportive, it is frustrating to deliver good relative performance in a negative investment climate. But at times like this we take great comfort in our research emphasis and the confidence this gives us in making investment decisions. We’ve spent many, many hours analyzing the factors at play in this environment, looking at data and talking to other investment professionals we respect. The following Q&A summarizes our thoughts.

Why does the stock market keep dropping?

In our opinion there are three reasons:

1. Economics and profits: The economic recovery is faltering and while we can’t predict whether we will return to a recessionary environment, forward-looking economic measures are deteriorating. The weakness is most apparent in the manufacturing sector. Consumer spending has held up reasonably well but some analysts are concerned that if the trend of increasing layoffs continues, consumer spending will ultimately slow. That would be trouble because consumer spending has been the primary positive in the economy. The weak economy is a problem because businesses are not as profitable when the economy is weak. Though profits have experienced some recovery this year, the rebound has not been strong. Moreover, analysts are cutting profit estimates for the rest of the year and into next year.

2. War: The risk of war with Iraq has driven oil prices higher and made investors nervous. The economic relevance of war in this region (as opposed to other conflicts in Afghanistan, and before that, Yugoslavia) is primarily the risk that oil exports out of the region are disrupted. Though this seems to be a low probability, anything that destabilizes the Middle East tends to worry investors. A secondary concern is the possibility that a war with Iraq could have ripple effects in a very unstable region that might fan terrorist flames.

3. Bubble Aftermath: In the early days of 2000, many investors were unconcerned about valuations, fundamentals, or any sort of rational analysis of risk. The last few years have been one heck of a reality check. Investors are now much more cognizant of risk, so much so that their angst may be causing them to shift to a glass-is-half-empty mindset. There is great concern about the economy and Iraq as mentioned above but it doesn’t end there. There is also a general confusion about valuations. It is not unusual after bubbles for the investor sentiment pendulum to swing all the way to irrational paralysis, leaving markets at undervalued levels for several years.

Has the 47% decline in the S&P 500 since March of 2000 resulted in bargain-priced stocks?

I have looked at valuation in a variety of ways (valuation is more art than science). By any method worthy of consideration, the market looks quite undervalued. In fact it is more undervalued relative to interest rates than it has been since before the great bull market that started in 1982. However, it is not as undervalued as it was after the 1973/74 bear market.

Beyond our valuation analysis itself, our conviction with respect to valuation levels is buttressed by feedback we are getting from stock fund managers we respect (for their ability and their candor). Many tell us that at a stock-picking level there are a number of stocks selling at attractive prices.

But aren’t interest rates unsustainably low? What would it mean for stock valuations if rates rose?

We agree that interest rates are probably unsustainably low. And lower rates make the market look more undervalued. But even if we assume the ten-year Treasury yields 5%, instead of its current level of 3.7%, stocks are selling below their fair value based on valuation metrics that held over the past 20 years. (Note: we believe that, outside of the bubble period, ‘98/’99 investors valued stocks in a reasonable manner over most of the 1980s and 1990s. And in order to reasonably balance returns between cash, stocks and bonds, we strongly believe that at some point in the future the market will revert to a similar valuation environment.) It is important to note that our valuation analysis isn’t intended to be exact. But when the undervaluation is this extreme it reminds us of the Ben Graham saying, “Over the short-term the market is a voting machine but over the long-term it is a weighing machine.” At present we are confident stocks offer a lot of value on a per pound basis, and because of that we will eventually be rewarded with good returns.

How confident are you in your valuation analysis? Some “experts” say stocks are huge bargains while others say stocks are still way overvalued.

It is nothing new to see widely divergent opinions among “experts” about the market’s valuation. There are some analysts whose work we respect and we are interested in their views. However, many so-called experts have either done sloppy work or in many cases they have an agenda that impacts their objectivity. We have no built-in bias and our analysis is rigorous. That said, we must repeat that valuation analysis is only part science. There is a lot of judgment involved, since part of the formula involves assessing what investors are willing to pay to own riskier assets like stocks. Moreover, its value is mostly as an indicator of long-term return prospects, so valuation analysis isn’t helpful in the near-term. But, bottom line, we have a very high degree of confidence in our analysis and conclusions and believe the value added to our long-term decision-making is substantial.

So does this mean that the market has bottomed and that stock prices will rebound quickly?

No, unfortunately it does not. Our valuation work tells us nothing about timing. Stocks can stay undervalued for extended time periods. There are real risks and those risks are the reasons the market has been declining, as discussed above. How they play out will determine whether a rebound is imminent or will take longer to materialize.

In the near term it appears unlikely that stocks will surge given uncertainty about Iraq. However, there are many scenarios that could reduce the perceived risk (or increase it). But absent more clarity it will be hard for the stock market to rally.

In addition, the economic risks are real. It is important to note that the market is partially pricing in some of these risks. But there are some scenarios that we view as pessimistic that are not fully priced in. Until the economy starts to show more signs of improvement the stock market will have difficulty sustaining an advance and could decline further. At present it seems that the bulk of the economic news is negative. For example, the manufacturing sector is declining and experiencing deflation, layoffs are increasing and global leading indicators are declining. Longer-term we remain concerned about debt levels and how they may impact corporate investment and the sustainability of consumer spending. However, when a recovery gains a better foothold the profit outlook will improve and stocks are very likely to begin to rebound. The fact that economic statistics are discouraging today does not mean that much more encouraging numbers might not be around the corner. The problem is that investors don’t know.

The third reason why stocks might not quickly rebound is that investor’s risk appetites have not only been impacted by the economy and Iraq but also by the magnitude and length of the bear market. There is no question in our minds that tech stocks and much of the stock market in general reached bubble levels. History has shown that once a bubble is popped, investor confidence takes quite a while to return. So we have less confidence that stocks will return to what we define as a normal valuation in the next couple of years. We could well be wrong about this but as this major bear market has dragged on and we’ve given more thought to the aftermath of bubble environments, our confidence in a sustained rebound any time soon to pre-bubble valuation levels has declined.

So the stock market is a long-term bargain but the next several years are unclear…then why own stocks now?

Members of our investment team have over two decades of investment experience and we all consider ourselves students of investment history. One lesson that has been taught time and time again is that it is dangerous to underestimate the ability of the stock market to surprise investors. Bear markets always bottom at the point of maximum pessimism. This lesson was learned on the heels of the Asian meltdown in 1998, and it was learned when the Gulf War started in January 1991, and there are many other examples. At present, fear and pessimism are much more apparent than greed and optimism. Clearly some of the negatives are already priced into stocks (thus the undervaluation) and a few unexpected positives could turn things around. For example, there is a massive wave of mortgage refinancing happening now. A Fed study suggests that based on past relationships a meaningful amount of the refinancing proceeds will make it back into home improvements and other consumer spending. This could result in an unexpected spike in consumer demand. Events in the Middle East could surprise on the upside just as they could on the downside. Being intellectually honest, even a pessimist must admit that the negative scenarios are not sure things. Positive scenarios are also quite possible. So the point is that with the market at a bargain level on a long-term basis, we don’t want to risk missing out on the rebound simply because we can’t say for sure when it will come. We recognize that it’s possible that a sustained rebound might not come soon and that stock prices could go lower. But if a rebound does come suddenly we will have missed an opportunity to profit from the undervaluation that we believe is now reflected in stock prices.

A related point is that moving more heavily into defensive investments requires knowing when to increase stock allocations again. To say this is tricky is a huge understatement. The indicators that will signal that risk has declined will send stocks surging before we will be able to re-assess the risk/reward trade-offs. For example, in the month after the Gulf War began the stock market rose 17%. It was up 19% in the month after it bottomed in 1998. We’re simply not confident that we can turn on a dime and catch these types of moves. So with the market clearly undervalued based on our analysis, on a long-term basis, it makes sense for long-term investors to be patient and wait for the returns that we expect will be delivered sooner or later.

So is staying the course the best strategy?

Staying the course is an over-used term that implies discipline but also sometimes suggests complacency or lack of thought. We take pride in our discipline, which we believe is a key to good long-term performance. One way in which we stay true to our discipline is by constantly analyzing and re-analyzing each competing investment alternative. As our thinking has evolved and we’ve become more conscious of the possibility that the bubble aftermath might mute investors’ appetite for risk for a longer period than would otherwise be the case, we are considering making larger allocations to other asset classes but only if they offer comparable return potential with different risk characteristics. For example, we are thinking about the importance of income at a time when investors don’t trust earnings numbers and are generally risk-averse. This might mean putting more money into REITs or high-yield bonds or considering other areas. It is quite possible that we will do nothing but we are in the process of debating some possible shifts in exposure. We will report back on the status of our thinking and discuss changes (if there are any) in the coming months.

Given the undervaluation in stocks are patient investors set up for another bull market like we saw in the 1980s and 1990s?

No. Even though the market is more undervalued than it was at the start of the 1980s/90s great bull market, interest rates are much lower now than they were then. In late summer of 1982 the ten-year Treasury yielded about 15%. Now that yield is less than 4%. The decline of the ten-year Treasury yield from the mid-teens to current levels justified a massive increase in P/E multiples. With rates so low, obviously this can’t happen again. In fact it is more likely that rates will back up a bit (which is why we assume a higher, more sustainable interest rate in our valuation analysis). So back in 1982 stocks were somewhat undervalued, but more important, they were set up to benefit from a huge two-decade drop in interest rates as inflation was tamed. Stocks are actually more undervalued now but don’t have the P/E multiple expansion potential that they had back then. That means return potential is less now, on a five-year time horizon, than it was back then. But, return prospects are still attractive with the potential for low double-digit returns, assuming that within five years, investor confidence returns and we are back near “normal” valuations.

Are there specific areas of opportunity in the stock market?

At a stock-picking level we believe there are specific areas of opportunity. However, based on relative valuations we are largely agnostic about growth versus value. We like value slightly better, but not enough to meet our threshold to justify overweighting. We are also close to changing our “fat-pitch” view on small-caps. Small-caps still look cheaper than large-caps but the discount has narrowed dramatically. And small caps have already had a good run that is close to being in line with past periods of cyclical outperformance. (Note: if next month we reduce our target allocations to small-caps it may not trigger changes at the fund level, since portions of our small-cap exposure stem from flexible managers who have already been gravitating upwards in market cap. We will report back next month.) We are also agnostic about the U.S. versus foreign markets; again, foreign looks slightly better but not enough to warrant an overweighting. Our lack of preference for specific asset classes or market segments is because these appear to be in a fair-value range relative to each other. And while we have a slight preference for small-caps as well as foreign stocks and value stocks, the case we can build is not strong enough to justify significantly overweighting any of these areas. This lack of clearly superior opportunities in any broad segments of the stock market means that we are relying on the skill of our stock pickers more than ever. Fortunately we have great confidence in the stock pickers we are invested with, and for most, their flexibility to pursue the best opportunities wherever they may be should make it easier for them to beat their benchmarks.

How does our willingness to trade-off short-term risk for long-term return vary across our different portfolio strategies?

We are more sensitive to risk guidelines in our Conservative portfolios. In these portfolios we assume that our mandate is skewed more toward capital preservation. Much of that mandate is taken care of by our more conservative neutral allocation. However, with this year’s horrific market decline the risk of violating our risk thresholds on a 12-month basis is higher than it has ever been since we are already there after only nine months despite beating benchmarks. We’re cognizant of this risk and we continue to consider potential changes that could reduce risk at the margin. The trade-off is the risk of being whipsawed and missing out on the beginning of a rebound. For now, largely because of the long-term value we see in stocks and high-yield bonds, we are not getting any more defensive. But, we continue to consider the possibility.

As we consider the risks to each of our portfolio strategies, what is our assessment of the worst case for stocks?

The concerns about a possible deflationary scenario remain. The manufacturing sector is already in deflation. And import prices are deflating. It is difficult to assess the probabilities so this does have us concerned. What gives us comfort is that we know the risk is on the Fed’s radar and we believe the Fed has the ability to instill more confidence in the economy that would further reduce the risks. They would do this by improving liquidity directly and indirectly via their influence over commercial banks. And, there are fiscal policy levers that could be used to compliment the Fed’s efforts. So we still believe deflation is not a probable scenario. If it does occur, the question then becomes how much deflation and whether it lingers or not. If deflation is sustained the downside in stocks could be another 20% to 30% or perhaps more assuming more profit decline and risk aversion on the part of investors—though some of the risk is already priced in the stock market. It is important to remember that there are always risks to investors and to a certain extent it’s hard to invest without being an optimist. And given the strength of our country’s consumer and the flexibility of our capitalist system, we believe only investors who are particularly risk averse with relatively short time horizons should take into account deflation risk. Those who feel that way should be in our most conservative model. That model will not completely avoid the downside of a worst-case environment, but losses will be more limited. Understanding the downside is important but knowing the magnitude of the highly likely long-term upside is a more important factor to our investment decisions.


Jon Houk, CFP®