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Where do we go from here and what are our options now that stock values have fallen in excess of 50% from their peak?  When will the current recession end and when can we expect the market recovery to begin?  These are questions that the members of our firm hear frequently and there are no easy answers.

The Gurus

It is impossible to turn on the radio or television without hearing a wide range of forecasts, from predictions of economic recovery in the second half of 2009 to financial Armageddon that will rival the Great Depression.  How do you know who to believe?  Who should you listen to?  History tells us that anyone attempting to predict short-term (less than 10 years) stock market performance is almost certainly going to be wrong.  Take for example, Harry Dent.  Mr. Dent has written several best selling books and in 2006 he predicted “the Dow hitting 40,000 by the end of the decade, the NASDAQ advancing at least ten times from its October 2001 lows to around 13,500, and potentially as high as 20,000 by 2009…The Great Boom resurging into its final and strongest stage in 2007, and even more fully in 2008, lasting until late 2009 to early 2010.”  His most recent book, “The Great Depression Ahead”, obviously contradicts his previous ridiculous predictions.  Mr. Dent has become a millionaire by selling books and market timing newsletters that make outrageous predictions.  It is interesting to note that they seem targeted to match the exact sentiment that predominates at the time of their publication.  Mr. Dent has advised some mutual funds run by a couple of major fund companies using his predictions.  Both have gone bust. This is just one example but it makes an important point.  If you are listening to the prognostications of supposed “experts” in the media, you’re probably wasting your time and likely experiencing unnecessary stress that will keep you up at night.

The fact is, no one knows exactly when the stock market will bottom or exactly when the economic recovery will begin.  The consensus among 50 economists surveyed by the Wall Street Journal is that the US GDP will turn positive by the fourth quarter of 2009.  There is ample historical evidence that indicates that recovery in the equities market usually leads the economic recovery.

In the meantime, volatility remains extremely high and there is a constant stream of bad news focused on breaking the lows set in November 2008 and markets retrenching to 1997 levels.  How much further could the market fall in the short term?  Should you consider getting out of equities and into a “safe” investment to avoid further losses?

Time for a Flight to Safety?

As a Registered Investment Advisor with a responsibility to put the client’s best interest first, it is incumbent upon us to inform clients of the trade-offs and the corresponding risks of their actions and to provide a rational perspective based on an understanding of the way markets work.  While a client’s appetite for risk may change, a change to the portfolio should only be considered once there is a clear understanding of the consequences.

Managing risk always involves reducing or eliminating some risks at the expense of increasing or taking others.  When considering investment portfolios, there are three risks that must be weighed:

• Market risk - the risk that stock prices will decline
• Inflation risk - the risk of losing long-term purchasing power
• Longevity risk - the risk of outliving your money

Getting out of equities eliminates market risk, or the chance of further declines in portfolio value.  However, this will increase the risk of losing purchasing power, as a risk-free investment is virtually guaranteed to lose real value after taxes and inflation.  The loss of purchasing power increases the chance that you will outlive your money.  It is critically important to understand that risk is multidimensional, and that any decision to increase or decrease certain risks at the expense of others should be viewed as a long-term decision made with a thorough understanding of the trade-offs, not as a knee jerk reaction to short-term market volatility.

Expectations and Market Timing

Many clients express the desire to get out of equities and temporarily move to the sidelines - in effect, to ride out the storm in the shelter of the harbor and set sail again when the weather improves.  There are obvious problems with this attempt to time the market.  Once you exit the market, how do you know when to get back in?  Waiting until the economy strengthens or stabilizes will likely cause you to miss the recovery in the stock market, which usually leads any economic recovery.  In this example, by the time the weather clears, the tide may have already gone out.

The primary motive may also be to move to the sidelines to avoid further losses, based on intuition that the poor economic outlook, overall pessimism, and seemingly endless stream of bad news must surely correlate with a continued slide in stock prices.  This logic will not necessarily hold because market prices are set based on expectations from all available information.  Security prices are generally a function of discounted expected future cash flows.  Therefore, part of the recent decline in prices is attributable to lower expected future cash flows due to the economic gloom and doom.  However, a recovery in stock prices can occur even if future cash flows decline.  This can happen if cash flows decline less than expected in an environment where expectations are dismal, at best.  Extrapolating the recent past and assuming that stock prices will continue to fall implies that new information will be worse than expected.  In reality, this news is unknowable particularly when compared to expectations already priced into stocks.

Market Equilibrium and Expected Return

Expected future cash flow is one part of the stock pricing equation.  Another is the discount rate used, which is equivalent to the company’s cost of capital or the investor’s expected return.  Risk and return are related.  If economic doom and gloom represent increased risk, then a rise in the discount rate also forces stock prices lower.  A rise in the discount rate also means an increase in expected return for the investor.

In contrast to the common news headline that “sellers outnumbered buyers today”, every share of stock is held by someone; and for every seller there must be a buyer.  In order for the market to function, investors accepting the risk of buying or holding stocks in an environment filled with pessimism, uncertainty, and volatility are rewarded by lower prices and a higher expected return.  So, for every investor seeking to offload risk by decreasing equity exposure, someone else must be willing to take on that risk by increasing equity exposure.  One side of the trade will not systematically beat the other.  Weigh the risks and trade-offs associated with getting out of stocks and consider sticking around for the higher expected returns.  You have already experienced the risk.  Ignoring the present value of your portfolio, consider how you would deploy a new portfolio if you were investing cash today.  The answer determines how your existing portfolio should be structured.

Time to Recover

An alternative to sticking around for the higher expected returns is moving your portfolio to less risky assets that offer lower expected returns.  This is a rational choice for investors who are willing to trade market risk for inflation and longevity risk.  However, it is a good idea to add some perspective to this decision by considering how long it will take to recoup a 50% decline assuming various rates of return.  A few benchmarks are helpful.  Currently, the US risk free rate of return is close to zero.  For the purposes of this example, assume it is 1%.  Fixed income investments with more term or credit risk return about 3% to 7%.  Historical returns from stocks are around 10% and are frequently much higher after a period of severe decline.

Expected Return	Years to Recover 50% Decline
1%	70
2%	35
3%	23
5%	14
6%	12
7%	10
10%	7
15%	5

No one can predict the future - and stock prices may decline further before they recover - but, most people do not have a short-term need for their invested assets since a long time horizon is a prerequisite to investing in equities.

The Stock Pickers

Perhaps you’ve heard one of the “experts” being interviewed say that “it’s a stock picker’s market” right now.  Surely, by hiring the guru that can pick the winners, we can both decrease the risk of further declines and increase the probability that we will see a high rate of return when the market recovers.  If you are familiar with 50 years of data, you know that it is highly unlikely that actively managed portfolios will beat their benchmarks.  If not, consider this.  According to Morningstar, 63% of actively managed diversified US equity mutual funds and 72% of actively managed US small cap funds failed to beat their benchmark index in 2008.  These annual numbers are typical of any significant time period.  Of course, you can always try to predict which manager will be in the minority that beats their benchmark.  Unfortunately the evidence is clear on this as well.  There is no reliable way to do so.  In the world of active management, there is almost no correlation between a good track record and any subsequent performance.  Let’s examine some instructive anecdotal evidence of the fallacy of manager selection.  We’ll take a look at the performance of the industry’s most celebrated managers over the past 3 years (Ken Heebner - CGM Focus Fund), the past 10 years (Bill Miller - Legg Mason Value Trust), and the past 20 years (Warren Buffet - Berkshire Hathaway).

	2008	YTD 2009 (Through 3/6)
CGM Focus Fund	-48.2%	-24.1%
Legg Mason Value Trust	-55.1%	-27.7%
Berkshire Hathaway	-31.8%	-24.2%
S&P 500 Index	-37.0%	-23.9%

The winner of this contest, if there is one, is Warren Buffet.  It is not coincidental that Mr. Buffet has stated that most investors should invest in index funds.  Just in case you haven’t already figured it out, you’re wasting your time listening to Jim Cramer too, unless it’s strictly for entertainment value.  According to a well researched article from Barron’s (February 10, 2009), Cramer’s stock picks are “wildly inconsistent” and “the only way to reliably profit from Cramer’s stock picks was to short them”.

A History Lesson

Examining historical data about market downturns can be instructive.  While we should not rely solely on data from the past to predict future performance, this information lends perspective to the resilience of capital markets over time.  By looking at rolling one year periodic returns from January 1926 through February 2009, the current decline ranks as the 15^th worst.  In the 14 declines of greater severity, only one had a negative annualized return for the subsequent three year period and the average annualized return for the subsequent three year period was 15.28%.  None of the 14 declines of greater severity had a negative annualized return for the subsequent five year period and the average annualized return over the subsequent five years was 22.20%.  In addition, there was no subsequent ten year period of time with a negative return.  In other words, in the 14 worst one year declines, the market was, on average, higher by 53.2% after 3 years and by 72.5% after 5 years.

In summary, the decline in stock prices has been dramatic and painful.  Before you react by abandoning equity allocations, it is important to consider these factors:

Risk is multidimensional: Eliminating or reducing one risk will magnify others.

Stock prices frequently lead the business cycle: A recovery in stock prices tends to lead a recovery in economic conditions and there is no evidence that risk premiums become reliably negative during recessions.

Risk premiums and economic conditions are countercyclical: Risk premiums tend to be higher when economic conditions are weak.

Prices reflect all current information: More bad news will not necessarily cause further stock price declines.  It is news relative to expectations that matters.

Payback time: Weigh the upside of higher expected returns against the probability that equity markets will not reach previous highs within the payback time associated with less risky investments.

Stock picking does not reduce risk: Active management sounds like a great idea, except it is expensive and it doesn’t work.

Brent Everett is Vice President and the Chief Investment Officer at Talis Advisors, a wealth management firm headquartered in Plano, Texas.  Brent is passionate about focusing on client needs and designing the ideal investment portfolio to help them achieve Peaceful Wealth throughout their lives.  Brent can be reached at 866-608-2547 or on the  web at http://www.talisadvisors.com

This entry was posted on Tuesday, March 10th, 2009 at 2:21 pm and is filed under Peaceful Wealth Essays. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.