Up and Down and Up and...

The Roller Coaster Continues...

I sit to write this missive and start typing the same thing I typed last time. What more is there to say? The economy is most clearly going backwards; the bond market is behaving entirely irrationally; stocks keep getting cheaper. What's an investment manager to do? I'll take the easy route and just answer the two questions that we get from clients, friends and the Friday morning Rotary meeting...

1. Where is the bottom? You already know my answer: I don't know. But what I do know is to look at past cycles and examine what was going on and how the market bottomed. In my analytical world, the "price" of stocks isn't the number you see on the front page of Yahoo -- it's an inflation-adjusted price-earnings ratio that looks at the last 10 years of earnings. My PE ratio tells me how much I am paying -- the price -- for the expected earnings of stocks over some reasonably long future period. That, and that alone, is the price that we care about when parsing historic tables and making judgments about stocks.

Using our methodology, stocks have bottomed with a PE of 7-8 several times in the past 75 years. They closed today at a PE of about 13. That means that the S&P 500 *could* fall another 45%. Yikes. That would be a 70% decline from its peak in summer 2007. A huge fall, to be sure, but not unprecedented.

However, as my friend and friendly competitor Eric Hull pointed out to me recently, those single-digit PE bottoms have generally occurred in a period of accelerating, double-digit inflation. The market bottoms in periods of declining and low inflation have been in the 11 to 13 range. When we came to work this morning, the PE was at 12.5 and we bought some stocks. Not a lot -- just 2-5% in most accounts.

I will not make any prediction about a possible market bottom, but I can tell you this with all candor: History shows that investors who buy stocks at prices like we see today are amply rewarded over 5-7 year periods. Patience is the key -- if you have the stomach for some volatility, the odds are very high that the total return on stocks over the next 5-7 years will be higher than the returns to bonds or cash, especially after adjusting for inflation.

2. What Kind of Stocks Should I Buy? For the first time in 50 years, the dividend yield on a basket of blue-chip stocks is significantly higher than the yield on long-term treasurys. The 10-year treasury closed today yielding 3.17%, and the yield on our favorite bundle of dividend stocks is over 5.5%. Even better, yields on stocks rise with inflation over time, while yields on bonds are fixed.

This situation might not strike you as all that earth-shattering, but I assure you it is. This is a major milestone that I never thought I would see in my lifetime. For my entire career, the choice about stocks came down to something like this: I can buy stocks and earn a nothing yield of 2% and hope stocks go up. Or, I can put money in cash and bonds and earn 5-6%. But I will miss out on any stock upside.

Today, we can own stocks and earn much higher income than on cash and bonds, and we still have all the upside of stocks. Keep in mind that, if we buy $100k of stocks and receive a $5k annual dividend, we keep getting that $5k even if the stocks go down. That $5k is higher than the $1k to $3k we would have gotten from cash or bonds. From an income perspective, we are no worse off by owning stocks -- even if they go down in the near term. If you have the willpower to stay with that decision for 5-7 years, I am highly confident you will be happy you did.

Our recommendation, should you choose to buy stocks right now, is to look at dividend-oriented stock mutual funds and ETFs. The usual search tools at Morningstar and Schwab can point you in the right direction.

Have a wonderful Thanksgiving week!

Cheers,
Rick Ashburn

Back to Business...

With the election behind us, we should now consider what the near-term holds for our portfolios. To tackle the first question on everyone's mind: Is Barack Obama going to be good for our portfolios? My view has long been that the President has far less effect on economic outcomes than folks would like to believe. Mostly, people believe that if something good happened on "their guy's" watch, then he deserves credit for it. If something bad happens, it's not his fault. Conversely, if something bad happens on the "other guy's" watch, it's clearly that guy's fault. Phooey. Mostly, stuff just happens. I don't need to be shy about the fact that I'm no fan of G. W. Bush, but I'm not about to lay this financial crisis and economic downturn at his feet alone. Lay it at Greenspan's feet? You bet, but that's a blog for another day...

President-Elect Obama has shown all the signs of preparing to deal with our economic problem in a thoughtful and rational way without resorting to populist salves. He has, to date, surrounded himself with experienced and thoughtful advisors with a decidedly centrist economic bent. We remain optimistic that, to the degree an Administration can do much at all, the pending Obama administration will do a good job. The real cures for our economic turmoil are out here on main street and time needs to pass for things to turn right again.

I like to think about our current predicament as a family that has built a third story on its house, and then moved everything up to the third floor. The view from the third floor is grand and we have all the worldly comforts we can imagine. But then one day we realize that we can't afford the third floor that we built and begin to move back down to the second floor.

Once we are back on the second floor and a little time passes, we will realize that the view from here is darn near the same. We have pretty much the same stuff, even if it's not as new as we would like. Frankly, life is hardly distinguishable from that third floor we used to think was so essential.

The US Consumer is in the process of moving down to the second floor. The painful disruption is not in the eventual destination -- it is in the moving down process itself. The longer it takes to get the move over with and to board up and forget about the third floor, the longer the recession will last and the longer the bear market will last. As I write this, the move down seems to be picking up speed. While I do not gloss over the pain of that move down -- job losses, bankruptcies, depleted portfolios -- it's better to get the move over with sooner rather than later.

Our investment themes for the time that the movers are still carrying boxes:

- Remain underweight to stocks. Look for opportunties to buy small amounts when the S&P500 index is below about 925. Accelerate a move back to full allocations if the S&P500 moves sharply down into the <800 range.
- Stay short on the bond maturity spectrum. 3-5 years at the longest.
- Stay in high-quality bonds. Treasuries, mortgages and high-grade corporates.
- Buy muni bonds. Again, stay short (3-5 years). Munis are a screaming good deal right now. Stick with high-quality GO (ie, voter-approved) and utility revenue bonds and you won't need to worry about looming budget problems in the municipal sector.

Congrats to those whose candidates/initiatives won and condolences to the not so fortunate. We're all still one big happy family and we now look to the road ahead.