How Low Can it Go?

I figure there's a ten-to-one rule that applies to questions. For every client that takes the trouble to call or email me with a question, there have to be ten others who were thinking the same thing, but didn't ask me outright. I got three calls the past two days with the same question, so about thirty others are out there thinking about the same thing.

How low can stocks go from here? We're down 12% from the start of the year already, and we're testing the low set back in November. Do we stay the course? Do we bail out?

Giving the honest answer first: Yes, stocks can go quite a bit lower from here. We have no way of knowing and no way of making a forecast. All we can do is look to the current situation and consult some history.

By our estimation, the S&P 500 at 788 (today's close) represents an under-valuation of about 17%. In the great majority of past eras when stocks could be purchased at this valuation level, investors have been amply rewarded with annualized returns over the ensuing five years of 5% or more above inflation. On that basis, we are quite confident that our investments in stocks will turn out nicely if we are patient.

But, that avoids the question: How low can it go? In the previous two major bottoms (and major recessions), stocks fell to much lower levels. Adjusting everything in terms of today's prices, the S&P500 would have to fall to about 400 in order to match the low of 1982 and 475 to match the low of 1974. Those are staggering numbers, to be sure. When stocks bottomed in 1974, they did so from a valuation peak reached in 1965; fair value was reached in 1970.

The low reached in 1982 wasn't really off of any highs or even fair-value -- stocks bottomed in 1974 and stayed below fair value all the way out to 1990. Sixteen years! That long period of below-trend valuation is what set up the 19 year bull market that ended in 2000.

We are today below fair value off of a valuation peak reached at the end of 1999. We only touched fair value (for the first time since 1990!) in October 2008. We have had an 18-year round trip from fair value to fair value. As a side note: Annualized return over that time? 3.3% after inflation. So much for stocks paying a long-term return of 5-7% above inflation, as some pundits claim. When stocks are bought for fair value, and then sold for fair value, the returns aren't all that stunning. Why? Because corporate earnings growth per share isn't all that stunning.

Now for the important part -- the, "Yeah, but..."

At both of the major market bottoms in 1974 and 1982, inflation was very high. Annual inflation touched 12.3% in late 1974 and hit 14.7% in mid-1980. Inflation had already started to moderate by the market bottom of 1982, but interest rates were still high and corporate earnings were still declining.

At each of the past two major market bottoms, the country was experiencing not only a sharp recession, but strong inflation to go with it. In any economic recovery, we will expect inflation to move higher. What we do not expect is for inflation to run into double-digits and to precede the economic recovery.

So, that is what we are paying most attention to: Will inflation spike above the long-term "tolerance" level of 3-4%, or will it spike sharply higher? Will that inflationary spike occur in conjunction with an earnings recovery, or will the inflation arise before a recovery? If inflation arises too soon, and rises too high -- stocks are in for a hard time. As I wrote in the piece below, we worry about inflation moving above-trend over the medium-range cycle as the economy recovers.

Our outlook, then: We expect any sharp spike of inflation to be short-lived. Unless employment is in a full-bore recovery, we expect the Fed to move quickly to quash any inflation above its policy range. Likewise, we expect any sharp selloffs of stocks driven by inflation worries to also be short-lived.

We do, however, expect a genuine economic recovery to be accompanied by an orderly movement of inflation to somewhat above trend. In the fullness of time, this movement is the one we want to anticipate and protect against, as it will grind down the value of our investments.

As I have written before, an investor can implement strategies to protect against short-term inflation or long-term inflation. But you have to choose which is the bigger concern. You can't really have it both ways. We choose to place modest protections against short-term spikes of inflation (natural resources, energy) and stronger protections against persistent inflation (short bond durations, stocks, real estate).

In sum, stocks can certainly go lower from here. However, we believe any such move will be short-lived and will offer us the opportunity to rebalance portfolios to take advantage of low valuations.

Tactical Change to Portfolios

In the post immediately below this one, I offered some thoughts about a potential dollar decline. In the interim, I've done some more thinkin' and analyzin' about our current state of affairs, including the imminent stimulus package. As has often been the case over the past several years, I found in the writings of Jeremy Grantham the crystalized message that had been foggily drifting around in my head. I couldn't quite get my hands on that fog, but Grantham managed to present me with a "That's it!" moment.

We are in the midst of a great write-down of asset values -- real estate and equity in businesses for the most part. Prior to this value destruction, total private debt was about half of the asset values. As the values come down, so too must the debt. We are headed for a debt reduction in the $10 to $12 trillion range. That reduction needs to occur before we can return to our long-term GDP trend line.

There are three ways to reduce debt.

One: The old fashioned way -- pay it down. Stop consuming and investing and instead use cash wages and earnings to pay down debt. This translates into a drawn-out period of suppressed economic activity. And it takes a long time.

Two: Default. If you don't pay it back, and the lender can't collect, the debt kinda disappears. This is problematic for you, to be sure, but it's happening right now on a grand scale.

Three: Inflation. If you can pay back a dollar of debt incurred in 2005 with a dollar-fifty of money earned (for the same work) in 2012, your debt has effectively been reduced by a third.

The first of these is modestly underway at present. Consumer saving rates rose sharply in late 2008, and much of that saving is going to pay down debt. But, this is a slow, slow process. For historic precedent, you can look to Japan's economy post-1989. It took the better part of 15 years, but this is how Japan largely managed its debt reduction. We have bet on this trend by continuing our underweighting of stocks and real estate.

The second of these is emphatically underway and we're not the only ones to realize it. Default rates are exploding upwards. In fact, we expect to profit from a probable over-reaction in some sectors. We've purchased debt at discounts of 20%-30% on which we expect to incur loss rates of only 0%-15%.

The last debt-reduction method (inflation) is not yet in full swing. However, it's coming and we want to be ahead of the curve. The stimulus package, together with the Fed's continuing commitment to create (ie, "print") money with a vengeance, all but ensures an above-trend period of inflation sometime over the next X years. How long is X? We cannot know for sure, but we think the cost of being early is low.

Our principal current investment positions that provide insulation from a weakening dollar and rising inflation are energy and natural resource stocks. We have also kept our bond maturities short, but that's more of a defensive posture than a profit-seeking one.

This week, we have added positions in developed-market foreign bonds. We owned such positions for several years and gradually eliminated them throughout 2008. We are buying those same positions back now, but at about ~20% lower prices. The exposure to foreign bonds is a hedge against a weakening dollar -- if the dollar weakens, the bonds rise in value. If we are right, we profit nicely. If we are wrong, we earn about the same interest rate we could earn on domestic bonds. We think the odds of the dollar strongly strengthening from here are low.

This is my favorite type of investment scenario -- one where the payoff probabilities are asymmetrical. The downside is low or improbable; the upside is high or probable.

We will continue to watch carefully for opportunities to shift gradually toward an inflation-defensive posture.

What if the Dollar Collapses?

We get this question with some regularity, so I figured I'd write up our thinking. The dollar has been gaining strength against foreign currencies since last July, when the bottom started falling out of the US economy. By "gaining strength" we mean that a dollar buys more units of a foreign currency than before. If one dollar bought 50 units of currency X, it now buys 60 units. If a cup of coffee in country X cost 50 units in July, and 50 units today, we come out for the better since we now have both the cup of coffee and 10 extra foreign currency units to spend. That's why we use the word "strengthen" -- our currency buys more foreign stuff, all else equal. The word "strengthen" sounds positive, and the word "weaken" sounds negative. As you might expect, people tend to panic at the thought of our dollar weakening or even plummeting. If it sounds bad, and if it uses scary words to describe, it must be bad...yes?

Before we get to worrying about that, I pose the somewhat glib and off-hand question, "Why do you care if the dollar falls?" What really happens when the dollar falls? What direct effect does it have on your life? The answer -- like everything in economics -- is, "It depends." In ECON 101, we learn that when the price of something changes, there are two opposite effects going on at the same time. On the one hand, the seller gets more money per unit sold and that puts upward pressure on his total revenues (the "Income Effect"). On the other hand, people will reduce the number of those things they buy by shifting their purchasing to substitute products (the "Substitution Effect"). That puts downward pressure on the seller's revenues. Which effect wins out? No way to know -- it depends on the specifics of the situation. And so it is with the selling of the dollar (we being the seller).

So again, why should I care if the dollar falls? First, a cup of coffee when I travel overseas will cost more. If you travel a lot, that might matter to you. Generally, there will be upward pressure on the price of foreign-made goods. An LCD TV might cost a little more. A Toyota might or might not -- many are made here in the US of A. In the full picture of our spending habits, these price movements are not all that powerful -- we can substitute our buying among various goods, made in various countries and manage our standard of living accordingly.

There is one import whose price can rise with a falling dollar and harm us more quickly: capital. A major portion of our global balance of payments is the purchase by foreigners of our debt -- we import dollars by exporting debt. If the dollar begins to slide, foreigners might wish to own fewer of our bonds since the value of those bonds will be falling when measured in their own local currency. Selling pressure in the bond markets will drive domestic interest rates upwards.

And finally, there is one import product which we cannot easily live without or substitute away from: Oil and other natural resources. A slide in the dollar can cause our cost per-barrel of oil to rise. If the dollar is buying fewer and fewer units of other currencies and of foreign-produced goods, the oil exporting countries will take that into account and demand additional dollars to make up the gap. It is this effect that most concerns us.

A long-term slide in the dollar on the world exchange markets will most likely lead to persistently high real interest rates (the amount by which rates exceed inflation), and to higher oil prices. This does not necessarily lead directly to inflation. As we saw in 2007, a spike in oil prices can put the brakes on our economy faster than Merrill Lynch can write bonus checks. Inflation plummeted from 5% to zero in six months.

Which asset classes offer protection? Energy and natural resources stocks (we favor a T. Rowe Price mutual fund); and discounted short-to-medium term bonds in the corporate and municipal sectors. Folks ask us about TIPs, or inflation-protected bonds. These don't provide protection against rising real interest rates. If inflation stays tamed, and interest rates rise, TIPs will not perform well at all. The other asset we are staying away from at the moment is US Treasuries. While they are safe if held to maturity, the yields are absurdly low and do not compensate us for the risk of rising rates as the recession bottoms out.

In sum, we care about a falling dollar primarily in terms of the effect on (1) the globally-set price of oil and other natural resources, and (2) domestic interest rates in excess of the rate of inflation. Remember -- rising commodity and oil prices do not necessarily lead to long-term persistent inflation. The Income and Substitution Effects will pull in opposite directions. In the short-term, the Income Effect usually dominates. In the fullness of time, the Substitution Effect will steer our consumption to other energy and resource supplies. As we have written before, you can either worry about short-term inflation or long-term inflation, but you can't have it both ways. We worry more about the long term and will take positions in our portfolios accordingly.