Sensible Investing

Year 2009 marks the end of the decade, and I say Good Riddance!  The Naughts, as some people call it, turned out to be the absolutely worst decade in stock market history, with S&P 500 losing 3.3% on average every year.   Compare that to the 30′s: during that decade, the market rose 1.8% annually!  Clearly, as bad as the Great Recession has been, it still can’t even begin to compare in economic terms to the Great Depression.  The main reason for the poor market performance during the last 10 years is that stock prices rose very fast in the 80′s and 90′s.  By the way, those 20 years followed poor 70′s; 30′s were also followed by a decades-long stretch of market gains.  By this historical perspective, next major move should be up (despite that good 2009).

My sentiment about last quarter of 2009 remains very similar to that of a couple previous quarters.  The economy continues to exhibit more and more signs of clear recovery, in GDP growth, improving housing market, stabilizing unemployment, strong corporate earnings, low interest rates, and even consumer sentiment.   The sentiment of market advisors, however, remains decidedly guarded since the gains occurred much quicker than anybody could have anticipated.  Many believe that this is still a bear market rally.  Indeed, can the market really go higher having already risen so much and so fast since March?  The short answer is — yes, it can.  It was unimaginable to think that it could drop even further from the levels of one year ago – and yet it did.

I am sure you realize that I am not actually making a prediction here; I never do.  The future is unknown and my guess is as good as yours.  There is a very good possibility, however, that the market will continue its climb of the wall of worry.

Take a look at a recent monthly commentary from Legg Mason Capital Management.   Here’s an excerpt from the report:

Before closing, we’d like to leave our readers with two views of the market—the inside view and the outside view—and let each reader decide which is the more relevant framework for investing. The inside view says that the market can’t go up because our current circumstances are too perilous and uncertain. The laundry list of worries has been well chronicled by the media: a still-fragile financial system, a likely sub-par economic recovery, yawning budget and trade deficits, a vulnerable dollar, threats from both inflationary and deflationary forces, high and still-rising unemployment, continuing wars in Iraq and Afghanistan, nuclear saber-rattling by Iran, massive funding requirements for Social Security, Medicare and Medicaid, the burden of health care reform and a probable rise in tax rates. Yada, Yada! It’s a wonder any of us can get ourselves out of bed in the morning.

The outside view says, yes, we’ve got plenty of things to worry about, but that’s been true throughout history. Worries, concerns and problems are always an unavoidable part of the investment landscape, just as they are an unavoidable part of life. The outside view asks us to look past the current situation at the bigger picture. Over the longterm, stocks have been great wealth builders. This has been especially true after they have suffered extended periods of poor performance, such as the 10-year period we have just witnessed. To be more specific, according to data compiled by Jeremy Siegel at the University of Pennsylvania, stocks have provided average annual real returns (after inflation) of 6.66% for all 10-year periods going back to 1871. There have been fourteen 10-year periods, including the current one, where stock returns were negative. In every one of the previous 13 instances, the subsequent 10-year returns have averaged 10% real, about 50% better than the long-term average, and more than twice the return of bonds.

With funds currently flowing out of domestic equity mutual funds and pouring into bond funds, investors are being overwhelmingly influenced by the inside view. We think they are making a big mistake.

Today, we had some really good news on unemployment.   Contrary to predictions of rising to 10.5% or even 11% rate, it unexpectedly dropped to 10%.  The economy did lose 11,000 jobs last month, but as you can see from the graph, it was the smallest amount since the recession began, and considerably smaller than estimated 125,000 loss.

The government also revised job loss amounts for the previous months downward.  If this trend continues, there is a very good chance that we will see job creation as soon as the end of this year or in January.

More details in this CNN Money article.

According to this article from Investors Business Daily, investors are still very skeptical of the equities.  In September and October, for example, they pulled out $17 billion from stock market funds and directed the proceeds mainly into bond funds.  Year-to-date, $1.91 billion was pulled out of the stock funds.

From a contrarian perspective, this is great news.  This means that investors stayed skeptical all the way up during the current rally and chose to either sit on their cash or funnel it to “safe” bond funds (with interest rates near zero, I don’t think bond funds will be safe for long).

The wall of worry is still alive and well.

Good news on economy continue rolling along. Here’s a summary for the last week or so:

- Q3 GDP grew at 3.5%, so now the recession is finally officially over.
- Retail sales were better than expected.
- Auto manufactures, such as Ford, Nissan, Toyota reported (relatively) good results with sales higher than a year ago. Ford reported $1.8B profit. Apparently, it is still possible to make money in the auto business.
- Job cuts by employers are moderating, and unemployment claims are falling. In fact, more employers are planning to add jobs than ones planning to eliminate them.
- The housing market continues its recovery. Pending home sales rose by 6.1% and are now at its highest level in three years.
- Earnings reports continue upward trend of the last two quarters. Fully 80% of companies beat earnings estimates, which is a record.

Note that consumer spending and unemployment have been thorns in this recovery for quite some time. As you can see, now we are getting more and more positive news for both.

The market, in its infinite wisdom, decided to greet these news with a sell-off earlier this week, and continued high volatility later. One could argue that a consolidation is due after a rally we had, or this could be a case of “buy on rumor, sell on news”. In any event, markets can be quite irrational in the short term, but in the long term, it is the fundamentals and earnings that matter.

It appears that the cockroach theory is right, at least as far as earnings surprises are concerned.  Just like in Q2 and shown in this post, a vast majority of companies are exceeding earnings estimates, as evidenced in weekly summary from briefing.com.  Once again, the market advance has been validated by excellent quarterly reports.

The overall market sentiment now is very similar to that of the previous quarter.  There is still plenty of skepticism around, driven by uncertainty of this recovery and the very fact that market gains happened so extraordinarily quickly.  We are still climbing the wall of worry, with many investors remaining on the sidelines convinced that we are in the bear market rally (which from the contrarian point of view is the ideal market condition).  Similarly to the last quarter, the coming earnings season is going to be hugely important.  Q2 (as well as Q1) results exceeded expectations, and of course the markets are driven by the earnings.  If this trend continues, so will this rally.

There are also important differences between current and previous quarters.  Major economic indicators improved significantly.  For example, then the economy was still contracting (although at a lower rate of decline) and housing prices were falling.  Now it is a virtual certainty that GDP rose in Q3 and the housing market is stabilizing.  Not everything is roses, of course.  Just a few days ago, manufacturing, consumer confidence, and unemployment reports were worse than expected.   This recovery, as any other, will have its hurdles and the markets could get bumpy.

The market action over the last two years confirmed my long-held belief that market timing is impossible and that one has to stay invested to participate in sharp upward moves.  Chances are, someone who sold on the way down is still on the sidelines waiting for a good market.  And they often buy after the market has already been good.

While everyone seems to be in agreement that the recession is over (or nearly over, anyway), the debate du jour is about how vigorous the coming recovery will be.  The prevailing opinion is that it is going to be slow and shallow, given high unemployment and poor consumer spending.  Here is a different view, which argues that prevailing opinions are usually wrong and given the depth of the recession we just had, the recovery will be anything but shallow.

There is an old saying on Wall Street that bull markets climb the wall of worry.  With the markets up 50% from the March lows, there are plenty of worries to go around: uncertainty about strength of the recovery, fears of double-dip recession, and the very fact that the markets went up so much in a short period of time.  On top of that, we are about the enter the statistically worst month of the year, September.  No wonder that there is a lot of talk about upcoming correction.

From the contrarian point of view, that is exactly why it won’t happen, or if it does happen, it will be relatively mild.  This rally certainly has fundamentals supporting it, in the form of improving manufacturing reports, durable goods orders, and even housing.  After severe spending cuts, pent-up demand for various goods is apparent today, especially on the business side.  A good example of this is IT industry, even though this particular pent-up demand is amplified by the upcoming release of Windows 7 operating system from Microsoft.  This week, Dell and Intel both increased revenue outlooks for the rest of the year.

The two admittedly very important missing links in this recovery are still anemic consumer spending and high unemployment.   The question now is whether employers cut too many jobs during the crisis and thus created pent-up demand for work.  There is some evidence of that in recent reports that new and continuing unemployment claims are stating to fall.  If that is the case, expect the markets to continue its climb up the wall of worry.

Today, the markets broke through psychologically important barriers of 1,000 for S&P 500 and 2,000 for Nasdaq, levels not seen since last fall.  Despite the gains, both indices are still about a third off their highs reached in the fall of 2007.

For complete details, look at this Wall Street Journal article.