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.