Is This Funky Market About Over?

The Investment View from Prescott, Arizona

Owning a share of stock means you own a share of the assets and earnings ability of that company.  That’s easy enough to understand.

In addition, to make money as an investor, you must buy shares for a lower price and sell at a higher price.  Buy low, Sell high.  Again, pretty simple stuff.

So if investing is so simple, why is stock investing so difficult?  

Because terms like “low” and “high” take on different meanings at various times.  As an example, it is easy to think you are buying low only to see prices go even lower.  

The flip side is that I think a safer way to invest is to buy high (something that is already going up) and sell higher.  It is just not easy to know where you are in the continuum of low to high.  

Ed Easterling of Crestmont Research has a unique, but very perceptive way of analyzing the markets.  Rather than focus just on prices, he studies at the relationship between corporate earnings (E) and stock prices (P), called the P/E ratio.

Low P/E ratios indicate cheaper markets.  High P/E ratios represent markets that are already priced high.   The movement of P/E ratios up and down as the economy and markets change can tell us a lot.
I often use the term “generational bear market” to describe a long period with many individual bear markets.  20% or greater declines are called bear markets.  Investing in stocks during bear markets is hard to do successfully.

I refer to these periods as “generational” not because of the length of time they run, but because they have the potential to either wipe out an entire generation of investors or so completely sour them on investing that they never want to do more than bury money in the back yard (which has its own set of risks).  

We had three generational bear markets during the 1900s.

The 1966-82 generational bear included 4 individual bear market cycles, including one that lost 43% of the market’s value.  

P/E ratios for that period began at 28 in 1966, and bottomed out at 7 in 1982 at the same time the stock market bottomed.  At that point, it only took 8 years of company earnings to equal what it cost to buy the average stock. That means stocks were cheap in terms of the earnings you were buying, at least compared to the beginning of that generational bear.

The 1929-49 period is muddied due to the economic distortions of WWII, but it included five separate bear markets, including three that presented catastrophic declines of over 40%.  P/E ratios began the period at 28 when stocks were expensive and bottomed at 9.

The 1901-20 generational bear market began with the P/E ratio being 23 and ended with it at 5.  The Dow Jones Industrial Average began the period at 71 and ended at 72 thanks to six separate bear markets within that period.  Not much profit for 20 years of trying.

But the significant point here is the pattern of P/E ratios being in the 20s at the beginning of generational bears and single digits at the end.

Currently the P/E ratio of the S&P 500 Index stands at 13.  This is not as high as it was in 2000 (42 – Yikes! That was expensive), but still about twice as high as we saw at the end of the past 3 generational bear markets.

Applying Easterling’s analysis to the current circumstances, we are unlikely to be at the end of this generational cycle because P/E ratios are only about half way back to the level at which we normally see generational bull markets resume.

Either corporate earnings have to increase, or prices have to come down more to bring P/E ratios in line with historical values at the end of generational bears markets.

That, combined with the fact that the last 3 generational bear markets have presented 4, 5, and 6 individual bears, and we have had only two in the current generational cycle, tells me that we need to stay prepared for more market upheavals because history strongly suggests that we aren’t done yet.

In this market, the ability to Adapt to Changing Markets® may be the key to preserving capital since there is no single investment that is immune from risk.  This year’s darling may be next year’s disaster.

I believe being able to move from one class of investment to another as markets change is the best way to protect your lifestyle and retirement plans.  To continue to blindly invest with no defensive strategy for a portfolio is a recipe for disaster.

If you are my client, you already have the benefit of this flexibility.  If you are not yet my client, now is the time you should consider becoming one – before the next big decline.  Call today for an appointment to get started.  (928) 778-4000

Thank you.

Managing Money For Free

Several times over the years, I have offered to manage the savings of local non-profit entities on a pro-bono basis. For free.  This year has seen two new non-profits sign on as clients.

Prescott has been very good to me and my family, and this is one way I can give something back to the community.

If you work with a non-profit that has savings or an endowment, and you are not happy with the performance of the account, please call to discuss whether my pro-bono offer might be appropriate for your organization.   (928) 778-4000.

How’s the Market Doing?

There were a slew of positive economic reports last week, and the stock market spiked up sharply in response.  By some measures, a buy signal for the market was triggered.  

There are still more negatives in the stock market, as well as in the economy, and some of the issues are significant, too.  If those negatives begin to fall away and get replaced with more buy signals, perhaps we will be seeing the beginnings of a real market turnaround.

However, we have to remember we are in the two most bearish months of the year in the most bearish year in the 4-year election cycle. This is no time to throw caution to the wind.

Looking at the charts, we are still caught in the trading range we entered a year ago – essentially a sideways movement in the stock market with little net profit.  Until the market breaks decisively up or down out of the range, we won’t know what the market will actually be doing for the long run.

Please remember, that my comments on the current market outlook reflect its condition, and are not meant as a prediction.   Only time will tell whether this is the start of a lasting uptrend or just another head fake by the markets.

Riddle:

Q: Throw it off the highest building, and I’ll not break. But put me in the ocean, and I will.

What am I?

A: A tissue.

What’s Going On In Your Portfolio?

Our growth accounts had begun last week positioned for the market slide to continue, holding the leveraged short investments I wrote about over the past few newsletters.  However, the jump in the market last week caused me to close out our short positions when our small gains turned into small losses.

With the market potentially turning around, I dipped our collective toes into the stock market buying 15% of individual stocks that are doing well, along with 15% of emerging market stock funds.  20% gold and 20% preferred stocks round out our growth holdings.  Cash levels are at 30%.

Being only 30% exposed to the stock market tells you that my confidence in the rally continuing is not strong.

Flexible Income accounts also hold 20% gold (a pseudo-currency), 20% preferred stocks, 40% strategic income funds, and 10% in a currency fund along with 10% cash.

What We Were Saying Back Then

In my September 16, 2008 newsletter I said, “I have seen good markets to invest in, and this isn’t one of them.”

Over the next nine weeks, the stock market lost an unbelievable 38% of its value before finding a temporary bottom on November 20th.

Although I do not see the level of problems in our economy today (September 6, 2010) that we had two years ago, I would not call this a healthy market by any stretch of the imagination.  

The general market weakness is a good set-up, whereby a shock to the system could potentially precipitate another waterfall decline in our financial markets.  I am referring to things like terrorist activity, foreign country defaults or other “out of the blue” incidents that could affect investor’s willingness to invest in an already weak environment.

Major market crashes rarely happen at market peaks, but when the market is already displaying weakness.  Right now, the S&P 500 is almost 10% below its high of April 23rd, so despite last week’s good showing, a decline is still underway.

I would recommend that investors tread lightly for now.

Just Let Me Know

As a client of mine you may know me as an investment manager, but I have years of related experiences to draw upon.  Just let me know if there is anything else I can help you with.  Membership has its privileges, you know.  The only thing I ask in return is that if you have any friends that could use my services that you think of me.  I’ll treat them just the way I have treated you.  That is the way I do business.

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.