Letter to Our Clients - April 2013

April 2013


Dear Clients and Friends:

As I write this at the end of March, major US stock market averages are at or near their all-time highs.

Or are they? And regardless, is this a cause for concern?

By the numbers, it is true the Dow Jones Industrial Average and the S&P 500 (both un-managed indexes which cannot be owned directly) are in record territory. But, if adjusted for inflation, these indexes are nowhere near their peaks in 2000 and 2007.

Even so, over the last 13 years it has seemed that whenever the stock markets reach new highs, they drop again. Why will not the same thing happen again?

Maybe it will and maybe it won’t. We will not know for sure for several years. Regardless, there are some points which should be considered.

Is the stock market dangerously high?

One of the most common ways to determine whether a stock, or an index, is “cheap” or “expensive” is to look at its Price/Earnings Ratio, called its P/E. (For example, a stock that has a trading value of $1 per share, and has $1 per share of earnings, has a P/E ratio of “1.” A stock trading at $100 per share, with $1 per share earnings, has a P/E of “100.” The lower the P/E, all things being equal, the better the value the stock should be.)

The long-term historical average P/E of the Dow and S&P 500 is between 14 to 17. In 2000 it was in the mid-30’s (at or near its all-time high), and in 2007 it was in the mid-20’s (definitely above average). Today it is about 15 to 17. (No two experts seem to agree on precisely how to measure P/E ratios, which is why it is prudent to use such wide ranges). In other words, today’s stock market values are at “normal” levels.

A second important consideration is the health of US companies. Looking at the S&P 500, which is basically the 500 largest domestic companies, profits are at record highs and estimated to be double what they were in 2000. Corporations are sitting on record amounts of cash and generally have very strong balance sheets. (This is one explanation for the high unemployment rate – why should corporations hire new employees when they are making so much money just doing what they are doing?)

Both of these factors are reasons why optimists say that the US stock market is not “over-valued,” why it is not in a bubble.

What about federal debt, or the Federal Reserve’s programs of pushing dollars into the US economy, or the non-discretionary federal spending (Social Security, Medicare, Medicaid)? Here is a roundabout answer.

Stock market performance is not based upon politics. It is based upon profitability. When businesses provide goods or services at a profit, investors in those companies are usually rewarded.

The challenge is that the stock markets usually make major moves before economic or profit trends are apparent. The stock market dropped in 2000 and 2007, well before the recessions actually began. The markets began to rise dramatically long before there was any evidence of hope for the US economy.

Investors who wait to invest until the “all-clear” sign has been lit, or who sell only when the “danger” sign is flashing, will constantly be buying high and selling low. No wonder they think the stock market is for crazy people!

There is no way to say what the stock market is telling us now. Personally I still think we are in that long-term “secular bear market” I discussed in my letter of January, 2011 (which can be viewed on our website under “Letters to Clients – Archives”). However, I also think the lows will not be as dramatic as 2000-2002 and 2007-2009, and the highs will be within the upper ranges of the last 13 years, plus or minus a bit.

What I think is not meant to be guidance. Investors need to review their accounts to see if they are aligned with their investment strategy. For example, if the plan was to have between 60% and 70% in the stock market, and now the accounts in aggregate are at 75% or 80% in the stock market, then we should make the adjustments necessary to bring the accounts back into balance.

Unfortunately, many people invest in the belief that the financial markets will behave in the future as they have in the recent past. For some that is a 12 month window. The market has been up for the last year, therefore it will be up for the next year, therefore it is safe to put more money into stocks and to buy more aggressive positions. For others, their recent history is the last 5 years or 13 years. For them the financial markets have delivered terrible returns, therefore it is never safe to have any (or much) money in the stock market. Neither approach is likely to generate investment “success,” because both approaches are a form of “timing.” We believe it is more prudent, safer, and more likely to generate success for investors to develop a philosophy or a strategy based on their situation and “risk tolerances,” and then adjust the portfolio to conform to that strategy. We think it unwise to change strategies based upon expectations of what will happen in the future.

As we balance portfolios between cash, bonds, stocks and “other,” here are some of the current issues which dominate portfolio management.

First is inflation. Many have been warning about runaway inflation since interest rates dropped to historic lows in 2008. At the moment, inflation is running at less than 3%, if government statistics can be trusted (no further comment!). Inflation is higher than 3% for some things (health care and college education) and less than that for other things (electronics). Food prices fluctuate and can go dramatically higher for reasons other than federal policy, and gasoline prices are also subject to supply and delivery constraints, and to global demand. All considered, though, it is safe to say that inflation today is about 3%. It may go higher in coming years, but it might not. We must deal with the present and plan for the future – whatever it might bring. (In fact, some economists worry that there is a bigger risk of long-term deflation than there is with inflation. There are also some compelling studies which argue that inflation is not caused by programs such as the current government spending policies, but instead is caused by increases in the money supply – which has not been occurring for the last few years. All this is too academic to discuss further in this letter.)

Inflation causes problems for fixed income investments such as bank accounts and bonds. Bank accounts especially can be seen as “risk-free” because they are guaranteed to not go down in value. However, because of inflation, they are guaranteed to lose purchasing power equal to the inflation rate. This is a real and serious “loss,” but is ignored by many when their only measure of performance is whether the account value is up or down at the end of the month. We suggest you use “cash” accounts only as reserves, where you keep money you might need in emergencies, but do not consider these accounts as prudent long-term investment products.

Next there is real estate. This may be a good time to buy real estate, but contrary to popular belief, real estate holdings do not always go up in value. More importantly, real estate is not a liquid asset. It usually cannot be sold quickly and at a reasonable price if money is needed in a hurry. In our opinion, owning real estate is a viable long-term investment program for some people, but it is also relatively high-risk.

Some people believe the only really prudent place to put money is in precious metals, and especially in gold. The challenge is that precious metals do not make anything or generate any income. One buys gold (for example) on the expectation that someone else will buy it later for more than it costs now. That seems like the definition of speculation. Think of this. The price of gold is close to twice what its value was in 1980 (and is currently dropping). In the meantime, the Dow and the S&P have grown to more than 14 times their value in 1980, and believe it or not, the economic outlook for the US was much more bleak in 1980 than it is today.

The last main alternative to the stock market is the bond market. Bonds traditionally have offered three reasons to own them.

First, they usually do not move up or down at the same time the stock market does, and they usually do not move up or down as rapidly.  Thus they lend stability to a portfolio and counterbalance the potentially more dramatic movements of the stock market.

Second, they generate cash-flow, potentially at a rate higher than bank accounts. This is certainly true today.

Third, they have offered the potential for appreciation, similar to stocks or real estate. When interest rates rise, the value of existing bonds drops. When interest rates drop, the value of existing bonds goes up. Interest rates have been dropping from 1982 to the present. (The fluctuation of bond prices is greatest for bonds many years from maturity, and becomes less and less as the maturity date approaches.) Since we are in an era of record-low interest rates, the potential for the increase in bond values is minimal. Thus, the third historical reason to own bonds does not apply now.

We are left with the two justifications for bonds – to reduce portfolio fluctuation, and to seek more cash-flow than is available in normal bank accounts.

In conclusion, as we build or maintain investment portfolios, we think the stock market today offers much better opportunity for growth and for income than the alternatives, BUT, the stock market exposes investors to the nervousness of fluctuation along the way – especially since the headlines tell us the indexes continue to reach new highs. The more an investor can accept this uncertainty, the more their portfolio can/should own a diversified, balanced portfolio of stocks. In our opinion, this is true even with the stock markets at these levels. The decision to be ___% in stocks, ___% in bonds and ___% in cash should not be based on one’s opinions about how high or low, or when, the stock markets will move, or what will happen to bonds when interest rates rise. Instead it should be a decision based upon a long-term understanding of one’s ability to tolerate the unpredictable. (This is one thing that will never go away – the unpredictability of life in general and the financial markets in particular.)

As always, please contact us if there is anything you would like to discuss. And, again, thank you for the opportunity to work with you.

Best Wishes,

Robert K. Haley, JD, CFP®, AIF®


Indices are un-managed and cannot be owned directly. Past performance is not indicative of future results.