"A Doozy of a Market"

Sydney M. Williams

Thought of the Day

“A Doozy of a Market”

November 10, 2011

By August 8th the S&P 500 had fallen 18% from its April 29th interim high of 1363.61. About the same time daily volatility, which for twelve months had been docile, began accelerating. A 3.7% decline in the market, as we saw yesterday, is an eye opener. While it is not the biggest decline we have seen or are likely to see, it is, nevertheless, like getting sucker-punched and disquiets the mind as well as the stomach.

The reasons, not surprisingly, were attributed to Europe and the dance we have been witnessing between the parsimonious north and the profligate south, and now especially the fun loving Italians. Italy is a country, as the wags put it, that is too big to fail and too big to save; thereby creating a conundrum for which the wisdom of a Solomon is needed. And no Solomon can be found. Of course intransigence is a condition not limited to Europe. One has only to look at the stonewalling in Washington.

The real problem for both Europe and the United States is a refusal to admit the real cause of the credit collapse. In any crisis, a scapegoat must be found. Politicians and most of the press, in both places, have found one in bankers. They are a convenient target. There are not that many of them. Some of them make unseemly amounts of money. Arrogance is not an unknown characteristic, as when Lloyd Blankfein suggested Goldman was only doing “God’s work.” When the system needed savings, bankers were among the chief beneficiaries. But, importantly, they serve as a diversion to politicians who have avoided the mirror while looking for culprits. More than anything it was a culture they helped create, one with no accountability, that created the chaos.

The cause was societal. Government was (and is) as responsible as any segment of our society in fostering this environment of irresponsibility. People were urged to take on debt. And they did. Politicians and union leaders made promises on which they could never deliver. People, unquestioning, accepted those pledges. It was (and is) a Walter Mitty world.

The situation in Europe should serve as a cautionary tale for the United States, that the road to Socialism is paved with unintended consequences, and at the end of the day common sense must prevail. When the money is gone; it’s gone. But unfortunately, that lesson has not been learned. Voters in Ohio on Tuesday overturned Republican Governor John Kasich’s efforts to place limits on public employee unions’ collective bargaining rights. Perhaps taking their cue from Ohio, yesterday Democrats on the Super Committee walked out on discussions, claiming that Republican offers of $500 billion in revenue increases over ten years was unacceptable, as it results from lowering rates and eliminating deductions. Part of the problem derives from the fact that all assumptions are based on static accounting, which does not factor any behavioral effects of new rules. But part of the problem is simply a version of class warfare, a condition encouraged by the President in his rabble-rousing populist speeches, as he chases around the country campaigning for a second term. Both Democrats and Republicans should be looking to do those things that would enhance economic growth, period. Demonizing the wealthy may make good press, but it does not address the real problem of spending and unrealistic promises.

In my opinion, it is these macro factors that have been weighing on stock prices. The western world is gradually shifting from a never-never world built on dreams to a more realistic one based on facts and the competition emerging from the East and other emerging countries. The change is not easy and some people will suffer. For every two steps forward there is at least one step backward. But investors should always keep in mind the discounting nature of markets. When we pick up a paper and read of problems in Ohio or Greece, or when we hear that Italy had to pay 6.07% for one-year notes, we are not the first to read or hear that news.

Ronald O’Hanley of Fidelity spoke yesterday in Boston. He pointed out that since the beginning of 2008 $1.2 trillion in cumulative outflows have departed U.S. equity mutual funds, a considerable sum even for a market that is valued at $15 trillion. Mr. O’Hanley pointed out that the reasons had to do with de-risking and diversification. Volatility, ten plus years of mediocre returns and the fact that 10,000 people in the United States are reaching retirement age every day – and will continue to do so until the last baby boomer reaches 65 in 2029 – only aggravate the situation. But, again none of this news is new.

Markets almost always deny simple analysis. The last time the market experienced the type of volatility we are seeing today was in the September 2008-April 2009 period, a time during which the S&P500 declined from 1166.36 to 872.81. Of course, the S&P in September 2008 was already down 25% from its October 2007 high. People who bought stocks during that time have generally done well.

Corporations are laden with cash. According to the Federal Reserve, non-financial corporations have more than $2 trillion on their balance sheets at the end of June. As Mr. O’Hanley put it, “While there is a bull market in corporate earnings, there’s a bear market in stock multiples.” I am not so sure I would go that far, but stocks generally seem fairly valued, which suggests that stock pickers should be able to find values. But, for any sustained rally, daily volatility will likely diminish.

It is worth reviewing a study done by Birinyi Associates in 2007, entitled “The Good, the Bad and the Beautiful,” a piece I wrote about three years ago. The report looked at three different investing scenarios over a forty-year period: 1) Buy and hold; 2) without the five worst days of each year and 3) without the five best days of each year. The results are telling. Under a buy and hold strategy, one dollar invested in February 1966 became $16.58 by May 2007. Avoiding the five worst days, the dollar became $2,520.94, while missing the five best days, the dollar over those forty years became $0.11. One can conclude that market timing works, but one had better be very good at it. For the rest of us, we should recognize that over time stocks have done well and that attempts to time the market is generally unprofitable.

So, my sense is that we are in a market in which company fundamentals are improving, but a political system that has yet to come to grips with the real causes of the crisis. There are many companies that pay attractive dividends, in some cases yielding more than their bonds, and in more cases yielding more than the Ten-year Treasury. To use a non sequitor, I remain cautiously optimistic. Any full fledged bull market will have to wait, in my opinion, until we have greater clarification on the political front and that the culture that created the 2008 crisis has dissipated. On the other hand, it would be a mistake, in my opinion, not to have some exposure to stocks.