Year End Review

Looking Back - and Looking Forward

2009 was one of those years that reminded us what a roller coaster the stock market can be – and also of the dangers of conventional thinking.

After the collapse in global financial markets last fall and the resulting pummeling taken by stock markets around the world, the consensus in January was that the worst was behind us. That was a sharp reminder of the danger of conventional thinking – by early March, markets in Canada had declined by a further 15% and the U.S. was down by 25%.

At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one in five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact and we began seeing signs of an economic recovery. From the market’s bottom on March 9 to the end of November, global markets were up by 50% to 65%.

Thus, 2009 was a sharp reminder that it’s impossible to predict short term market movements.

Instead we need to focus on two key questions:

1. First, what do the prospects for economic and profit growth look like in the mid term – 12 to 18 months and beyond?
2. Second, to what extent are these prospects for growth accurately reflected in today’s prices of stocks and bonds?

Mid-Term Prospects For Growth

In building portfolios, we have to start with some core assumptions about the environment we’ll be in going forward.

Noted British historian Paul Johnson has written that at every given point in time, you can always point to good news and bad news – the only difference is the balance between the two and what the media pays attention to.

In early 2000 (at the height of the tech bubble) and the beginning of 2008 (at the top of the real estate and finance bubble), all we read about was good news – almost no attention was paid to any offsetting concerns. By contrast, during market bottoms at the end of 2003 and early 2009, all we saw was the bad news – it’s as if there were no positives on the horizon.

Despite the recovery in the global economy and markets since the early part of this year, the general sentiment and confidence level among many people today is quite negative. Much of that is driven by concerns about the U.S. economy – still the engine of global growth.

And certainly there are lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline) and Government deficits.

Without dismissing the short term challenges facing the US, it’s important not to lose sight of some important underlying positives.

In an August cover story on “The case for optimism” Business Week Magazine highlighted a number of reasons to be positive, among them the impact of technology and free markets in emerging economies.

Click here to read more about what Business Week had to say:
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories

And recently two respected columnists at the New York Times, Thomas Friedman and David Brooks, weighed in on both the positives in the U.S. and some of the challenges that America faces.

http://www.nytimes.com/2009/11/22/opinion/22friedman.html
http://www.nytimes.com/2009/11/17/opinion/17brooks.html

The bottom line is: In the mid term I believe the positives outweigh the negatives and that the dire predictions about America’s decline are overstated. It may not see the rapid growth we’ve seen in the past but it will see solid growth.

Today’s Valuation Levels

Being right on our midterm outlook for the economy only helps us if we buy stocks and bonds at attractive prices.

With regard to bonds, at current interest rates of about 3% it is hard to make a case for Government bonds as anything except a safe harbour against more market disruption.

The returns on corporate bonds are more interesting – especially toward the bottom of the investment grade category, which currently yield about 6%. Note that we do have to be very selective here, since companies with low investment grade ratings are susceptible to shocks and downgrades should the economy run into difficulty.
On the issue of valuation levels of stocks, there are lots of academics who have made a career of studying markets. Of these, I follow two in particular – Jeremy Siegel at the Wharton School at the University of Pennsylvania and Robert Shiller at Yale. Between them, they forecast both the technology and the U.S. real estate bubbles.

Robert Shiller believes stocks should be valued based on their average earnings over the past ten years, using what he calls the Cyclically Adujsted Price Earnings ratio (CAPE for short). Employing that measure, at the end of November Shiller calculates the U.S. market’s multiple is 19.5 x times average earnings for the past ten years, within the normal historical range (although at the high end of that range.)

Prior to 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below twenty times average ten year earnings. Throughout the period from 1997 to 2001, this multiple was in the thirties and forties – when the multiple was in its forties, you were paying twice as much for a dollar of earnings as you are today.

Jeremy Siegel is the best known researcher on long term returns in the stock market and author of Stocks for the Long Run, often cited as one of the all-time ten most influential books on investing. Among his claims to fame is an article in the Wall Street Journal at the peak of the tech mania in early 2000, predicting that sector’s collapse.

In September, Siegel did two interviews on long term returns and current valuations, in which he talked about his research and his opinion that stocks offered good value at the time. You can see those interviews below:

Professor Jeremy Siegel on today’s market outlook:
http://www.clientinsights.ca/video/today-s-valuation-levels-and-market-outlook/type:investor

Professor Jeremy Siegel on long term stock returns:
http://www.clientinsights.ca/video/stocks-for-the-long-run-and-long-term-returns/type:investor

The bottom line from these two experts: While stocks are not as cheap as they were in March, by historical standards they do offer reasonable value.

While we can expect continued volatility in 2010, we do believe that returns on stocks in the period ahead will be in line with historical levels.

The Right Approach For Your Portfolio

While my team and I spend a great deal of time focusing on the big picture, the most important issue is how we adapt that view to each client’s individual portfolio.

For older clients, we have always been believers in maintaining conservative, balanced portfolios – that stance protected our retired clients from the worst of the decline in 2008 and early this year. Today, we are focusing on higher quality stocks, as we believe that these will provide the best risk return trade-off going forward.

In summary, we are cautiously optimistic about the American, Canadian and the global economy’s ability to work through some of the current issues they face – and believe that valuations on stocks will make quality stocks an attractive investment in the mid-term.

We look forward to continuing to work with you in 2010 to ensure you have the portfolio that is right for you – and thank you again for the opportunity to work with you over the past while.

As always, my team and I area always available to talk about any questions that you might have.

In the meantime, best wishes for a relaxing holiday season – I look forward to talking in 2010.