Stock markets continued their downward move through November and into December. For November, the S&P 500 Index had negative returns of 7.2%. Stock in sectors that are perceived to have higher risk suffered even greater losses - the Russell 2000 Index of small companies experienced a loss of 11.8% in November.
Most of us are now familiar with the major market headlines:
We are now in the worst bear market since the 1930s. At its low point on November 21, 2008, the S&P 500 had declined 53.0% from its peak in October 2007.
Market volatility is at extreme levels. For example, on December 1st, the S&P 500 declined 8.9% - yet it received only modest media attention as investors have become accustomed to wild swings. The S&P 500 has either advanced or declined by more than 6% in six of the past 12 trading days. Under ordinary market conditions, the average daily move is less than 1%.
On December 1st, the National Bureau of Economic Research declared that the US economy is in a recession, which began in December 2007.
So far this quarter, the dominant investment trend has been a “flight to quality.” Money has moved away from riskier assets and into the safest categories – Treasury securities, insured certificates of deposits and money market funds. Small and mid-size companies have been hit the hardest.
Even within the large company sector there has been an amazing difference in performance between the largest companies and all others. The S&P 500 Index has lost 30.7% in the last 12 weeks. During this time frame, the 50 largest companies in the S&P 500 have lost an average of 23.8%, the other 450 companies have lost an average of 38.5%.
For investors with money in the stock market (which includes most Americans) there has been a significant loss of value – at least on paper. The value of all publicly traded securities (Wilshire 5000 Index) has declined by $8.6 trillion from its peak. Some experts have estimated that the total loss of US wealth, when including other asset classes, such as real estate and bonds, is approaching $20 trillion.
For most Americans, the loss is unrealized; they continue to hold their stocks, bonds, mutual funds, and homes in anticipation of a recovery in market value. Most individuals realize there can be a large difference between the market price of an asset and the actual intrinsic value of that same asset.
However, some investors have sold their equity positions and many others now question whether stocks remain a viable asset class for long-term investors. Does it still make sense to own stocks?
The primary reason for owning stocks is to meet the long-term objective of growth of capital. Equities have been the best performing asset class over long-term investment periods. The following graph shows the S&P 500 Index since 1950. Over that period, stocks have averaged annual total returns of 10.7%. Stocks are the only financial asset class that appreciates over time – as companies have been successful in building value for shareholders. Stocks are the only asset class that has an income stream (dividends) that increases over time.
Stocks have historically delivered about twice the annualized return of bonds over long-term time periods.
However, stocks have much greater risk than other asset classes. The primary risks are loss of principal, volatility (price fluctuation), and the uncertainty of returns. Each of these risks is currently at levels not seen since the 1930s.
With the S&P 500 currently down more than 40% for 2008, there is a possibility that this year will go down as the worst year on record. Only one year, 1931, has had negative returns of greater than 40%. Since 1940, only two years, 1974 (-25.9%) and 2002 (-22.0%), have produced losses of more than 20%.
Many are calling the current bear market a once-in-a-lifetime event. In an interview on CNBC, Warren Buffett put a positive spin on this occurrence. He noted that his major holding, Berkshire Hathaway, had declined more than 50% from its peak. It was the third time that this occurred, having had similar declines in 1974 and 1987. He commented that he hoped it would happen another one or two times over his remaining lifetime. The optimistic remark expressed both his desire for longevity as well as his appreciation of the investment opportunities that are created by bear markets.
Have the current economic and market conditions changed the way investors should regard stocks going forward? In all likelihood, investors will perceive stocks to be a riskier asset class. To a large degree, this perception is justified considering the depth of the bear market and the excessive volatility.
In addition, investors will likely see stocks as a lower returning asset class, since they will be most influenced by recent history. Not only has the past year been bleak, the trailing 10-year returns for stocks are now negative. This is in stark contrast to the bear markets of 2002, 1998 and 1987. At the bottom of those bear markets, investors still had annualized 10-year returns of more than 10%. In those situations, it was much easier regard the market decline as an aberration.
While the poor 10-year performance will taint most investors’ perceptions, in past instances it has been a predictor of significantly above-average future performance. On the previous occasions when 10-year performance was below 5% annualized returns, the following 10 years had annual average returns of 15.2%. It seems likely that over the next several years, stocks will possess both high risk and high return characteristics. The high returns should materialize as stocks return to more normal levels of valuation and the economy recovers from a recession.
Equity Investing Philosophy
There are many investment philosophies that can be employed to achieve an investor’s objective. A major key to long-term investment success is to develop a well-defined investment philosophy, and to adhere to it on a consistent basis. Altering one investment approach based on market conditions will typically detract from long-term performance. Patience and discipline are required when markets become chaotic.
A successful equity investment philosophy might include the following components:
The amount of equities in a portfolio should be dictated by an investor’s objectives and risk tolerance. A high return objective, a high risk tolerance and a longer time horizon is consistent with an investment strategy that is primarily oriented toward equities. Fixed income investments are used to offset stock market risk and produce a predictable level of income. An investor with a lower risk tolerance typically has more exposure to fixed income securities.
Market timing should not play a significant role in the equity strategy. This philosophy is based on numerous studies which show that market timing strategies generally weaken long-term performance. To be successful at timing the market, one must consistently be able to sell at the top and buy at the bottom. In reality, most investors do exactly the opposite; they are euphoric at market peaks and fearful near the bottoms.
Rebalancing a portfolio on a regular basis imposes a discipline that usually results in buying low and selling high. When the equity portion of the portfolio has fallen below its target level due to a stock market correction, rebalancing forces investor to reduce fixed income exposure and use the proceeds to buy stocks when they are cheap.
Equity risk is managed through diversification. There are many types of risk – company risk, market risk, sector risk, geographic risk, economic risk, interest rate risk, etc. Diversification means limiting exposure to any one type of risk. The equity portion of a portfolio should have exposure to most major industry sectors, growth and value stocks, large and small companies and international markets.
Investments should be made in companies that appear to be undervalued in relation to their earnings, cash flows and growth rates. In addition, other factors such as management strength, financial condition, profitability, and consistency of performance need to be considered. Equity investing requires patience, as some investments will not work out as anticipated, and others will need to be held for a considerable length of time for them to be successful.
It is important to acknowledge that adherence to this philosophy will not prevent a loss of market value during a correction or bear market. In fact, it recognizes the volatility and unpredictability of the stock market. Employing this philosophy is intended to achieve attractive long-term returns, while attempting to manage risk.