Advice for Investing in Turbulent Times

The market tumbles - what does it mean for investors?

Fear is at extreme levels. This is a multi decade opportunity; it is an opportunity to profit. With the kind of valuations the SP500 is trading at, risks are low and perceived risks high; it is a time like no other to invest. Most sensible long term investors have an asset allocation strategy. If asset class allocations are out of sync, re-balance and do it now. Once asset class allocation is completed, re-balance sector allocations. Then wait to smile.

1. Asset class allocation adopted by several people goes 60-30-10 (Equity/Bonds/Cash). Assuming that asset classes have not been rebalanced since 1 January, 2008, an equity portfolio is likely down approximately 28%. The asset class allocation will be 52-36-12 at this point in time. Investors need to reduce weight-age to bonds and cash to take the equity allocation back to 60%.

2. In light of the large moves in the capital markets, investors should consider reviewing their asset class allocations (a) once quarterly, and (b) when the portfolio has declined 8% since the last review.

3. With the SP500 trading at 1036 as I write, valuations as a multiple of 2007 Operating Earnings including Dividends are 9.3; valuations as a multiple of 2007 Operating Earnings excluding Dividends is 12.4. The average multiple over the last 20 years has been 14.6 for the prior year's Operating Earnings including Dividends; the average multiple over the last 20 years has been 20.2 for the prior year's Operating Earnings excluding Dividends. With valuations so far below average, while perceived risks remain elevated, the real risks are low. Investors should re-evaluate their risk appetite to determine whether a temporary asset class allocation of 70-20-10 is appropriate. With fear levels elevated, this could be an unrivaled opportunity for long term investors.

4. Changes to valuations have not been consistent across sectors. Investors need to re-balance their sector allocations to reflect the changes.

5. Investors can also consider the weight-age given to sectors, in order to position their portfolios in accordance with the economy's position in present economic and secular cycle. Example weight-age is noted below (All Stocks-Secular Investors (16 Year Horizon)-Cyclial Investors (5 Year Horizon):

6. In order to reduce portfolio risks (Beta) investors should consider diversification. Using ETF's is a good method to diversify, provided that investors are happy to reduce portfolio risk at the cost of forgoing alpha returns from superior stock selection. If investors are seeking alpha returns, consider large cap names to manage volatility, and select at least two stocks in each sector for better diversification.

7. Solvency and liquidity risks in the financial services sector remain elevated. It is recommended that conservative stock selection is used in place of an ETF.

8. Assuming that the market will trade at the worst levels in the past two decades, the SP500 could go as low as 926-991. Should this materialize, historic trends would suggest a year end price target of 1082-1140. A very conservative 2011 price target using 2007 earnings levels with a return to historic multiples is indicative of SP500 levels of between 1623 and 1687; that equates to a return of 57% to 63% from SP500 levels at 1036.

9. Keep in mind that things can get worse than they have got in the past twenty years; equity has however long provided the best long term returns - the choice to accept the risks associated with the rewards is made by the investor.

10. The long term secular picture is encouraging. The world has never seen an expansion of the magnitude being contemplated. The urbanization and industrialization of India and China is huge; the closest is historic comparable the re-building of Europe, Germany & Japan post World War II. In an economic expansion of this magnitude, equity as an asset class can be expected to out-perform. US corporates have access to unrivalled management expertise, intellectual property and capital; they have also embraced globalization with open arms. They can be expected to outperform.

11. You can view the SP500 historic earnings and dividend data here.

Comments

[Larry House:]

Sound advice straight from the book. I differ a bit. With the times what they are, I won't hesitate to change my allocation for some period of time. I am 17% stocks now, and normally I would be at least 50%. I am overweight short-term bonds and cash. It is YOUR allocation--not just what the book says. My personal view is that stocks will probably not out-return bonds for some time. I am confortable with my allocation, and that is what matters to me.

2008 Oct 07 12:40 PM

[ThoenTBrite:]

Shiv, all I have to say is that you are a genius. I keep your editorials as a learning guide for my Economic students. But, you really have to get a better picture than that. I won't compare it to a Wanted poster but there must be a more flattering portrait of you to add to your astute and learned columns. Keep plodding on...

2008 Oct 08 09:00 AM

[Shiv Kapoor:]

ThoenTBrite - Thanks for the kind words. The ugly slob image is carefully cultivated; been seen as the (under) dog it gives a massive advantage in negotiation! Besides my brother took all the family looks even though he came after me.

But seriously, since there are economic students at stake, I will point one fact out which is not raised by any readers. In addition to use of operating earnings as a divsor to calculate multiples, I use earnings + dividends as a divisor in calculating alternative mutiples; no one asked why. Since earnings are before dividends, it is somewhat illogical to use a sum of the two as a divisor. It works best because at market bottoms yield and valuation together become the key investor criteria; so an absolute value gives the information most relevant for investment decisions being made.

2008 Oct 08 01:37 PM