Monday, June 4, 2012

Where Are We?

By Matt Malick and Ben Atwater

There has been an increase in web chatter, television series, movies, books and news reports about various cosmic disaster scenarios including asteroids, solar flares and black holes. David Morrison, the senior scientist at NASA’s Ames Research Center in California and a Harvard PhD in astronomy, recently asked, “Why is our society so focused on potential disasters?”

Dr. Morrison’s question is applicable to not just astronomy, but also the pervasive negativity around virtually everything from politics to economics.

And it is no wonder. Using the U.S. stock market as a barometer of mood, it is at the same depressingly stagnant level as it was a year ago (spring 2011) . . . and fourteen years ago (summer 1998).

Not just that, but during the decade of the 2000s, investors experienced not one, but two drops of about 50% in the U.S. stock market. And after making major progress in 2009, the market has struggled with 20% declines beginning in the springs of 2010 and 2011. Although it rebounded convincingly each time, we are now mired in yet another slump.

After all this, you might assume that nobody would invest in stocks. This is partially correct. Beginning in 2007 and accelerating to this minute, investors have moved over $1.4 trillion from stock funds to bond funds.

Outside of mutual funds, institutional investors are also fleeing equities. Take the massive German insurer Allianz as a prime example. Today its portfolio is 6% stocks, whereas ten years ago it was 20% equities. Given the legal constraints that insurance companies must follow within their portfolios, 20% was a highly aggressive stock position, likely pushing regulatory limits. So at the worst possible time, Allianz had its maximum equity exposure. Now, a decade later, its stock exposure is muted.

This is also true of pension funds, many of which are substantially underfunded. A decade ago, U.S. public pension pools allocated about 70% of their assets to equities, now they have scaled that back to 54%. Not knowing the future, but with an eye toward the past, this is seemingly backward.

To paraphrase Warren Buffett, people tend to invest through the rearview mirror, which he reckons is about as advisable as driving in the same manner.

Chris Puplava, who operates the blog Financial Sense and is a Portfolio Manager with PFS Group in San Diego, CA, elaborates on Buffett’s sentiments:

What investors must remember is that secular bull market tops are formed at a time when everything couldn’t be better or life brighter. This was the backdrop of the 1929 secular bull market top in which the U.S. industrial giant was firing on all cylinders; or the 1969 secular bull market top in which nothing seemed impossible as the U.S. put the first man on the moon; or the 2000 secular bull market top when we entered a supposed new era of technology and permanent growth. Conversely, when things look like they couldn’t get any worse and that the whole world is going to end, new secular bull markets begin to form.

Right now seems to - once again - fit the description of ultimate pessimism. According to Barron’s, “the 10-year trailing annualized return (excluding dividends) has risen from below zero to a bit over 2%,” a depressing statistic in and of itself. But, what does that potentially tell us about the future?

further reports that, “if the S&P 500 is at today’s level on October 9, the tenth anniversary of the 2002 bear-market low, the ten-year trailing return would be 5.5%. That’s similar to post-bear periods in the late ‘40s and late ‘70s – decent times to lay patient bets on equities, but not the start of bull-market manias.” The point Barron’s makes is well illustrated in the below chart from Blackhorse Analytics.

Reversion to the mean would indicate that returns will trend substantially higher over the next decade.  But we are hardly suggesting smooth sailing. Instead, we believe that the market will eventually reward patience. You cannot predict the exact day when stocks will begin their next prolonged boom – it is impossible. But you can though invest while the seas are still rough, knowing that if history is any guide, clear skies will return.

So, where are we?

We do not pretend to know what will happen next week, next month or even next year. However, from a long-term perspective, we are likely closer to the end of the market’s doldrums than we are to its beginning.

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