Fat tails and other talk of risk

An accepted tenent of investing has been that returns group in a "normal distribution" around long-term averages.  As the thinking goes, some years are good, some bad but the possibility of really good and especially the really bad are so remote as to be somewhat dismissed.  The time period that started about two years ago with the September 15, 2008 bankruptcy of Lehman Brothers taught everyone that there was a very distinct possibility of really, really bad returns.

Now some are coming forward with studies to support the idea that the chances of bad returns are really much higher than had been previously thought.  The statistical probability of really bad returns occurring in any quarter by one study is about 5 times higher than previously thought.  The statisticians call such return outliers "fat tails" to describe their higher frequency than the "thin tails" previously assumed.  A very good study on this was recently released by Welton Investment Corporation and can be found on their web site at http://www.welton.com/.  We recommend this study to all who want to better understand the risks of investing going forward.

Could U.S. November Elections be Catalyst for Stocks?

A recent scoring of projected Congressional election results for this November as seen in the Wall Street Journal showed Republicans picking up 42 House seats to take majority at 220 to 215, and 7 Senate seats to close to 48 Rs and 52 Ds.  We recently listened to a money manager (with $45 billion under management) explain his optimism for stocks in a variety of terms, including those political.

The political positives per this manager were that the November election results would see enough change in Washington to give investors comfort of a more stock-market-friendly set of office holders, thus proving a catalyst for market gains.  If the projection for Republican gains proves accurate, we may well get the opportunity to see if the "catalyst" theory proves true.

The Disconnect Between Bonds and Stocks

The current interest rate yield on 10-year U.S. treasury bonds is about 2.6% as compared to about 4% on these same bonds in April of this year.  Those worried about a double-dip back into recession have aggressively purchased the U.S. 10-year resulting in this very low rate.  Comparable rates around the world are similarly low, with German 10-year at about 2.3%.  Japanese 10-year bonds are yielding under 1%, but this is a special situation with years of deflation and the vast majority of such bonds purchased and held by the Japanese themselves.

Now consider stocks.  A buyer of all 30 stocks in the Dow Jones Industrials Average would receive a dividend yield of 2.7%, plus any future dividend increases, plus any future growth in the price of the stocks.  When comparing this to the 10-year U.S. treasury bond yield of 2.6%, a bond buyer is essentially valuing future dividend increases and future stock price growth at zero.  This week we listened to a conference call by a stock mutual fund manager (who manages about $45 billion) where he indicated never in his career had he seen such a compelling case for owning stocks as compared to bonds.

It would seem that only one of these will turn out to be correct- either the case for bonds or for stocks.  Investors should pay close attention to this disconnect as they determine how to allocate their portfolios.

Are double-dip recession risks overblown?

We recently read an economist's pronouncement that the risks of a double-dip recession had now increased from one-in-five to one-in-four.  Another economist we follow stated that while a decline back into recession was certainly possible, it was not at all probable.

Economic problems are getting such a high level of play in the media that one wonders if market participants have overreacted.  The front page of today's Wall Street Journal carries an article discussing how small investors continue to "flee stocks".

The second quarter of 2010 saw the S&P 500 decline by about 11 1/2% amid these concerns.  At the same time many of the market valuation measures continue to improve.  Of course, the U.S. economy could descend into another recession and validate all of those who are reducing their equity holdings, but if equity pricing over the long-term does return to near its historical levels investors may someday look at this as a buying opportunity.

Escape Velocity

Scientists use the term "escape velocity" to describe the speed an object must have to escape the gravitational pull and not fall back down to the earth.  The term comes to mind in observing the U.S. and world economy as it attempts to escape the pull of deflationary forces and avoid falling back down into a double dip recession.

The deflationary forces include sovereign debt problems of Greece and other southern European countries, China's policy efforts to slow real estate speculation and deficit cutting challenges of all developed countries.  Today's unemployment report for the U.S. had net job losses (125,000) for the first time this year and adds to concerns over the ability to continue economic growth in the second half of 2010.

No one can say when we will reach escape velocity, but we all know at some point we will experience sustained economic growth.  In the meantime the market worries are resulting in some increasingly attractive valuations for the S&P 500.  Price to sales is 1 compared to a 10-year average of 1.4.  Price to earnings is 11.5x (on forward earnings) as compared to an average of 16.1x for the past ten years.  We make no prediction as to the market but would observe that the valuation case for stocks is definitely strengthening.

Looking back over 2009- Stocks

Wow!  Stock returns for 2009 were superb, particularly that part of the year from the lows reach March 9 of this year.  With a return of 28% year-to-date and 69% from March 9th to present, the S&P 500 demonstrates how well stocks did.

Stocks of developed international markets did even better, in part due to currency gains from a weak dollar.  The index known as MSCI EAFE is the generally accepted benchmark for these markets, and has a year-to-date return of 31%.

Leading the pack in stock returns were the emerging markets of countries like China, India and Brazil.  The return for the MSCI index for emerging markets year-to-date is 78%.  These stocks went down quite a bit more than developed markets in 2008, so they were coming from lower levels.  Also, they benefited from investor sentiment that sees these countries as the primary driver of worldwide economic growth for years to come.

So 2009 taught us that there are recoveries after the stock lows brought about by forced selling of those who must deleverage and emotional selling of those who got scared and followed.  Investors who really prospered maintained their discipline, followed their allocation plan, and even better identified opportunities that the tidal waves of selling created.  There was much to learn from 2009 and those who tried to time the market or who reacted emotionally and sold at the lows paid a big price for the lesson.  Let's hope investors can remember these lessons for a while.

What does recovery mean?

The U.S. economy contracted at an annual rate of 1% in the 2nd quarter which is a significant improvement over the decline of 6.4% (annualized) in the first quarter. This is a significant improvement and has been accompanied by over a 50% increase in stock prices as measured by the S&P 500 from the March lows. Some portion of the improvement in stock prices and in the economy must be attributed to actions by the Federal Reserve and the Treasury. The government supports are not sustainable in the long-term, and to some extent must be removed at some point in the future.

So what kind of recovery will we see, particularly as some government stimulus is removed? Stock price increases would seem to indicated the market believes we will see a strong period of growth as inventories rebuild and consumer demand increases. We are somewhat skeptical of this, and would instead worry that 2010 could see an economy with high unemployment and slow growth (possibly even periods of declines). We quote the analysts at PIMCO who said on August 20, "Government intervention on an unprecedented scale... has brought about stabilization. But this does not provide the foundation for a V-shaped return to business-as-usual. The violent rise in unemployment, above 9% in U.S. and Eurozone, is a significant challenge to income growth, and in turn, consumption growth and top line growth for business."

We may have a long way to go before we reach what truly feels like recovery. This seems to be time for caution by investors.