Yet, amid all the sturm and drang, Warren Buffett boasted that on Monday, August 6, his investment vehicle, Berkshire Hathaway, bought more shares than any other day this year. As he explained it, "I like buying on sale."
We all like a bargain, but it's hard to see a catalyst for a near term market rebound. The traditional sources of stimulus, monetary and fiscal authorities, seem to be out of bullets, while the European debt crisis seem to echo Lehman and our own 2008 financial travails, but without strong centralized power to deal with it.
In this country, the Federal Reserve now seem impotent, having already lowered rates to zero, yet with little to show for it; recent criticism that the Fed Chairman has been treasonous by his money printing may keep him on the sidelines.
Meanwhile, on the fiscal side of things, Keynesian stimulus spending proved of little avail. While it's hard to argue that Government spending impedes economic demand, the recent budget wrangling makes destimulus or spending cutbacks a real risk for the near term path of our economy and the market.
Investors also ponder the slow disintegration of the European monetary union and the implications that might have for European financial institutions and ultimately our own. Indeed, US money market funds have been methodically cleansing their portfolios of European certificates of deposits.
The bullish case is that the Euro authorities watched the devastating effect the Lehman failure had on our economy, which will provide the political will to stabilize the sovereign debt problems. However, who really believes German taxpayers will ultimately assist their profligate cousins on Europe's southern fringe?
Bottom Line Advice
We agree with Warren Buffett. Stocks are now on sale and many attractive opportunities exist. While valuation is not a catalyst for a market rise, trying to pinpoint catalysts and make short term calls is a fool's errand. Long term investors should now be reallocating from cash and fixed income to restore their long term equity weightings.
Has the Market Really Been That Lousy?
Main Street and Wall Street sentiment is poor. Indeed, consumer sentiment for July sank to the lowest since August, 1980, renewing concerns that the sour outlook would translate into lower spending, thus leading to recession.
However, the recent market weakness was, frankly, way over due. Coming into July the S&P 500 index was up over 30% for the trailing 12 months. It had advanced 92% from 2009's market bottom. Bull markets are never a straight line. Bouts of profit taking are inevitable.
Even today, with dividends the Dow has returned over 8% in the last 12 months. Stock investors must take the long term view, and recognize that volatility is the price for superior long term returns. The market was overdue for a pullback, and now we have it.
Is it Really the Worst Time for the Republic?
The drop in consumer confidence for July, to levels last seen 31 years ago, was a shocker. Investor optimism has plummeted, as fears rage that Europe is the 2008 financial crisis all over again, that there's no leadership in Washington, and that we are on the precipice of recession all over again.
Fortunately, current conditions are not anywhere near the market crash of October 19, 1987, the tragedy of 9/11, or the invasion of Iraq in March, 2003. Needless to say, investors who had the fortitude to buy stocks in response to those crises made a fortune.
Reaction to the S&P Downgrade is, Well, a No-Show
Some investors cite the rating agency Standard & Poor's' decision to downgrade the creditworthiness of US Treasury debt as a reason to flee the market.
Few seem to agree with S&P's decision, and many wonder if the rating agency didn't err as much as it did by awarding triple A ratings on mortgage backed securities in 2007.
Bond investors have ignored S&P's call, as they've piled into US Treasury debt ever since the downgrade; an exchange traded fund (TLT) holding a portfolio of long dated Treasuries has appreciated 9% since then, while the yield on the ten year US Treasury has plummeted from 2.56% to as low as 1.97% on August 18th.
S&P has sent a wakeup call to Washington to get its long term fiscal house in order. That's a long term positive for equity investors.
Insiders Buying Hand Over Fist
Corporate officers and directors are buying their stock heavily in this downturn, indeed, laying out 15% more than they did at the March, 2009 bottom. There's only one reason for an insider to acquire more stock, she believes the stock's going up. Some might discount one or two purchases as a public relations move, but not when the buying is this widespread.
Financial stocks are seeing some of the most buying relative to sales. Insiders have bought at Morgan Stanley (NYSE:MS), Bank of New York (NYSE:BK), JP Morgan (NYSE:JPM), and E-Trade (NASDAQ:ETFC).
While some fear the market and financials in particular, insider buying in the market generally and financials especially suggests a different take.
The Market is Supplying Its Own Stimulus
The market is now providing the US economy its own stimulus. For example, oil prices have dropped 30% since April, giving drivers and all energy users a beneficial shot in the arm. The large drop in mortgage rates makes monthly payments on new mortgages as much as 30% less than mortgages issued earlier this year. The 10% plus drop of the US Dollar versus overseas currencies makes everything American more competitive, from exports to Florida real estate.
We believe the recent drop in stock prices will also provide investors stimulus to add to positions.
The Market is Cheap
Using just about any metric, stocks are cheap. The price to earnings ratio is 12.3, a material discount from the historic average, 16.4. Stock prices are generally down 18% since April and about 30% off their October, 2007 peak.
Just as important, the market looks inexpensive compared to alternatives. The most oft cited alternative is US Treasuries. With the 10 year bond now yielding 2.07%, the risk premium, or margin between the earnings yield on stocks and that interest rate, is over 6%. Historically, that margin is in the 2 to 3% range. Similarly, the yield on the market (2.25% as measured by the S&P 500) is above the 10 year Treasury. That's rare in the modern era.
Another alternative is gold. With gold having no intrinsic value nor paying out any income, valuing the yellow metal is difficult. But, relative to the market it's certainly getting expensive and or the market cheap: In October, 2007, it took nearly 18 ounces of gold to buy the Dow. Today, that's down to under 6, the lowest since 1987. Investors should take advantage of stocks being relative bargains.
How to Position Yourself
Most investors have an allocation between risk assets, like stocks, and less risk assets, like fixed income and cash. Following surging bond prices and slumping stocks, investors are well advised to rebalance in favor of equities.
The current mantra is to stick to high quality, dividend paying stocks. While it's hard to argue against quality and dividends, the time to make such a move is during the good times, when most investors are reaching for more gains with lower quality, riskier holdings.
When market conditions improve, the most beaten down sectors will advance first. We certainly saw that following the March, 2009 bear market bottom, when financials did circles around, for example, utilities. Further, many dividend paying stocks may be owned as bond surrogates. If interest rates rise, these stocks may be left behind.
We prefer well managed cyclicals, financials, European multinationals, and fast growing emerging market plays.