Grabbing the Bear by the Ears

We know you’re worried. Despite decent returns in bonds this year, common stock, as measured by the Standard and Poors 500 (“S&P 500”), lost a third of its value in the six and a half month period between the end of March and now. In addition, the length of this downturn has already substantially exceeded the average duration of previous bear markets. The nine previous bear markets since World War II had an average length of 12 months while this bear phase has already been in existence for 30 months. In every case returns were higher in the year following the bottom of a bear market. In fact, the average 12 month return after a bear market bottom in the nine previous post-War downturns was +23.6% and the average price change two years later was +37.4%.

How do we know when the market has bottomed? We don’t. Bottoming is a process in every market downturn, not an identifiable moment in time. The precise number that represents the absolute bottom in the market will not be known until many months have elapsed. Since it is impossible to identify a bottom at the time it occurs an investor is better served by focusing on whether or not his or her tolerance for risk has changed and whether or not his or her current financial plan continues to have the highest likelihood of meeting investment goals.

What investor behavior is most worrisome in a market downturn? We’re worried that investors will panic and make a series of wrong decisions. For example, an investor who decides today to sell all stocks and place the proceeds in a money market fund is liquidating long duration assets (stocks), which presumably were emplaced originally to satisfy long term goals, in order to solve short term problems (the onset of fear and panic). Disturbing long term decisions to meet short term concerns is a little like the head of a household taking out a 30 year mortgage and using the proceeds to buy groceries. No homeowner would sanction such a mismatch of long and short term decisions. No investor should either.

A decision to move out of stocks is really several decisions in that it also requires a decision about what to purchase and when. Each successive decision raises the potential for error and has a high chance of exacerbating the negatives.

The same analysis holds true for a move from stocks into bonds. Bonds are decidedly less risky than stocks but, at this point, dedicating additional money to fixed income instruments should be the cornerstone of a risk reduction move, not a move designed to garner incremental return relative to common stocks.

What will be the catalysts that reverse the current negative trend and allow the market to begin a sustained move upward? Despite investors’ negative attitude toward stocks there is currently an entire generation of people conditioned to investing in equities. Not only did these people experience some success with stocks during the late 1990’s but they are also part of the group that has built up over $1 trillion in cash waiting to return to the marketplace.

What is needed is a psychological catalyst. Nothing breeds success like success. Most likely, the thing that will bring cash into the market is quite simply stock price appreciation. In other words, a move of 15 or 20% off the lows, then a pullback and a move to higher highs, will convince many investors that market lows have been seen and they will be compelled to move cash into the stock market or risk missing significant upside.

There must also be an earnings catalyst. We believe an earnings recovery is underway, having begun with the reporting of second quarter earnings, reversing several successive quarters of earnings declines. However, this reversal will most likely begin to be reflected in stock prices when the reported earnings represent positive surprises to the marketplace. Because the market adjusts to new information very quickly, an investor must already be positioned in the stock in order to experience the move occasioned by the surprise.

A reduction in uncertainty will also act as a positive market catalyst. Market participants have been asked to accept a host of uncertainties - threat of war, terrorism, a lack of ability to trust financial statements, corporate officers or securities analysts, declining earnings, corporate bankruptcies, a bear market and a recession. Any one of these injects the market with uncertainty and, in combination, have been devastating. As these uncertainties are resolved, market participants will be more willing to look further out into the future. The ability to discount a longer period of time will act as a positive catalyst to stock prices.

Oakwood equity portfolios are very conservatively positioned despite the pullback in prices that has occurred. We own very few growth stocks in client portfolios. In addition, issues held are of very high quality and most would be considered household names. Most of the wealth that has been built from stock in this country has come from holding top quality corporations through a variety of economic and market environments.

For many investors, we are balancing equity risk with a sizable commitment to bonds. Thus, our balanced clients are incurring a manageable level of risk. However, as market results are periodically reported, each investor must carefully examine long term objectives, determine whether or not sensitivity to risk has been further heightened by this downturn, then ensure that the portfolio reflects the appropriate mix of stocks and bonds and resist the urge to make portfolio moves based solely on emotion. The investor should then muster the requisite patience to stay the course, recognizing that bear markets bottom, that the bottom isn’t obvious at the time and that, in every case, the next market move has been upward.