The Henny Penny School of Investment Wisdom
Most of you should remember Henny Penny, from the children’s tale about a chicken that believes the sky is falling and the world is coming to an end when an acorn on its head. The chick decides to tell the King and on its journey meets other animals which join it in the quest; group mentality takes over. The phrase “The sky is falling!” is prominent in the story, and has become a common idiom indicating a hysterical or mistaken belief that disaster is imminent. This is not to say that we have not seen a lot of bad news lately as the stock market and global economy continues to struggle, we just need to keep it in perspective. To see why we aren’t ready to throw in the towel, and to see what happens to Penny’s friends.
It is true we saw a significant correction for virtually all major stock markets in the third quarter. The S&P 500 (SPY) Index lost 13.9% during the third quarter and has lost 17.1% from its 2011 high, which occurred on April 29. It was the worst third quarter performance for the S&P 500 since 1928, according to Bespoke Investment Group. The U.S. stock market has retreated for five consecutive months, with each month’s decline becoming progressively greater.
Trouble at home and abroad:
The Greek debt crisis remains in the news on a daily basis, currently without a solution. The failure of the U.S. Congress to address budget issues, the debacle over increasing the U.S. debt ceiling, and the downgrade of U.S. debt by Standard & Poor's all contributed to U.S. market’s steep decline. The problems in reaching an agreement on the debt ceiling highlighted the ineffectiveness of Congress in dealing with important economic issues and seemed to erode consumer, business, and investor confidence.
The steep market correction also reflects that many investors now believe that the U.S. has either entered another recession, or will shortly enter one.
There is an old Wall Street adage that says that the market has predicted 12 of the last 5 recessions. In a number of instances, the market has declined in anticipation of a recession; however, most of those recessions never materialized. For example, in the summer of 2010, the market suffered a 15.9% decline on fears of a double-dip recession, which never occurred. The economy continued to expand and the market recovered strongly. The stock market also suffered major corrections in 1995, 1998, 2003, and 2005 due to fears of a possible recession, none of which happened.
Unfortunately, the gains from the bottom of last year’s market correction have largely evaporated as recession fears are again unnerving investors.
This pattern of short-term volatility combined with poor long-term returns has lead many investors to believe that market-timing is a viable strategy for generating returns – or at least avoiding losses. However, this strategy is fraught with danger, since predicting the events which cause market movements is virtually impossible.
Much of the selling that occurs during a market correction is based on emotion.
After seeing a decline in market values, some investors become fearful that further losses will occur. This fear, and in some instances panic, will result in selling without any regard to the underlying value of the investments. For long-term investors who focus on the value of companies, there is no reason to sell undervalued positions, and if cash is available, a market correction usually presents an opportunity to buy. For example, renowned investor, Warren Buffett, commented to Bloomberg Television that he had purchased $4 billion of equities during the third quarter as the lower market presented attractive values.
During market corrections, it takes a stronger resolve on the part of long-term investors to stick with an investment strategy. With the decline in market value, long-term performance is eroded and investors lose confidence in equities as a long-term investment vehicle. However, despite the negative news, there are a number of reasons for owning equities:
Oh, and do you remember what happens to Penny’s friends (the average investors) in at least one version of the story? A fox invites them to its lair and eats them all. --I have not been able to verify a version that puts the fox in a business suit on Wall Street, but you can decide for yourself…
John A. Davidson, CFP
john@kyleshill.com
Disclaimer: The author is the Owner of KylesHill Group, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance.
It is true we saw a significant correction for virtually all major stock markets in the third quarter. The S&P 500 (SPY) Index lost 13.9% during the third quarter and has lost 17.1% from its 2011 high, which occurred on April 29. It was the worst third quarter performance for the S&P 500 since 1928, according to Bespoke Investment Group. The U.S. stock market has retreated for five consecutive months, with each month’s decline becoming progressively greater.
Trouble at home and abroad:
The Greek debt crisis remains in the news on a daily basis, currently without a solution. The failure of the U.S. Congress to address budget issues, the debacle over increasing the U.S. debt ceiling, and the downgrade of U.S. debt by Standard & Poor's all contributed to U.S. market’s steep decline. The problems in reaching an agreement on the debt ceiling highlighted the ineffectiveness of Congress in dealing with important economic issues and seemed to erode consumer, business, and investor confidence.
The steep market correction also reflects that many investors now believe that the U.S. has either entered another recession, or will shortly enter one.
There is an old Wall Street adage that says that the market has predicted 12 of the last 5 recessions. In a number of instances, the market has declined in anticipation of a recession; however, most of those recessions never materialized. For example, in the summer of 2010, the market suffered a 15.9% decline on fears of a double-dip recession, which never occurred. The economy continued to expand and the market recovered strongly. The stock market also suffered major corrections in 1995, 1998, 2003, and 2005 due to fears of a possible recession, none of which happened.
Unfortunately, the gains from the bottom of last year’s market correction have largely evaporated as recession fears are again unnerving investors.
This pattern of short-term volatility combined with poor long-term returns has lead many investors to believe that market-timing is a viable strategy for generating returns – or at least avoiding losses. However, this strategy is fraught with danger, since predicting the events which cause market movements is virtually impossible.
Much of the selling that occurs during a market correction is based on emotion.
After seeing a decline in market values, some investors become fearful that further losses will occur. This fear, and in some instances panic, will result in selling without any regard to the underlying value of the investments. For long-term investors who focus on the value of companies, there is no reason to sell undervalued positions, and if cash is available, a market correction usually presents an opportunity to buy. For example, renowned investor, Warren Buffett, commented to Bloomberg Television that he had purchased $4 billion of equities during the third quarter as the lower market presented attractive values.
During market corrections, it takes a stronger resolve on the part of long-term investors to stick with an investment strategy. With the decline in market value, long-term performance is eroded and investors lose confidence in equities as a long-term investment vehicle. However, despite the negative news, there are a number of reasons for owning equities:
- Stocks appear to be undervalued compared with their long-term earnings potential, dividends, and other valuation metrics. For example, the S&P 500 is trading at just 11.0 times forward earnings, significantly below its historical average.
- Earnings for U.S. companies are at record levels. While the S&P 500 Index trades at approximately the same level that it was 10 years ago, earnings for the index have increased from $38.85 in 2001 to an estimated $98.02 for 2011.
- Cash on corporate balance sheets is at record levels; balance sheets are in great shape. Treasury Strategies, a consulting firm, reported that corporate cash now stands at $2.05 trillion, 4.5% higher than the previous quarter, and 46% higher than in March 2009.
- Stocks generate more income than bonds. The dividend yield of the S&P 500 is currently 2.39%. The yield of the Barclays Capital U.S. Aggregate Bond Index is 2.35%. The yield on the 10-year Treasury bond is 1.71%.
- Expectations for stocks and the economy have declined significantly in recent months. If a recession does not develop, stocks are likely to rally, as they did in the fourth quarter of 2010.
- Politicians are likely to take actions that will boost stock prices. We are currently in the third year of the presidential cycle. The third year is by far the best performing year of the four-year presidential cycle, probably due to actions intended to stimulate the economy and markets prior to the presidential election in the fourth year. There has not been a negative third year since 1939. Since 1930, the S&P 500 Index has averaged 18.4% in the third year of the presidential cycle.
Oh, and do you remember what happens to Penny’s friends (the average investors) in at least one version of the story? A fox invites them to its lair and eats them all. --I have not been able to verify a version that puts the fox in a business suit on Wall Street, but you can decide for yourself…
John A. Davidson, CFP
john@kyleshill.com
Disclaimer: The author is the Owner of KylesHill Group, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance.