Newsletters 2012 Newsletters Nothing to Fear...
Friday, 13 January 2012 12:52
After opening self-directed education IRAs for my two daughters early last year, I sat them down and discussed how these accounts might serve as tools to educate them on the magic of compounding and discipline of investing in great companies. Hoping to empower them to pick their own investments, I encouraged them to think about familiar brands and challenged them to find at least five companies to begin building their portfolios. My then 11-year old daughter selected Apple, Target, McDonald’s, Pepsico, AT&T, and Johnson & Johnson. My then 8-year old daughter chose Hershey, McDonald’s, Disney, Walgreen’s, AT&T and Netflix. Netflix? The stock was trading at $180 per share at the time and selling at an astronomical valuation. She insisted and I relented, knowing that the experience of losing money may be the most valuable investment lesson of all.
Within a few months, Netflix shares turned parabolic, soaring from $180 to over $250 per share and ultimately peaking at $300. While I had always preached the virtues of long-term investing, I could not resist in suggesting to my younger daughter that perhaps it was a good time to consider taking profits in her pet stock. When I brought the idea to her attention, she quickly reminded me that we wanted to “buy low and sell high”. Right Dad? We sold the stock with a very handsome gain and reinvested the proceeds in a few new blue-chips, thankfully ones that Dad finds much more boring than Netflix, now trading at $90 per share!
This amusing experience with my daughter helps remind me how important it is to filter out the emotions that inevitably influence our investment decisions. She was emotionally unattached to Netflix and agreed to sell the stock on the fatherly simplicity of “buy low, sell high”. At the time, there was enormous enthusiasm for the Netflix story, with hindsight demonstrating that analysts and investors were far too optimistic about the company’s prospects. Still others riding the Netflix rocket ship had become intoxicated by their substantial winnings, hoping that the ride would continue. Optimism, hope and even greed are powerful emotions that lead many investors astray.
Today, the most prevalent emotion in the stock market seems to be fear. To be sure, there are many uncertainties in the world and many moving parts that have the potential to go wrong. Fear that the euro-union may collapse. Fear of mounting U.S. debt and deficits. Fear of a real estate bubble in China. Fear of an Iranian nuclear crisis. Fear of rising taxes. Fear of rising health care costs. Fear of a double-dip recession. These fears collectively have crystallized as palpable pessimism for stocks and investor’s seemingly quenchless thirst for safety. For all the sound theories and justifications for the many possible negative outcomes, selling stocks or avoiding investing altogether out of fear is recipe for poor investment results. As Warren Buffet so famously quipped, investors ought to “be fearful when others are greedy and greedy when others are fearful”.
Perhaps the most tell-tale sign of risk aversion and fear can be found in the yield on U.S. Treasury bonds. Today, the yield on the benchmark ten-year Treasury bond stands at 1.93%, even as inflation, measured by CPI, is tracking at an annualized rate of between 2.0% and 2.4%. After taxes and inflation, Treasuries are guaranteed to lose money, albeit “safely”. Meanwhile, the indicated dividend yield on the S&P 500 stands at 2.2% with very solid prospects for continued growth of income and principal. On an income basis alone, stocks rarely offer such an advantage over bonds.
The other most glaring sign of fear and risk aversion can be observed by the over-abundance of sidelined cash. There is a reported $10 trillion in U.S. bank deposits, $8.5 trillion sitting in domestic branches and $1.5 trillion in overseas branches of U.S. banks. For perspective, the total market capitalization of the S&P 500, which accounts for 75% of all U.S. stock market capitalization approximates $10 trillion. These are liquid accounts that can be withdrawn immediately such as checking, savings and money market deposits. According to the Investment Company Institute, retail and institutional money market mutual funds account for approximately $2.7 trillion. Non-financial U.S. corporations account for another $2 trillion. That such a substantial sum is parked while earning virtually nothing is testament to the level of fear and uncertainty that exists. Meanwhile, China is exploring ways to diversify its $3.2 trillion foreign exchange reserves into stocks in order to boost returns.
We offer no crystal ball on how the European saga will ultimately unfold, what the outcome will be for the U.S. Presidential election or whether Iran will block the Strait of Hormuz. However, we can point reliably to recent data that clearly indicates moderate growth in the U.S. economy. Diverse economic measures such as construction spending, ISM Manufacturing Index, ISM Services Index, factory orders, motor vehicle sales, jobless claims, consumer confidence, Chicago Purchasing Managers Index, Philly Fed Index, housing starts, existing and new home sales, durable goods orders and Conference Board’s Leading Economic Indicators Index all point to U.S. economic growth that may be set to accelerate.
With the S&P 500 trading at a PE of 12 on 2012 earnings estimates and with the aforementioned dividend yield on stocks higher than the yield on ten-year Treasury bonds, it is clear that there is a dearth of optimism in the stock market. Illustrating the impact of fear, stocks are priced for what might go wrong instead of what may go right. Stripping out the emotions of the day, the U.S. economy has picked up steam, equity valuations are modest, emerging markets are strong, the Federal Reserve remains highly accommodative, interest rates are low, earnings and dividends are rising and corporate balance sheets are in great shape. I can hear my daughter now.
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