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Lincoln Institute


Stock Market Volatility Redux

by Doug Keegan
 

When it comes to the stock market, are we back to the future? Volatility has returned, with the S&P 500 up big one week, down big the next. So what do these moves suggest? Is a global double-dip recession imminent? Or, is this the start of a new bull market? What is the average investor to do? Here to explain is Doug Keegan of Harris SBSB.


Doug, some say the economic data doesn't look good. We've seen continued volatility in the stock market. Can you please detail what you're seeing and what may lie ahead for investors?

You're right, Lowman. The economic data is troubling. In fact, the evidence has risen to the point where I now think there is a strong case the economy could be in recession within 6 months. But that doesn't mean that the stock market won't go higher. Corporations are still making money and managing operations well. So, I don't want to come across as a doom and gloomer. I'd like to share 5 positives and 5 negatives. Let's start with the negatives:

#1 Political Will: We have a dysfunctional Congress -- no direction on tax policy and little direction on fiscal policy. Employers are under attack. They've got to deal with health care reform, potentially higher taxes, financial regulation, cap and trade, and possibly card check unionization. And because of mid-term elections, I don't see any major tax legislation getting passed until later this year. And with regards to fiscal policy, Lowman, we don't even have a budget.

#2 Global Sovereign Debt Crises: We have countries teetering on bankruptcy with no consensus on how to deal with it. In one corner, you've got the deficit hawks who want governments to stop spending. In the other corner you've got the Keynesians who want governments to keep spending. This divide creates uncertainty.

#3 Jobs: Let me remind everyone that since this recession started back in December 2007, some 15 million people have lost their jobs. This is the worse slump since the 1930s. Every new job has 6 applicants. Wages are down. Living standards are down. Unless we see stronger consumer demand, employers won't hire. This is what economists call a jobless recovery.

#4 Negative Leading Economic Indicators: The Economic Cycle Research Institute's leading economic indicators are showing that there's a significant slowdown in the works. When this metric gets below -5%, which it has, it suggests our economy will grow less than 1%. That's anemic. In order for our economy to create jobs, we need 4% growth.

#5 Money Flow: Money isn't flowing. Money is the life blood of capitalism. If it's not flowing, you'll get a financial heart attack. Look, consumers aren't spending and corporations aren't investing. When people are repairing their personal finances, they don't spend. That hurts economic growth and puts pressure on prices. We're now fighting deflation.

So those are the negatives, can you share with us the positives?

#1 Slow Down is Normal: You can't keep recovering at a 45 degree angle. Trees don't grow to the sky. Though the rate of recovery is slowing down, we're still recovering. But without this pull back, recovery is not sustainable.

#2 Business Management: Corporations have done an outstanding job managing this recession. We have solid profit growth, strong productivity gains, and good balance sheets. Corporations are flush with cash. They have money to increase dividends, do acquisitions and be stable during these troubled times.

#3 Stocks on Sale: If you take a look at the S&P 500, stock prices are low relative to expected corporate earnings. In fact, the stock market is pricing S&P 500 earnings less than the consensus. If we have S&P 500 earnings for 2011 at $85, with the S&P currently near 1100, that gives us a multiple of 13 times earnings. The historical multiple is near 15. So, it appears that stocks are currently on sale if corporate earnings live up to expectations.

#4 Dividends: Since large companies are flush with cash, they can pay high dividends. If you can get a 6% dividend, even if the market stays flat, that's still a 6% return. In this market, I'll take it.

#5 Low Interest Rates: Interest rates are at historic lows, which make it favorable for consumers, corporations and governments to borrow and refinance. Just last week, the average rate on a 30-year fixed mortgage dropped to 4.5%. We haven't seen rates like this since the 1950s. If you factor in projected inflation and the home mortgage interest tax deduction, its like banks are giving money away. That's incredible.


So, given both the positives and the negatives, what can investors expect?

Look, price declines are normal. Some declines are long, some are short. On average, a decline takes 4 months from start to finish. Half reach their lows just 2 months in. Since 1945, 82% of all short-term declines in the S&P 500 were over before they reached -15%. The rest morphed into bear markets most of the time, meaning a decline of -20% or more.

So what does this tell us?

Well, 2 months in, this decline has exceeded the average. So the odds, simply looking at the statistics, favor this decline to morph into a bear market. Then again, it may not. In my opinion, absent another financial-type collapse, I expect this decline to be more similar to the average, meaning a decline between -15% and -25%. So, maybe the worse is behind us. I don't know. That's just my best guess. But, if it does get worse and we do go into recession, I think you'll see governments from around the world provide stimulus to keep the recession from becoming a very severe recession.

Doug, back in January, you shared with us a portfolio construction that helps investors weather stock market volatility. Some investors just can't stomach volatility. Can you briefly explain that portfolio?

Sure, this is a buy and hold strategy that works in volatile market environments. And it's designed to protect you know no matter what happens and makes you less vulnerable to mistakes in judgment. But you have to stick with it and you must rebalance to maintain the strategy.

What you want to own are five asset classes: stocks, bonds, real estate, natural resources, and cash. To keep it simple, place 20% into each asset class. With stocks, invest in a global stock index fund that is based on a country's percentage contribution to world economic output. Why? Because a country's economic output and stock returns track together. For example, if China eventually becomes 20% of the world's stock market value, then 20% of the global stock fund would be invested in China without you having to lift a finger. That makes sense to me. Use the same approach with bonds, but with the goal being to diversify away default risk. As for real estate, invest half in a publicly traded global real estate fund and half in a non-publicly traded real estate trust to reduce not only volatility, but to provide cash dividends as well. With natural resources, buy a broadly diversified commodities index fund representing energy, precious metals, industrial metals, livestock, and agriculture. Owning natural resources allows you to participate in the ever-growing global demand for raw materials. And finally, cash. Don't just sit on U.S. dollars. Instead, invest in a fund that holds a basket of currencies from around the world, especially from countries that practice sound monetary policy.

While this portfolio is meant to provide safety, you still must have the discipline to stick with it and rebalance it over time as inevitably one asset class will outperform the others. That's how you sell high and buy low, or in reverse, buy low and sell high. If you rebalance, stay disciplined, keep diversified, and keep expenses low, you'll be well on your way to achieving the financial security you want.


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