By Bob Wood, MMNS
Pedestrians walk through an office building in Tokyo January 8, 2009. Deepening economic problems are forcing the government to prioritize spending to support the economy rather than steps to restore its tattered finances.
Itâ€™s that time of year again when the financial media, the big brokers – at least whatâ€™s left of them — and others with a vested interest in selling stocks and mutual funds prophesy whatâ€™s ahead for the markets. Based on what they offered last year, donâ€™t expect much that will prove useful for investors.
Last year in this column, I accomplished this exercise, in part, with help from Barrons magazine, which offers its own annual â€˜â€™outlookâ€™â€™ articles featuring opinions by some very well known market participants. In last yearâ€™s edition, seers predicted that the S&P 500 would end 2008 between 1,525 and 1,750.
The fact that 2008 is over with the index having fallen to the 900 level doesnâ€™t seem to have deterred either Barrons or its contributors from issuing yet another set of predictions. And wouldnâ€™t you know, in the aggregate, they foresee higher stock prices by this yearâ€™s end!
We can assume that those who make their living selling financial vehicles like stocks and mutual funds will, most likely, offer hopeful forecasts. At what point these salespeople will be held accountable for costing investors money, no one knows.
And that, precisely, is my point. No one knows with any certainty what the coming year will bring. But Iâ€™m sure that no one would have dared predict what actually unfolded in our economy and the domestic stock markets in 2008, though the demise of some of the biggest financial institutions was foretold to some extent by a very few analysts. But even those who saw it coming expressed surprise at how fast the collapse happened and how many seemingly invincible firms went bust.
Yet did anyone predicted that the equity indexes like the Dow, S&P 500 and the NASDAQ 100 would see their worst years since the 1930s – or, in the case of the latter, its worst year ever? Even while I was writing bearish columns for this space, I admit that I didnâ€™t see the markets falling apart like at no other time in my lifetime.
That the markets endured such a terrible year suggests that investors, lured in by the encouragement of these same badly-flawed seers in the financial media, will make the same mistakes again. They often do, expecting that, over time, the markets will always move higher, albeit with periodic setbacks such as the one experienced in 2008, and, more importantly, since the summer of 1997.
You can build a chart for viewing S&P 500 performance from back then to see what I mean. That index has made exactly no progress in almost 12 years! Yet how many investors will look at a bad year like 2008 and expect a rebound, since that is what should happen after market crashes? How many will see how little progress stocks have made in more than 10 years and still expect that a meaningful rally is inevitable? Too many, I fear.
During this â€˜â€™lost decadeâ€™â€™ for stocks, many analysts, Jeremy Siegel for one, were assuring us the â€˜â€™stocks for the long-runâ€™â€™ argument was still valid. Siegel often pointed out that we had never before experienced a negative 10-year run for stocks.
That thesis is now officially dead, as investors in Japan could have told Siegel years ago. And who would have imagined that 2008 could be the worst year ever for that countryâ€™s stock market, as, indeed, happened? Who would have imagined that a market suffering from perhaps the worst long-term bear market of the past 100 years would endure its worst year of the cycle?
Unfortunately, that point will be lost on too many investors in the domestic stock markets in 2009. Many will blindly assume success or be overtaken by hope and ignore the other side of the risk spectrum. While market promoters will continue to predict upside price targets for the major indices or whatever stock they need to sell, we will hear little mention of the downside potential.
Wouldnâ€™t it have been helpful if someone credible had offered that full perspective a year ago, while the upside potential for the S&P 500 was as high as 1,750, the downside potential was somewhere under 1,000? With that broad view, investors might have allocated their capital differently, according to the spread and range of possibilities.
Watch this year to see how many offer predictions that include a meaningful downside target for the S&P or the Dow. Some realists, commonly referred to as â€œBears,â€ do suggest that the S&P 500 could fall to a low of 400 in 2009, with the Dow perhaps diving as low as 4,000!
Would that type of balanced information change your outlook and where you might invest? Of course, those are scary numbers, but look closely at the rationale for both sides of the argument and determine which seems sturdier to you. Remember, those bearish types were proven right again in 2008!
Those offering optimistic price targets for the major averages will point to positives like the economic stimulus packages coming from our leaders in Washington and lower energy prices. In the past, they say, recessions lasted little more than a year before recovery took place.
How sturdy do those factors look to you? Are they based more on faith and hope than on any tangible considerations? How much did stimulus plans and tax cuts help in 2008? And who can be sure that this recession will not deepen and linger much longer than the experts suggest? Those same experts are still expressing astonishment at what happened in 2008.
On the realistic side, the S&P 500 is still priced for near perfection, selling at about 20 times reported trailing earnings. Stronger corporate earnings could help bring that multiple down a lot. But where will robust economic activity come from?
And then consider another crucial component, investor sentiment, which has been as important as anything else in boosting stock prices in the past. But todayâ€™s investors are feeling the pain caused by too many scandals and too many losses — for too long.
Until the housing and jobs markets perk up, I wouldnâ€™t expect much in terms of an improving economic picture or rising earnings. And since history supports that enduring bull markets do not begin anywhere near todayâ€™s lofty valuations, the downside risk is still very real.
So whatâ€™s the potential for the latter? Well, secular bull markets do tend to start when stocks sell at lower valuations, somewhere around 10 times earnings, on average. That would obviously require cutting the S&P 500 and the Dow in half from todayâ€™s levels. Should earnings continue to fall in response to a weak spending climate, all bets could be off.
More than anything, I worry about the many investors who will buy the faulty notion that just because 2008 was the worst year since the 1930s, 2009 will definitely be better. These people need to do a little basic math before allocating their capital.
The S&P 500 fell by over 38% in 2008, from 1,468 to 903, a 565 point drop. A loss of another 350 points would match that terrible performance in 2009. Given the record volatility in todayâ€™s markets, that type of loss seems entirely possible.
Before accepting your advisorâ€™s recommendation for allocating your accounts for the new year or making decisions yourself, consider the flaw in the theory that over time, the markets will always head higher, and even more so after very bad years. No iron-clad law deems that maxim worthy of risking your capital.
Anything is possible, but we never know in advance what will happen. As seen in Japanâ€™s market during the past year, our financial markets could get worse than anyone imagines.
Carefully consider the upside potential to determine how much exposure you are willing to risk. Then think about the downside potential and how much exposure you can afford with that possibility. When looking at a wide range of potential outcomes, when any is just as possible as the other, you can possibly afford yourself a more realistic asset allocation.
Have a great week,
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.