Return-Free Volatility

By Bob Wood, MMNS

Recently, when asked for my view on today’s stock market environment and its near future, I responded that we are living in a period of ‘’return-free volatility.’’ My answer met with laughter, but this situation, of course, is no laughing matter for investors.

Here we are, at the end of March, and stocks are again in rally mode. This activity is helping to push the major indices all the way up to where they were — in mid-February. And about where they were in the middle of January. And, for that matter, they’re once again where they were in mid-October 2008!

According to my count, March’s rally attempt is the eighth — the eighth time in the past six months that bullish promoters are counseling us to see the bright side of our financial environment to avoid missing this new move higher. But to what end do we put our money at risk in such uncertain times?

For as long as I’ve been writing this column, I’ve been preaching that the U.S. is working through a secular bear market. That means that investors are lucky if they simply maintain their original investments after having endured constant ups and downs in share prices. Classic secular bear markets tend to last about as long as the secular bull markets which preceded them. In this current case, we’ve probably gone about half-way through the bear cycle.

Of course, Wall Street and its promoters have little trouble finding ways to assure us that “good times are right around the next corner” and providing a never-ending stream of reasons showing why their prediction is assuredly accurate — this time. Wall Street’s purpose is to sell and maintain high levels of trading activity. And that activity almost always results in solid profits for its generators, regardless of what stock prices actually do.

The trouble now, in convincing us to stay involved in the stock market, is that their sales pitches are supported by mighty flimsy rationale, at best. For example, how can anyone forcibly argue that stocks are cheap? Current quotes for the S&P 500 are running at the historically lofty earnings multiple of 28, owing much to how steeply corporate earnings have fallen. Sure, share prices have dropped, and so has the S&P 500 — about 45% — from where it began 2008.

But earnings have fallen even more, which makes the average P/E of that index continue to rise, while share prices are falling. So if these promoters can make a credible case for how corporate earnings will rebound strongly in coming months, they may convince us that stocks really are cheap, or at least, fairly valued based on forward earnings. But how many times have they made this promise over the past three years: that we are seeing the highest level of valuation since the market peak in early 2000?

What these optimists are relying on now is that economy will rebound soon. Yet we all know that consumers are responsible for about 70% of our U.S. economic activity. And today’s consumers are in no shape to deliver their end of this bargain, considering how much over-spending they’ve done in the past several years. Burdened with too much debt, consumers are cutting back, with future spending expected to remain muted for some time to come.

Think of it this way: a consumer owing $500,000 on his home mortgage and other obligations from past spending feels comfortable when his combined assets — home value and stock portfolio — are worth $1 million. But with home prices down about 30% and stock prices down about 40% from previous peaks, this consumer now holds assets worth about two thirds of previous estimates. Meanwhile, how far has he paid down his debt?

With more than $500,000 in net worth, spending is an easy thing to do. But now, with only $150,000 in net worth, the consumer finds the comfort of his ‘’wealth effect’’ largely gone.

And what do we know about the status of the consumer’s income and how that might affect his feelings about spending? Our economy has been shedding jobs for over a year now, and we continue to set new records weekly, showing how many Americans are collecting unemployment benefits. That unsettling bit of data causes enough concern that many workers are wondering if their jobs will be the next to go. Suddenly, frugality looks like an idea whose time has come.

A recent survey by the Discover U.S. Spending Monitor shows that over-spending in the past means that many of us failed to save for that “rainy day,” so roughly half of American workers are concerned that, in the event of job losses, their cash reserves would last about one month before they felt economic hardships.

Consumers have painted themselves into a nasty corner, since job losses across a broad spectrum of industries means few opportunities for landing a new job. And with 20 weeks now the average time for finding new work, workers are facing a time period well beyond what many can afford to bear.

Making matters even worse is a rather new event called “wage deflation.” Companies in the newspaper industry have announced pay cuts of between five and 10 percent, resulting from cost cutting moves designed to prevent further job losses. Other companies, such as IBM, Hewlett Packard, Microsoft and ConWay Freight have announced similar moves to pare costs.

Doesn’t it make sense, with jobs hard to come by and the supply of available workers rising each month, that wages will fall? And they are falling.

Paring down the average consumer’s debt will take years, since it took years to build that debt up to today’s record levels. And the Obama administration’s answer for relieving this financial strain seems oddly similar to past solutions: making more credit and borrowing available — so people can spend even more!

To me, that fix makes no sense at all, but what choice do we have at this point? No politician wants to preside over a nation in the grips of a nasty recession or a depression, where, some think, we may be headed.

Making money in the stock market is difficult even during the best of times. And these certainly are not the best of times. An interesting short piece appearing in the March 30, 2009 issue of Barrons magazine reveals research by Robert Arnott, which clearly shows that stocks are a bad bargain over long periods, especially when economic times are hard.

Returns on 20-year Treasury bonds outperformed the stock market from 1803 until 1871, a period lasting about as long as average life expectancy in those days! Bonds also outperformed stocks from 1929 until 1949, and that period of time might compare very closely to today’s environment.

And bonds have outperformed stocks from 1968 until today, owing much to how the stock market has now lost about half its value from the Dow high seen in October 2007. Yet didn’t we have some strong economic periods during those 40 years? Yes we did, with the 80s and 90s showing some of our best years ever. But just a couple of bad years wiped out much of those gains, while cautious bond investors fared better with much less volatility and uncertainty about where the economy was headed.

Today’s advice? Think long-term — and consider the time required before vibrancy returns to our economy. And, as usual, look to other places for better gains in risky assets. As of today, the S&P 500 is down over 9% on the year; meanwhile Brazil’s market is higher by 11%, Russia’s market is up 14% and China’s stock market has risen by 30%.

You’ve heard my cry for global market decoupling for the past couple years, while I’ve been soundly pronounced “dead wrong” by the experts. But maybe my day is coming, and, if you look to some foreign markets for your investing ideas, maybe your day is coming, too!

Have a great week.

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc.,

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