First Quarter 2013 Letter to Clients

As the major stock indexes have, one-by-one, broken through their previous record highs in recent months, it has been interesting to observe that the dominant reaction among many investors has not been one of celebration but, rather, trepidation.

The anxiety is palpable. While many people have been heartened to see their portfolio values back to pre-2008 levels, there is also a sense of unease that perhaps the market is “ahead of itself.” This is an emotional reaction to the traumatic memories of what happened in 2008 after the market last reached these levels. It is understandable to associate a level of, say, 14,000 in the Dow with the bubble-like atmosphere for stocks in 2007. This is not, however, to say it is accurate.

It is our experience that, when investors become anxious, rationales for making short-term changes to their portfolios are not far behind. In this case, those rationales are being used to justify reducing stock exposure. So let’s examine the four most common rationales we are hearing these days to see if they make sense:

Rationale #1: “We should take some of our ‘winnings’ off the table”

This is the worldview of “investing as gambling” – akin to the feeling one has of enjoying a big run at the blackjack table, only to see a long, painful run of bad cards take all those beautiful chips away from you and put them back in the dealer’s tray. But then your luck turns again and you suddenly win them back. And that’s when the voice of caution starts talking to you: “Let’s just cut our losses and run” it says. “We don’t want to go through that trauma again, do we?”

There is merit to this mentality when it comes to gambling, because we know that the odds are against us and the house always wins eventually. You may have a good run of luck for awhile, but if you stick around long enough, you can be assured that the chips will eventually end up back in the dealer’s tray.

But imagine a Las Vegas full of casinos that were always trying to cut their losses when a few gamblers got on hot streaks and shut their doors for the day before any more “damage” could be done. The reality is that nearly all of those gamblers would see their lucky streaks vanish and their winnings would be returned to the house, but only if the house stayed the course and let the odds work for them. Those casinos that lacked this fundamental understanding of how odds really worked would be out of business in short order.

Understand that, when it comes to investing, the investors are the house. Investors who stick around long enough have always been the winners. This is because, unlike gambling, investing is not about luck. It is about the benefits of ownership. When we invest in the stock market, we become owners of companies and of all those cash flows that will accrue to those companies in the years ahead. So it’s not about “taking our winnings off the table” before the odds catch up with us, because the odds are with us. It is, instead, about hanging around in the market long enough to give the odds that are in our favor time to catch up to us. It’s about letting the benefits of ownership accrue to us so that we get to see our winnings keep growing and growing over time.

Rationale #2: “We’re due for a downturn”

There is actually truth to this argument, but it isn’t because of any particular level the market has achieved. Rather, it’s just the nature of stock investing. Historically, the average peak-to-trough (highest point to lowest point) decline in any given year in the stock market is 14%. And full-fledged bear markets (defined as a 20% or greater decline) occur on average one out of every three years.

By this measure, then, we are always due for a downturn because it’s the short-term nature of stocks to bounce up and down, sometimes dramatically. So, with the market at a level of around 14,000, it wouldn’t be unusual at all to see a decline this year of, say, 2,000 or 3,000 points over the course of a few weeks or months. It could be more, could be less. But a decline such as this wouldn’t be unusual.

The real issue is, what should we do about a downturn?

Here history shows time and again that any preventive action investors take will almost always be damaging rather than beneficial. Investors get out of the market too late and get back in the market too late and ultimately end up missing out on the returns they would have achieved had they quit worrying about the downturn-du-jour and just stayed invested.

Instead of trying to predict and avoid downturns, which only exaggerates losses, investors need to find their inner peace and embrace the reality of short-term volatility in the market, because that is the reason stocks deliver higher returns than bonds and cash.

Rationale #3: “With the market at this level, stock valuations are too high”

While the Dow may be at levels similar to 2007, the environment for stocks is much better now than it was then. In 2007 investors faced the growing realization that an unsustainable real estate bubble was about to pop, taking the stock market with it. Today, the financial system has been cleared of trillions of dollars of toxic mortgage-backed securities, home prices are back to levels somewhere between “bargain” and “reasonable,” and consumers and corporations have de-leveraged their balance sheets to levels last seen in the late 1980s.

The underlying valuation of stocks is much better as well, as seen in this chart showing the historical price-to-earnings ratio of the Dow:

Now take a look at how low historically some of the other valuation metrics for the Dow are relative to their historical average (the exception being dividend yield, where higher is better):

Obviously, while the numbers on the stock indexes may look the same, the market fundamentals in 2013 are very different from what they were in 2007. From this perspective, even though stocks have enjoyed strong gains in recent years, the death of the rally may be greatly exaggerated.

There is another aspect to this notion of the market being “too high” that is worth examining. Over the long term, the stock market goes up. We know this is not news to you, but many investors forget it in the moment. When your time horizon starts to move to twenty years or more, the reality is that stocks have always finished significantly higher than where they started. Thus, an investor who gets out of the market in fear that it is “too high” faces a philosophical dilemma. If stocks historically always climb, when will the investor ever feel comfortable that it is not too high? At 20,000? At 50,000? At 100,000?

The notion of the market being too high or too low is a subjective one and as such is subject to human error. In our opinion, it is better to let the market work out which stocks are over- or under-valued at any given time by adjusting share prices accordingly as new information becomes available. This, in turn, will work out the overall valuation of the market over time, without any guesswork required on the part of the investor.

Rationale #4: “Bonds are safer than stocks”

It is true that bonds are safer than stocks from a short-term volatility perspective. But what about from a real-return (inflation-adjusted) perspective? Because, for investors facing the possibility of a three-decade long retirement, keeping up with inflation is where the real focus should be.

From that perspective, it becomes clear that the real risk for investors is in bonds. With interest rates hovering near zero, there is nowhere for rates to go but up. And when those rates start moving up, bond prices will start falling. This is not conjecture; it is simple math. Stocks, meanwhile, are a relative bargain on an historical basis, with a significant upside relative to bonds.

For investors with shorter-term, high-quality bonds such as we use at Capital Directions, the downturn would be modest and would hopefully be compensated for by a buoyant stock market. But for the thousands of investors who fled to bonds seeking safety and then invested in lower-quality, longer-term bonds seeking to boost yield, they are in for a rude awakening. Prices on these lower quality, longer maturity bonds will suffer significant losses in a rising interest rate environment.

Conclusion

It’s not hard to understand, and even sympathize with, the lingering hangover investors have from the 2000s. The decade saw not one, but two, declines in the market of 50% or more, the worst financial crisis since the Great Depression and a global financial panic in the fall of 2008. Those memories are not easily forgotten, nor should they be.

But, in our opinion, the traumatic memories of the 2000s should not just be remembered for experience’s sake, but also for what we learned as investors from the roundtrip. Well-diversified investors who did nothing but stay the course during the 2000s came through all the trauma with their portfolios completely intact and with modest gains to boot.

How many investors do you know who “took action” during those ten years can say the same thing?