Tarpley & Underwood
Financial Advisors, LLC
A View on Market Volatility
March 5, 2009
As we look forward into this continued, very scary economic decline we must remember that markets do their best to see into the future and reflect that future in their prices. So, the key question is what is priced into stocks today? We discussed three metrics in our 4th quarter Quarterly Letter; all currently suggest the market is cheaper than it was back in early January (no surprise since stocks have declined since then).
•One metric we discussed, the Shiller P/E, was then at 15x and is now down to 12x normalized earnings (using the S&P 500’s recent price of 700). In the past, this valuation level has been a good entry point for long-term investors into the stock market.
•The second metric is the 9-year risk premium (which is the comparison of stock returns to a “risk-free” return—we use the S&P 500 and Treasury Bills). Based on this measure, stocks are coming off of their worst nine-year return relative to T-Bills ever—including the Great Depression period (we looked at returns since 1926). This strongly suggests stocks are not expensive and annualized returns over multi-year periods after the lowest risk-premium periods were double-digit.
•Expected annualized S&P 500 returns in our most pessimistic five-year scenario are up to 7% (we have adjusted some of our assumptions slightly lower since early January). If equity P/E multiples turn out to be even lower than what we are now using in that scenario, returns could be further reduced by 1% to 3%. That would be quite harsh and would result in unprecedented bad returns based on the other metrics mentioned above. But even in that case, returns are positive and probably in line with what the bond indexes deliver, and better than cash. Five-year annualized returns are higher in other scenarios that are still negative but not as much so.
•Finally, the massive dumping of stocks in the last part of 2008 led to valuation discrepancies which seem to be reversing a bit.
It may seem impossible to imagine a market rally from here. It can happen, and it will at some point. By definition, investors are most pessimistic at a market bottom. There is a huge amount of cash on the sidelines, which is good. When everyone is hugely pessimistic there are few investors left to sell. Then, as bargain hunters start to step in, a powerful rally can develop. Our expectation is that we could see several rallies and declines before we move on to another bull market. We are confident in our longer-term expectations, but as we have been saying for several months now, we are prepared for a very rocky ride.
So while we are confident that from current levels stocks offer good longer-term return potential, we don’t know what might happen in the shorter term. This uncertainty creates a dilemma that is very important to understand. Stocks could drop further, perhaps substantially, or they could rebound sharply. If we try to predict this and invest accordingly, we have to consider the consequences of being wrong. If we go to cash the market could rebound sharply before we can get back in.
