Those "Hills" and Mattress Stuffing
Cover Story, by Mark Robertson, Managing Partner July 1st, 2006
It's a challenge to ignore the noise and avoid the panic while the herd of average investors heads for the hills.
I’m not sure what’s so “triggering” about the number three, but it’s fairly reliable over time in the investing world. As the stock market delivers a third consecutive month of losses, larger numbers of investors begin to question methods and begin listening to those who encourage us to “run for the hills.” The same is true for three years of negative returns as we experienced from 2000-2002. Some investors headed for those hills (wherever they might be) possibly to never return to the realm of long-term investing. What and where are these “hills” and what do we would do if we ever went there?
Third Time Charms
The phone calls or emails come in groups of three and they almost always come after three months of slumping stock prices. I knew it was “time” again as the end of June approached and prices returned to levels last seen during December 2005.
The first call came from a family member who’d just heard from an office colleague. He’d been advised to “sell everything and run for the hills” by his investment advisor. He’d returned to the office to share this wisdom and recommendation with as many people as possible. Selling our stocks is never easy, and I’m pretty sure that people like this would-be Chicken Little (we’ll call him C.L.) are really hoping for some company to share in the misery. My sister-in-law asked me what I thought about the advice, and I suggested that she advise C.L. to get a new advisor.
The second call came from a friend who’d invested in a number of high-quality stocks in an individual retirement account during the first quarter of 2006. His problem was that only one or two stocks (among 10-12) were displaying black ink for total returns. The total decline in his portfolio was 3-4% since April 2006. He didn’t say the words, but clearly wanted to know what I thought about heading for those hills at this time.
The third nail-biting skeptic delivered the final piece to the puzzle. Reflecting on the second quarter results for the Tin Cup model portfolio (see page 7) I was reminded that it was obvious that our method of focusing on projected returns and quality was no longer going to work any more.
Projected Overall Market Returns. With MIPAR bouncing near 9% as April toiled along, the market is vulnerable to a correction. The correction happened. MIPAR is now approaching 12% and buying opportunities are actually increasing while “average investors” seek higher ground. We recognize higher ground (as graphically shown here) is time to buy, not sell.
Seeking Higher Ground
As shown in the accompanying graphic, “higher ground” from the perspective of MIPAR, is actually a very good thing. Stock prices have receded but projected returns for most stocks are a few percentage points higher.
Run for the hills? Why? What would we do when we get there? Our question for C.L. is a fairly simple one. Do you really believe that it’s different this time? And if the answer is yes, specifically WHAT is different?
I’m serious. It’s anything but a flippant question. Because all we have to learn from is history and what has happened during prior corrections and bear markets. We know that over the long term, stock prices follow earnings trends and that so long as the underlying fundamentals (earnings and earnings growth expectations) remain intact, that the correction will end and stock prices will advance.
EPS Growth History and Forecast. Is it really “different this time?” Or does the EPS growth expectations for 2006 and 2007 fall into a fairly traditional range?
I decided to take a closer look at the EPS growth expectations for some of our favorite stocks. Using only those stocks with EPS stability rankings of 60 or more (the top 40% of all stocks followed by MANIFEST, approximately 1000 stocks) a graph of year/year EPS growth was built. Pay special attention to the last two points on the graph. These are the EPS growth forecasts for the rest of 2006 and 2007. These are updated weekly at Manifest Investing. You may rest assured that any major shifts in these will be brought to your attention immediately.
Bernanke’s Manhood??
I really do wish I was making this up, but the talking heads on CNBC and a wide variety of financial media seem to be fairly obsessed with Alan Greenspan’s successor and Bernanke’s apparent ability (and willingness) to kick sand in the face of the inflation dragon.
Interest rates have been increasing during 2005 and 2006. What does history teach us about the behavior of general stock prices during significant increases in interest rates? We need look no further back than 1994. Refer to the accompanying reminder.
Stock prices vs. Changing Interest Rates from 1994: The lower line is the total stock market (Wilshire 5000) and the upper line is the relative change in interest rates on a monthly basis during 1994. (FVX: 5-Yr Treasury Yield)
The Impact of Rising Interest Rates on Stock Prices. This reminder from 1994 illustrates a flat trend for stock prices during fairly massive increases in interest rates.
Kryptonite for Long-Term Investors?
It doesn’t take spandex and a large “S” on our chests to be successful long-term investors. But heeding the lessons of history is a powerful antidote to the short-term kryptonite that we’re endlessly exposed to. It’s a challenge to ignore the noise and avoid the panic while the herd of average investors heads for the hills. What’s different this time?
The correction over the last few months has delivered 10% drops in many stocks and 20% declines among a number of lower-quality companies. My IRA (like my friend’s) has declined some 3-4% and this never feels “good.” However, I take great comfort in avoiding those 10-20% swoons that others seem to be experiencing. The difference is attention to overall portfolio quality. As we reinforced in the June newsletter, history suggests that higher-quality stocks will weather corrections and bear markets better. Despite some challenges faced by some of the most widely-held stocks by MANIFEST subscribers (e.g. Home Depot, Pfizer, Bed Bath & Beyond) the overall outlook still looks pretty super to me.
What about Tin Cup? Skepticism about the effectiveness going forward is natural and welcomed. We know that curiosity is a powerful tool in our investing arsenal. My instinct is that we’re seeing a speed bump in the long-term results of the Tin Cup portfolio and that there’s nothing different this time. Heeding quality and seeking superior projected returns shows great promise. My experience is that every time investors question long-term potential, and MIPAR spikes up, and C.L. heads for “his hills,” it’s time to shop for the best stocks at the best projected returns.
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.