Mind Over Emotion

We are very fortunate to work with a client base which understands the key principles of investing and recognizes the lessons of financial market history. Regardless of the depth of that knowledge, however, environments like we’re experiencing now can shake investor confidence and overwhelm rationality.

At times like these we need to put things into perspective so we can more easily adhere to our long-term investment plans. Here are some important points to consider in the coming days and weeks:

• U.S. stocks gained 32 percent from July of last year to July this year. We have now lost about 17 percent since the current decline began a few weeks ago. This is not unusual—in fact, since 1926 the U.S. stock market has declined 20 percent or more 27 times (on average, about once every three years). In every instance the market has rebounded, typically unexpectedly and quickly.
• Last summer we were in a very similar position: The stock market declined 16 percent from late April into July and returns were negative year to date. Yet a market rally before the end of the year left the S&P 500 Index with a 15 percent gain for 2010.
• In comparison to 2008, market fundamentals and corporate earnings are much improved today: The operating earnings of S&P 500 companies reached an all-time high in the second quarter of this year, and very low bond yields and relatively low price-to-earnings ratios on stocks suggest that markets have largely priced-in a weak and uncertain economic environment.

Burton Malkiel, professor emeritus of economics at Princeton University and author of “A Random Walk Down Wall Street,” authored an excellent commentary appearing in Monday’s Wall Street Journal titled “Don’t Panic About the Stock Market.”  In it, Malkiel reviews the current economic and market environment and draws the following conclusions:

“This is not the market meltdown of 2008 all over again… Yes, we have problems, but the current situation bears no resemblance to 2008.”

“No one can predict what the stock market will do in this and coming weeks. Stocks may continue their decline, but I believe it would be a serious mistake for investors to panic and sell out.”

“We all need to be aware of the limits of our ability to forecast future stock prices. No one can tell you when the stock market will end its decline, but there are some things that we do know. Investors who have sold out their stocks at times when there have been very large declines in the market have invariably been wrong.”

“My advice for investors is to stay the course… Indeed, it is in times like this that investors should consider rebalancing their portfolios… Years from now you will be glad you did.”

While clients undoubtedly tire of hearing us tell them to “stay the course,” now is when hearing that refrain again and again proves most valuable. Despite (or perhaps, because of) the utter unpredictability of world and financial market events, adhering to a sound long-term investment plan has repeatedly proven to be the best course of action. This was our message during the bear market of 2000-2002 and again through the incredible depths of the 2008-2009 downturn. Clients who stayed true to the strategy were ultimately rewarded for their patience and discipline.

A Note on the Downgrade

On Friday evening, Standard & Poor’s downgraded the U.S. long-term sovereign debt rating one notch from “AAA” to “AA+” citing rapidly rising debt levels and the acrimonious political environment. Despite the actions by Standard & Poor’s, the nation’s other major ratings agencies (Moody’s and Fitch) reaffirmed the U.S. AAA rating, but remained on negative watch.

How did the bond market react Monday? Investors rushed to buy Treasuries, driving prices up and reducing the yield on the 10-year bond from 2.56% to 2.33%—its lowest level since January 2009. Despite the downgrade, U.S. Treasury bonds remain the world’s safe-haven amid economic uncertainty. Ultimately the effect of a singular downgrade is likely to be minimal, though it could have a positive impact if it serves as a wake-up call to politicians (and voters) who remain more concerned with political agendas than with effectively addressing long-term structural issues.