'Everyone has a plan until they get punched in the mouth."
In a recent series of client presentations, we used these words from Iron Mike Tyson to segue from the first half - a sobering look at what has happened in the economy, capital markets and our funds - to the more uplifting second half, which covered the reasons why there will be a stock market recovery and the importance of participating in it.
As investors drag themselves off the mat, it's difficult to see the whole picture. It's not a good time for thoughtful perspective. They know all too well what floored them - subprime mortgages, cyclical excesses, too much debt, poor business and political leadership, and the potential for the worst recession since the 1930s. But intense pain and emotion make it hard to see the opportunity that inevitably comes out of all that.
This column is dedicated to the stuff that's harder to see.
Extremes breed extremes. The severity of this downturn grew out of the recently departed business and market cycle that took it to the max in every way. The result: Stocks have halved and credit markets are the worst they've been since the D-D-D-Depression. One cycle sets up the next.
Extremes of a positive nature are starting to surface. Stock and corporate bond valuations are now assuming the worst. I read an analysis this week that showed if you buy a portfolio of five-year U.S. investment-grade corporate bonds and hold them to maturity, more than 45 per cent of the portfolio needs to default before you are worse off than holding a similar portfolio of government bonds. To put this in perspective, during the Great Depression, the actual default rate on similar rated bonds was 4 per cent.
It's a similar story with equities. When we buy a stock, we are acquiring a stream of future earnings. Because of the time value of money, near-term profits are more valuable than those from farther out - in a "discounted cash flow" or DCF calculation, the first three years account for roughly 10 per cent of a company's value.
When stocks go down as much as they have, three things have happened. Investors have made a major adjustment to their earnings estimates for the next year or two, revised their longer-term outlook and assigned a lower multiple to the entire earnings stream.
Opportunity comes from the fact that some companies will emerge from the downturn stronger than ever and deserving of a higher multiple. I recently had a fund manager tell me that we are at "generational lows" in terms of stock valuations. What he is saying is that the short-term factors have unduly influenced long-term estimates and valuations. Low multiples on depressed earnings - it's a beautiful thing.
It's not always obvious, but dividends account for a significant portion of equity returns. The dividend yield on the S&P/TSX composite index is now 4.5 per cent, a full percentage point higher than government bonds. International stocks, as represented by the EAFE index, have a dividend yield of 5.2 per cent. Even assuming some dividend cuts, these yields are at a good level from which to start the next cycle. And if it takes time to get started, investors are at least getting paid to wait.
While valuation metrics have turned in our favour, they are not as extreme as the sentiment indicators - the measure of how positive or negative investors are feeling about the future. Market sentiment is important because it's an indication of capitulation. If everyone who wants to sell has sold, that's a good thing. In a recent piece, Barton Biggs, a highly regarded hedge fund manager and market strategist, opined that he has "never seen capitulation and despair like this. We must be pretty close to maximum bearishness."
Like all these indicators, sentiment is imprecise. It isn't a timing tool, but rather a comfort factor. Bearishness tells us that the market has a healthy respect for risk. It's one of the necessary ingredients for a big market run.
One of the unique features of this downturn is the degree to which there has been distressed selling. As our financial system de-leverages, individuals and institutions have been forced to liquidate, not because of their assessment of value, but because the bankers want their money back. This process has weighed heavily on the markets, but it will run its course. I suspect the margined individual investor has been flushed out by now. Mr. Biggs and others say hedge funds are well along in answering the call from their prime brokers. And in general, the banks are moving fast to clean up their mess.
In the meantime, investors shouldn't lose sight of the mound of cash that is building up on the sidelines. As of the end of September, U.S. money market funds totalled $3.5-trillion (U.S.)., which equates to 45 per cent of the S&P 500's market capitalization. That percentage, which would be higher today, is well above previous highs hit in 1982 and 2003. The buying power is building.
Finally, investors need some perspective on the gloomy headlines - they are a good thing. Market recoveries don't start until after a recession has been declared. At some point, stocks and corporate bonds stop going down on negative news. They begin to look forward to better times ahead.
My message to the battered and bruised is to start preparing for the other side of the valley. It's time to get back on plan.
Tom Bradley