A Prussian general once said, “No plan survives first contact with the enemy”— or, as Mike Tyson once warned, “Everyone has a plan until they get hit in the face.” The plan, for investors, is to be disciplined and not react emotionally. But right now the enemy is panic and Tyson is the market. At present, investor concern over the near-term future of stock returns is caused by fears over the future of the U.S. and world economies. There is no question that the level of debt in the U.S. and the financial weakness of several other prominent countries around the globe are alarming. Surely the first ratings downgrade in our country’s history will have negative consequences, the magnitudes of which are still uncertain. Uncertainty is always uncomfortable. What we do know, however, is that the future of the S&P 500 is not likely to be tied to the current state of the economy. In fact if any relationship exists between the market and the economy through history, it is a negative one where investors should be buyers of equities when GDP growth is negative, unemployment is peaking, and consumer sentiment is low. This is because equities get cheap when the mood is overly pessimistic. But markets react much differently—on Friday morning, when the jobs report was better than expected, the S&P futures went from negative to sharply positive, before the market ultimately finished flat for the day.

 

Consider the following facts:

 

■ Following periods where GDP growth is negative (a palpable current fear), subsequent average S&P 500 returns are 21.36 percent, 12.24 percent and 12.10 percent (annualized) for the next one-, three-, and five-year periods.(note 1) If the economy does double dip, this could be useful.

 

■ The level of unemployment has a small +0.12 correlation with subsequent three-year stock returns since 1929—jobs data simply has not been helpful in predicting future returns.

 

■ Consumer confidence remains very low. The Investor’s Business Daily’s Economic Optimism Index fell to an all time low of 35.8,(note 2) and is down 31 percent for the year. But the best market returns since 1952 came after periods of low confidence (with an average annualized return the following five years of 11.5 percent), whereas the worst returns came after periods of high confidence(note 3) (average annualized loss of -2.42 percent).(note 4)

 

■ Our Enhanced Dividend strategy has a yield of 5.7 percent as of 8/5/11—more than double the yield on the ten-year note, which was 2.46 percent as of 8/5/11.

 

■ The market ultimately grows with earnings, and future stock returns are inversely related to current valuation levels. Just four percent of S&P 500 stocks are above their 50 day moving average, yet 75 percent of those companies beat earnings estimates in the latest quarter. As of 8/5/11, the Leuthold Group’s five-year normalized price-to-earnings ratio for the S&P is below the 1957 to date median.

 

Many of our favorite quotes about contrarian investing ( for example, “Buy when there is blood in the streets” and “Be greedy when others are fearful”) highlight the fact that during periods of extreme emotion, investors should be opportunistic, not reactionary. Research by Gregory Burns and others has shown that the feeling of anxiety and panic are so uncomfortable for people that they will very often accept greater short-term pain in order to avoid having to deal with more anxiety or uncertainty. In a test involving electric shocks, his subjects would accept a higher voltage right away to avoid lesser shocks at some unknown time in the future. Markets are no different, so we advocate a non-emotional response to this market selloff. We cannot ignore the possibility that we may see another bear market; after all this has been one of the most impressive bull markets in history. But any decision to sell should not be based on jobs reports, drops in GDP, or raw fear. We suggest those with at least a three-year time horizon start incrementally using any cash to buy attractive value and yield, in both the US and internationally.

 

Notes:

 

1 1946–2010, OSAM commentary, “The Economy and the Stock Market,” Sept. 2010 (see http://www.osam.com/commentary.aspx)

2 Survey conducted since 2001.

3 OSAM commentary, “The Economy and the Stock Market,” Sept. 2010

4 Based on the highest and lowest 10% of observations for consumer confidence, 1952–2010, OSAM commentary, “The Economy and the Stock Market,” Sept. 2010

 

 

 

(c) O'Shaughnessey Asset management

www.osam.com