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February 9, 2009

In the Teeth of the Bear

Bear markets try our soul.  They hurt.  This one is no different.  The S&P 500 dropped 37% in 2008, the third worst performance ever.  With such aloss, it is natural to feel nervous.  But cashing out now may not be the best option.  History tells us that the longer the depth and the duration of the fall is, the greater the subsequent rebound is.  In other words, what goes down may go back up.

The economic reports continue to issue gloom and doom so why should anyone hold on to hope now?  Well, this is not America’s first bear market.  Since 1926, there have been 13 bear markets, averaging one every 6 years.  This current bear market is the 3rd worst after the one that ended in 1932 and 1942, respectfully.

During this recession, fear and panic over credit issues took its toll on virtually all stocks.  This means that the current prices for quality companies have been severely discounted.  I have had the opportunity to talk to a number of different money managers of late.  The one common refrain is that there are real bargains in stocks.

Look at valuations today, and you may come to the same conclusion.  The Price Earnings Ratio (P/E ratio) is under 10, down from 28 only a short time ago.  [P/E ratio is a measure of the price paid for a share of stock relative to the companies’ earnings.] The long-term P/E ratio since 1930 is 17.2.  History indicates that when you can buy stocks at low P/E ratios, that leads to better stock market returns and vice versa.

So is now the time to invest more into equities?  No one knows when the bear market will bottom.  Perhaps it has already.  To help nervous investors move a portion of their portfolio back into stocks, many advisors recommend a strategy called dollar-cost averaging*.  In this strategy, you buy a fixed dollar amount of investments on a regular basis.  If the market falls further, you would be buying additional shares at the lower price.  When the market recovers, your shares go up in value.  The downside to this strategy is if the market recovers while most of your money is still in cash collecting little to no income.  Still, it is better to have some in the market during a recovery rather than none.  Talk to your financial advisor before starting any dollar cost averaging program.

What we do know is that the stock market is one of the best leading indicators for the economy.  Investors anticipating an economic recovery in the near future will invest in advance.  If you look at eight of the last eleven bear markets, the stock market bottomed about half way through the recession.   The stock market actually rose about 25 percent before the recession ended and even more afterwards.  Let’s be clear… a bull market usually begins during a recession.  The 1932 bull market rose 367% over the next five years.

Long-term investing in stocks takes patience.  Bull and bear cycles occur. Unfortunately, market timing is notoriously difficult to predict.  No one really knows the best time to buy or sell.  But, once again, history can be helpful.  If you had invested $1 in stock in 1925, it would be worth $2,020 today or about a 9.6% return per year.  One dollar invested in U.S. government bonds would equal $84 today or 5.5%.  One dollar in cash would be $21 today or 3.7% per year.  During that same period of time, inflation
averaged 3 percent per year.

This clearly shows the trade-off between risk and return.  Viewed from a large time-frame, even the great depression looks like just a small bump along the way.  But even if you look shorter term, say 5 to 10 years, you are almost always better off with stocks making up part of your portfolio.

The cardinal rule of investing is diversification.  When buying stocks, diversify by industry, style, country, etc.  Also, invest in different asset classes.  Bonds, commercial real estate, stocks and cash.  If you look carefully at 2008, you will discover industries such as consumer staples, health care, and utilities, while all down, still outperformed the overall market.  At the other end of the spectrum, the cyclical and credit-sensitive industries underperformed the market as a whole.

The table may turn when the bull market starts.  Investors may flock to the oversold cyclical and credit-sensitive industries, shunning the more defensive industries.  That is why diversification is so important.  There is an ebb and flow to the market.  By having a diversified portfolio you help, somewhat, smooth out the rough patches.

Today it is all about cash.  The total amount of cash sitting idle is at historic levels.  It is estimated that the amount of cash is equal to $8.9 trillion.  Compare that to the S&P 500 that was worth $7.2 trillion as of the end of January.  As I mentioned earlier, money managers are finding bargains.  What they need is cash to make the purchases.

All that is needed now is for our economic condition to show some signs of abating.  As that occurs, more and more investors will move back to stocks starting the bull market.  It is not a question of if, but more of question of when.

Now is the best time to get yourself prepared for your own personal Economic Recovery.  Review your total portfolio and ask yourself these questions:

*        How much do you need for current income?

*        How much for growth and income?

*        What about preservation of capital?

*        How much should be invested for long-term growth?

*        Is your current portfolio using the right strategies?

Get the answers you need and deserve.  I urge you to meet with your
financial advisor.

*Dollar-cost averaging involves continuous investment in securities regardless of fluctuating price levels of such securities.  The investor should consider his/her financial ability to continue his/her purchases through periods of low price levels.