Commentary & Insight

Market Update — Value in Volatile Markets

Ted Truscott, Chief Investment Officer
Feb. 14, 2008

"The rational response to low expected returns is to withdraw and wait until returns are higher. That response seems to have gone out of fashion. Today's response is to underestimate risks taken ..."

— Peter Bernstein, "On Failures of Information Flows," The Journal of Portfolio Management, Volume 34, Number 2

"Tumult shakes loose investment bargains and stimulates new thinking. Though it also moistens the palms, quickens the pulse and disturbs — occasionally — the settled patterns of sleep, what of it? Let the value restoration project proceed."

— James Grant, "Value Restoration at a Gallup," Grant's Interest Rate Observer, Volume 26, Number 2

Peter Bernstein and James Grant are two of the most important and interesting investment thinkers of our time. Bernstein is an authority on the subject of risk in financial markets and Grant is a certified contrarian who searches for value in markets by looking first at the cost of money. Bernstein wrote the quote above nearly a year ago and referred to it in the article cited above. His chief concern was that investors were vastly underestimating risks in order to justify the meager returns of many asset classes in 2007. The poor returns were a function of many factors — chief among them were easy credit and a large global supply of capital that did little to chase good investment ideas.

Both of the quotes refer to the same issue — value, which was largely absent from last year's stock and bond markets, but is now reappearing. In some cases, value is emerging at a rapid clip, but the disappointing part about the re-emergence of true value is that prices of stock and bonds are falling at the same time. In fact, falling prices are a necessary precondition to the re-emergence of value.

Why do falling prices create value?

There are several ways to understand this concept and one is to look at returns among certain asset classes for 2007:

2007 Returns (Source: Wall Street Journal)
S&P 500 index	5.49%
U.S. credit index AA-rated segment	5.39%
iMoneyNet/12-month yield on all taxable money market funds	4.48%

Note: It is not possible to invest directly in an index.

These three indices are broad measures of U.S. stocks, U.S. corporate bonds and money market funds. The small differential in returns tells the whole story. Both in theory, and often in practice, such a narrow differential should not occur. Stocks are riskier than corporate bonds and corporate bonds are riskier than cash. Investors should earn a substantial premium to hold stocks instead of bonds, and bonds instead of cash. So where is the value here? Certainly not in stocks — they barely returned more than bonds and only slightly more than cash. Corporate bonds were no bargain either with only slightly better returns than cash. We have provided charts in the past which showed that corporate bond spreads in 2007 were very tight versus risk-free treasuries (in plain English this means that expected returns were very low in corporate and many other bonds for the risks being taken).

In broad measurement terms, the U.S. stock market in 2007 was not particularly over-valued and it certainly bore no resemblance to the valuation extremes last seen in 1999. However, it is also clear that traditional value measures, both quantitative and fundamental, worked very poorly last year. In contrast, price momentum had one of its best years ever. In other words, stocks that were moving up in price (particularly growth stocks) performed very well last year, regardless of value. This was not and never is a sustainable model over the longer term.

This year, we are witnessing a return to the search for true value. Investors are now demanding better return for risk and prices are being driven down to a clearing level where returns are more appealing. To be sure, there are other factors driving down prices, including fear of recession, forced liquidations and turmoil in the housing market, but much of this turmoil is a mere catalyst for market participants to wake up and demand better returns.

How long before stocks and bonds represent fair value, or even a bargain?

We believe price declines could continue for many more months because just as markets reach irrational extremes on the upside, the same is often true on the downside. We are reminded of August 2002 when the bonds of certain telecommunications companies were offering returns of 30% — 40%. Investors were demanding equity returns for corporate bonds because of the fear that many telecommunications companies would seek bankruptcy. While some did, many did not and investors, who realized that a 30% return was more than adequate compensation for the risk being taken, made a fortune.

In the late 1990s, small cap value stocks were among the most unloved of asset classes and were generally the worst performing stocks in 1998 and 1999. It seemed that there was no value in value! And yet this asset class went on to become the best-performing asset class in 2000 and 2001. Why? Prices had fallen to such an extent that small value stocks represented an extremely compelling value.

But I am so worried — why not just stay in cash?

We believe cash is no longer a preferred asset class. That was last year's game, when owners of money market funds earned a return nearly equivalent to the S&P 500 with nowhere near the risk.

In order to stimulate the economy, the Federal Reserve Board has dramatically lowered interest rates and money market yields have fallen accordingly. With inflation rates estimated between 3% and 4%, yields are now negative in real terms. Keeping money in a CD or money market fund when real yields are negative is the financial equivalent of putting cash in a safety deposit box. There is plenty of safety but inflation will erode the purchasing power of that cash. Beyond that there is the vexing question of when to get back into the market.

Everyone is wrong at the turn!

This is one of the oldest sayings in the investment business and yet it continues to be surprisingly true. Few people are able to call markets correctly on a consistent basis. The roaring bulls from June 2007 do not appear to be quite so confident today, while the growling bears of 2003, who believed that the poor returns of 2000—2002 would continue, missed the huge rally of 2003. International was one of the worst-performing asset classes during the early and mid 1990s, and initially this was necessary as the Japanese market had to decline steeply for value to be restored. Those who abandoned international missed solid returns in the latter part of the 1990s as well as the period from 2003—2007.

When you have the proof, you don't have the price and when you have the price, you don't have the proof.

This is another market saying rich with meaning and is all about risk and reward. An investor who has all the proof that an investment is valuable will never purchase at a bargain price because other more clever and discerning investors will ultimately get there first. On the contrary, when investments are true bargains, there never seems to be enough information to justify a purchase.

Markets are many things. They convey lots of useful information and they do this through the mechanism of price. As investors, when we know the price we can discern the expected return and can also calculate the risks associated with achieving that expected return. Stocks and bonds are very valuable when the expected returns exceed the risks being taken. Given the steep declines in stock and bond prices, bargains are beginning to appear, but there is still plenty to worry about, isn't there? We are looking for that elusive proof that most of us may never find and will only become obvious once the bargains are gone.

We do know one thing — cash is certainly safe but that is likely its only value in today's markets. In investment terms, cash does not currently offer a particularly compelling value. We also believe in the market truism that everyone is wrong at the turn, so predicting when the market will rise again is an imprecise exercise. As such, we believe that clients, in consultation with their advisors and based on tolerance for risk, should think about using dollar-cost averaging* to gain exposure to stocks and bonds. Let the volatility of the market work on your behalf by averaging into the market rather than buying in all at once. The timing will be imprecise but if you wait too long for the proof, the really good money will have already been made.