Investor Forecast: Stormy Weather, Not Falling Sky

Since early this year, it feels as though there have constant steep drops in stock markets with every upward recovery being smaller and then followed by an even bigger decline. Indeed, the numbers confirm the impression: S&P TSX Composite Index's 1-year price return is -7.3%, the year-to-date price return is -14.8%, the price change since 2011 peak on April 5 -19.4%. The Google Finance chart of this period really doesn't look pretty.


Is the "Sky Falling"? - The feeling that things can and quite possibly might get even worse is quite understandable. Major country economies are weak, possibly heading into recession. On top of that, if a default by Greece could provoke a chain reaction to other European countries, what might be the result of country defaults considering that a mere investment bank's (Lehman) downfall in 2008 led to that horrendous market crash?

Answer: No, though there are definite menacing clouds, we believe the Sky is Not Falling. As we blogged about a few months back in Investing Risk: Defaults, or how often do investments go belly up?, country defaults happen, the last peak episode being around 1990 according to the chart in that post. The world weathered that period. Whether various authorities manage to prevent the seemingly inevitable default of Greece, the world economy is likely to survive and then revive after such an occurrence. Also instructive is the history of the recurrence of significant market losing periods, which we blogged about in Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises. The lesson of history is that it may take many years to recover but recovery does ensue, even in the very worst episodes of the past.

What therefore should we as investors do?

Action item 1 - Set Expectation to Long Holding Period for Equities: Our allocation of money to stocks must go along with an expectation of a holding period of at least ten years before we intend to cash in and start spending the money. The knowledge that we will not be needing the funds for many years will allow us to weather the financial storm and its aftermath. Setting our expectations appropriately helps us sleep better and avoid panic selling.

Action item 2 - Rebalance the Portfolio: A portfolio should contain target percentages of cash, fixed income and equities in proportions which we suggest should be explicitly set out, as we explained in the post on Investment Policy. Since equities have declined quite a bit while fixed income has stayed constant or gone up (e.g. the iShares DEX Universe Bond Index ETF - TSX: XBB - is up 2.6% over the past year), it is quite likely the equity vs fixed income percentages have gone out of whack. If the proportions have gone far enough askew, then now is an opportune time to take the cash or sell fixed income to buy equities. For more see our post on Rebalancing - What, Why and How.

Current stock market valuations are encouraging in that sense as they are at levels low enough to promise reasonable future returns for equities. Using the sources we blogged about in February 2010 in Is the Stock Market Over- or Under-Valued?, the signs are more promising or at least not worse now than back then.

• InvestorsFriend.com's Shawn Allen figured as of September 28th that the TSX Composite Index fair value is somewhere around 11,838, implying an investor could get an 8% return over a ten-year holding period. With the TSX gyrating around that level as of Oct.13th, the prospects are quite reasonable.
  
• Ben Stein and Phil DeMuth's Yes, You Can Time the Market indicators (Price, P/E Ratio, Dividend Yield, Earnings Yield vs AAA Bonds) for the S&P 500 bellwether US market index as of September 30th were all flashing Green for Buy.
• The CAPE vs q Ratio calculated by Smithers & Co. on September 16th showed the S&P 500 to be still over-priced at a price level of 1216, not much different from February 2010, but today the S&P 500 is lower at about 1200 so it would be less over-priced.
  
• In the same vein, the Schiller CAPE ratio is the same at 19.8 as it was in February 2010, and thus still exceeds the long-term average of 16.
  

The most fearful situation for most is having to face the unknown. It is easier to face adversity when it is defined. We hope that with the above facts in mind, our investor readers can be more confident and less anxious for the long term.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above commentary is not an investment recommendation. It rests on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.