With 2008 off to a rocky start, to say the least, and the second half of 2007 not exactly favorable for value-oriented investment strategies, we understand that it is becoming difficult for many folks to keep the faith that equities are the place to be, especially with the headlines dominated by talk of a U.S. recession and all sorts of other doom and gloom scenarios.
While we cannot predict what the future will hold, and we know that the stock markets like to go to extremes in either direction, meaning it would not be a big surprise if we saw more weakness in the near term, we can say that slowdowns and recessions always have given way to eventual recoveries and expansions. Certainly, we recognize that fear is a tough emotion to suppress, but I can say that we have lived through many scary downturns in my 20 years at Al Frank. These include Black Monday, Iraq I, the collapse of Long Term Capital Management, the Asian Contagion, presidential impeachment, the bursting of the tech bubble, September 11, accounting scandals and Iraq II.
What helped to keep us calm during all of those turbulent periods was historical perspective and keeping handy the latest yearly edition of the data-intensive book Stock, Bonds, Bills and Inflation, published by Morningstar. Although we don't yet have 2007 numbers from Morningstar, investors should be well aware that equities have returned 10.4% to 12.7% per annum since 1926, easily outpacing returns on bonds, bills and inflation.
Click for Morningstar data.
Perhaps even more interesting, given concerns about the dismal economic data that have been released of late, is that stocks actually have performed better one, two, three and five years out following weak reports on manufacturing and employment. We suppose that this should not be a great surprise in that the equity markets are anticipating mechanisms, so, generally speaking, stock prices have often fallen long before economic statistics confirm a slowdown and they start to rise well ahead of improvement in the data.
We obtained data on the Institute for Supply Management's (ISM) index of manufacturing activity and the Department of Labor's jobless rate, both dating back to 1948, as well as the Philadelphia Fed's general business-conditions index dating back to 1968. Utilizing monthly small-company and large-company stock performance figures from Morningstar, we looked at equity returns one, two, three and five years out from every monthly starting point through the end of 2006.
When the ISM figure was above 50, indicating expansion in manufacturing, large-company stocks posted an average gain of 10.7% one year out, while small-company stocks had an average gain of 13.2%. On the other hand, when the ISM number was below 50, as it is today, large-company stocks had an 18.3% average gain and small-company stocks had a 24.6% average gain over the next 12 months. There were 468 monthly data points whereby the ISM number was above 50 and 227 where it was less than or equal to 50.
Click here for the full study.
Using the current 5.0% unemployment rate figure as the dividing line, there were 475 monthly data points whereby the jobless rate was 5.0 or higher and 220 where it was less than 5.0%. When the unemployment rate was ‘low’, large-company stocks posted an average gain of 7.2% one year out, while small-company stocks had an average gain of 10.0%. On the other hand, when the unemployment rate was ‘high’, large-company stocks had a 15.9% average gain and small-company stocks had a 20.1% average gain over the next 12 months.
Click here for the full study.
Next, we look at the Philadelphia Fed numbers where a reading of zero or below indicates contraction (the latest reading was -20.9) and a figure above 0 indicates expansion. When the Philly Fed General Activity Index was positive, large-company stocks posted an average gain of 11.1% one year out, while small-company stocks had an average gain of 12.6%. On the other hand, when the Philly Fed number was negative, as it is today, large-company stocks had a 14.1% average gain and small-company stocks had a 23.4% average gain over the next 12 months. There were 331 monthly data points whereby the Philly Fed number was positive and 120 where it was zero or negative.
Click here for the full study.
Many readers might like to know what Al Frank would think of the current market environment. Happily, we have a library of 25 years worth of our founder's writings and I think that a piece he penned near the depths of the 1998 market swoon offers excellent words of wisdom…
"Too late to sell, too soon to buy, time to pray, could be our rationalized response to today's stock market. We are probably in a bear market, at least for the majority of stocks, especially the smaller capitalization equities. It may be too late (unwise) to sell the shares of good companies that have been beaten down and are seriously undervalued in terms of fundamental analysis. If we are in a strong decline in an ongoing bull market, then it may seem too soon to buy deeply undervalued shares even with their prospects for more than doubling on average during the next two or more years.
After all, why buy a stock now when it may be 20%-50% cheaper in a few weeks or months? Why invest good money in shares that could well be 'dead money' for many months or even years?
For me the answer to these questions is that in our 21 years of experience (and throughout market history), great gains have been made from buying bargain stocks in times of great stress and fear of the future. Substantial undervaluations do not occur when market players favor corporate prospects. The greatest bargains are found when fear of present 'possible' conditions is coupled with ignorance of past cycles. Such bargains consistently overcome huge price declines with even greater subsequent price advances.
Recently, as the stock markets sell off with alarming volatility, we hear and read more and more doomsday scenarios. If inflation doesn't get us, with rising wages and an overreacting Federal Reserve raising interest rates, then deflation and recession will get us with decreasing corporate profits or losses. If we do muddle through the Asian crises, the Y2K problem (the millennium bug in computers) will undo us with commerce in disarray and all manner of world-wide disasters developing, overwhelming living conditions and decimating currencies, properties, corporations and their shares.
For whatever analyzable reasons, stocks and the stock markets have always gone to irrational extremes, both up and down. While careful government and Federal Reserve actions may mitigate wildly fluctuating 'business cycles' by fine tuning, it is unlikely such similar results can be obtained for greed-stimulated or fear-ravaged stock markets.
Although we may not be able to predict how high or low our stocks will go, we can calculate to a sufficient degree, if not with great precision, the fair value of a corporation and its shares. Then, no matter what happens to the markets in the short run, we will time and again discover and buy bargains, hold them until they reach fair value, then sell them and repeat the exercise, cycle after cycle. We are likely to be 'wrong' at least a third of the time (much more in any given year) in terms of profitability. We may have to wait several years before many market prices equal fair values. But the wait will be worth it, even though there are doubts and difficult moments along the way. Yes, it would be wonderful to ascertain the future, 'buying low and selling high' without a hitch, but that is about as likely as winning the Power Ball lottery."
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Past Performance is no guarantee of future results.
The information contained herein is believed to be reliable. However, such information has not been verified by us and we do not make any representations as to its accuracy or completeness. Neither the information, nor any opinion expressed, shall be construed to be or constitute an offer to sell or a solicitation of an offer to buy any securities.
Opinions expressed are those of John Buckingham, which are subject to change without notice and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
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About Al Frank Asset Management
Al Frank Asset Management, Inc. (Al Frank) is an Investment Adviser, registered with the Securities & Exchange Commission, is editor of The Prudent Speculator (TPS) newsletter, editor and publisher of The Prudent Speculator TechValue Report (TVR) newsletter, and is the Investment Adviser to two value oriented no-load proprietary mutual funds and individually managed accounts.
Al Frank is committed to assisting our customers build wealth. We are a leading resource for value-based investor information in the financial community, where we combine our simple, proven philosophy of buying what we believe are under valued securities for their long-term appreciation with our experience, hard work, and intensive research to give you actionable investment information that can be used on a daily basis.
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