Investment advice for a wild market

Your retirement nest egg might have lost 40% of its value since this summer and 10% the last 2 weeks. What should you do? Here’s the advice I’ve been giving to friends who ask, as well as what I’ve been doing with my own portfolio.

First, let me begin by stating that I make no claim whatever to be able to predict whether stock prices will go up or down over the near term or when the market bottom might be reached. In part that humility is inspired by a large academic literature demonstrating that it’s very hard to predict stock prices with formal statistical models.

The one element of predictability for which I do see some support in the academic literature is the claim that the price/dividend or price/earnings ratios do not wander too far from their long-run historical averages. The implication of that finding is that when prices are high relative to dividends and earnings, you can expect below-average stock returns. The graph below, which I’ve updated from Robert Shiller’s historical data base, conveys some sense of that relation and where we stand at the moment.shiller_pe_nov_08.gifWe’re currently at a P/E around 14, a bit below the historical long-run average P/E of 16.3, meaning you could expect a slightly above-average return from buying stocks now. Specifically, if companies were to pay their shareholders all the income to which they’re entitled in the form of a dividend, that dividend would give you better than a 7% immediate return, and over the long run, the dividend would grow at least at the rate of inflation. That’s a return that proved more than sufficient compensation to investors for the extra risk they faced from stocks over the last century and a half, which included plenty of times tougher than those we’re going through at the moment. To me, a 7% real yield sounds like an attractive investment, despite the risk, and certainly dominates most other alternatives as a long-run vehicle for saving for retirement.But isn’t it possible that the P/E will decline further, to much below the historical average, before the carnage is finished? Sure it is. But here’s another way to look at that. Companies in fact don’t turn over 100% of their profits to the shareholders as dividends, but re-invest some of those profits in the hope that future earnings will increase faster than inflation. The typical stock in the S&P 500 today is giving you a 3% dividend, which you could hope will grow 3% faster than inflation over the long run as a consequence of the reinvested profits. That again to me sounds like a very nice investment. You can buy and hold for the long term with the philosophy that it’s that stream of growing dividends that you really want and are going to get. Let the market price of the stock go up or down from here wherever the psychology of the market may take it– you’ve still received what you paid for, and it’s a reasonable deal.But if stocks really weren’t such a good bargain a few years ago, why was the market valuing them as highly as it did? Shiller’s view is that investors simply miscalculated, misled by the fact that everybody else seemed to think they were worth that much. According to that philosophy, recessions and market busts are the time you should be buying. Here’s how Warren Buffett described how he put that into practice last month:

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds….

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

John Cochrane instead attributes the big swings in the historical P/E to changes over time in the compensation that investors require for risk. According to Cochrane’s view, people understood that they’d be getting less than a 6% expected real yield on stocks if they bought a few years ago, and that stocks purchased today offer you better than 6%. John summarizes his investment advice this way:

If you’re less leveraged, less affected by recessions, and have a longer horizon than the average, it makes sense to buy [now]. If you’re more leveraged, more affected by recession or have a shorter horizon, it might be the time to sell, even though you might be cashing out at the bottom.

As for which stocks to hold, one unquestionably sound investing principle is the benefit of diversification. But if you pay a big fee to somebody to manage your portfolio, you’re out that fee before you start, and the evidence is to me unpersuasive that high-priced fund managers can systematically outperform the market. So my advice for most people is to use broad funds that mindlessly, mechanically, and cheaply do something simple like try to hold a portfolio mimicking the S&P 500. Broader diversification into smaller companies and internationally is also an extremely good idea. My 403(b) invests 1/4 each in the following funds:

Yes, they’ve all tanked this year, but here’s the bright side– those monthly payments I’m still putting in are now more likely to get me something for my money!

We’ve also been saving some money beyond the 403(b) limits, and we’ve always just had this in T-bills. I felt pretty silly describing this part of my portfolio as a professional economist, but I was fearful of putting any more into stocks, given the graph above. Now I’m feeling pretty proud of myself for being so silly.

But my wife and I also feel that now is the time to move that money out of Treasuries and into the stock market. Outside of a 401(k) or 403(b), one disadvantage of stock index funds is that you’re taxed on realized capital gains as they arrive, whereas if you buy and hold individual stocks, you can postpone the capital gains tax. Because of compound interest, this can make a big difference. For example, if you face a 50% tax rate assessed every year on the gains from your 6% return, after tax you’re re-investing 3% for a 20-year cumulative return of [(1.03)^20 -1] or an 81% total return. On the other hand, if you can hold that 6% as unrealized capital gains and only pay the 50% tax when you sell, you’ve got 0.5[(1.06)^20 – 1] = 110% total return.

So we’ve been buying stocks over the last month, and greeted yesterday’s carnage as good news for us in that the downturn allowed us to execute two more of our outstanding limit buy orders. I didn’t do nearly enough research on individual stocks, but know the kind of equities I wanted– a P/E of maybe 11, dividend of at least 3%, long record of strong growth, a solid balance sheet, and a company that I knew at least something about personally. Here’s what we’ve bought (some of which meet those criteria better than others) along with some brief annotations on each:

  • 3M COMPANY (MMM). Growth comes from continually developing new products– a lot more than Scotch tape.
  • Apache Corp (APA). Yes, I know spot oil is below $60, but once the world recovers from this downturn, there’s room for quite a few more cars in China, and Apache should actually have some oil to sell.
  • AT&T (T): I’m a sucker for the 6% dividend.
  • Delhaize Group (DEG): Owns a number of grocery store chains; the ones I’ve used I like.
  • Home Depot (HD): They should survive, and when growth resumes, they have a very successful strategy.
  • Eli Lilly (LLY): Downside is likely legislation targeting drug company profits. But I like the long record of profitable R&D and 5.5% dividend.
  • Walgreen (WAG): Drugstores too will survive.
  • Johnson Controls (JCI): Downside: U.S. auto industry will be absolutely hammered. Upside: I don’t think Congress will allow domestic manufacturing to be completely eliminated, and JCI will be one of the survivors. Also may benefit from Obama’s green investments.

We plan on buying more next month. One thing that’s clearly underweighted in the little portfolio above is stocks in the financial sector. But in the brief time I’ve spent looking at a dozen or so of these, I didn’t find one that didn’t have some bad smell to it. What I’d really like is a regional bank that’s been run with a paleolithic conservatism during the go-go years. Any such entity would be in a good position to profit mightily from the current mess.

I look forward to hearing other suggestions or investment philosophy from our readers in the comment section below.


Originally published on November 13, 2008 at Econbrowser and reproduced here with the author’s permission.

3 Responses to "Investment advice for a wild market"

  1. Little Saver   November 14, 2008 at 8:29 am

    P/E is key, I agree.Good strategy, nevertheless the following question: are you using trailing E?If so, what about incalculating next year’s E? Assuming that the recession still has a way to go, future E may be considerably lower than trailing E, meaning that current stock prices correspond to a future P/E significantly above the average of 16.3.In other words, much depends on the severity of the recession and the evolution of future earnings. From that viewpoint, it seems normal that P/E tends to go far below the longtime average at the onset of a recession, to go up again when there’s some visibility on the depth of the recession and less uncertainty about further decreases in earnings. What’s your opinion on this factor?My best,

  2. Anonymous   November 14, 2008 at 9:03 am

    very good artible below:

  3. Michael Khor   November 15, 2008 at 1:07 pm

    I agree with Little Saver that PE and EPS can be delusionary, particularly; most analysts have not revised their prospective earnig(s) downwards. Wall Street and the media cheered when Buffet announced his investment in GS and GE. However, I am more inclined towards the view of Jim Jubak of MSN money that unlike others, Buffet is well rewarded by these companies (dividend of 10%) to wait for the economic recovery to buffer wrong market timing. Furthermore, Bill Fleckenstein of Contrarian Chronicles recommended on 10-27-08 that investors, “Leave Stocks to Buffet Temporarily,” because of his affinity to take risks and the impact of a severe recession are still unfolding. The question is could Buffet has other objective in endorsing these companies, such as to arrest the further decline in Bershire shares? For example, during the beginning of this major downtrend at the end of 2007, legendary mutual fund founder, Jim Bogle, and Jeremy Siegel recommended investors not to leave the market. With 20/20 hindsight, we now know how wrong they are more because of the conflict of interest than their ignorance.Given good stock selection, timing the market to optimize investment is extremely difficult. So in the long run, with a reasonable investment time horizon of 5 years or more your investment strategy will surely reap good returns at the current level of entry. According to your appended chart above and if you believe in Nouriel’s perspective that the current recession is the worst recession since the great depression, then PE could even fall to SIX, which will enhance your return further if you cumulate cash to wait???