To our clients:
It is understandable that you may be concerned about your stock market investments at times like the present, when stock prices have fallen sharply in an environment of pessimistic news stories about economic and political developments. It is probable that current problems in the rest of the world will cause a temporary reduction in the profitability of some important U.S. companies. However, that is not the sole reason, and perhaps not even the main reason, for the current decline in the stock market.
When the stock market is falling there is always bad news available to explain the decline. But stocks can go up just as well as down in the face of bad economic news, hence the stock market saying that bull markets climb a wall of worry. I.e., investors disregard bad news when stock prices are rising. So, let us look to the market itself for an explanation of the current decline.
A principal cause of every bear market is a preceding bull market, just as a principal cause of every economic recession is a preceding economic expansion. Human nature is the root cause of these recurring cycles of expansion and decline, of boom and bust, of rising and falling markets. Therefore, it is no secret that the best time to buy an investment is when prices are depressed, and the best time to sell, if one needs cash, is when prices are inflated. Buy low and sell high, so the saying goes. However, in the wise words of Benjamin Graham:
“These copybook maxims have always been easy to enunciate and always difficult to follow–because they go against that very human nature which produces the excesses of bull and bear markets–It is because the average man operates, and apparently must operate, in opposite fashion [buying hopefully when prices rise and selling despondently when they fall] that we have had the great advances and collapses of the past; and… are likely to have them in the future.”
Beginning in October 1990, at the end of the last bear market, the Dow Jones Industrial Average advanced 289% to its peak in July of 1998. The average annual rate of advance was 21.5%, not including dividends, as compared to a historical average advance of 6% per annum since 1918, not including dividends.
Since 1990 share prices of a few of the stock market leaders have risen 1,000%, 2,000% and even more, with advances of 70% or more since the beginning of this year. It is a rare achievement for any company to improve its profitability and prospects by 1,000% in just eight years. We believe that there is seldom, if ever, an underlying value that could justify a rise of 70% in market price six months following a 1,000% or better rise in the preceding seven years.
The past century of stock market history teaches that for market prices to be stable there must be a reasonable relationship of share prices to earnings and dividends. Over the past three years the broad stock market averages rose to extremely high and unsustainable levels in relation to earnings and dividends. After such episodes of euphoric buying, stock prices will always fall back, eventually, to levels that are more reasonable.
We have empathy for those who dread a decline in the market value of their portfolios. However, now is the time to take a long-term view. Most people who have owned stocks for the past few years have enjoyed a rise in market value far beyond that provided by stable value investments such as bank accounts. If one has no imminent need to spend the cash value currently represented by one’s stocks, there is little risk of loss from holding onto the stocks through a market decline. On average, a bear market lasts about a year and takes stock prices down about 30%. However, the decline is generally recovered after a year or two. Stocks have provided positive returns in every three-year holding period since 1940, with the exception of 1972-74 and 1973-75.
The long-term trend of rising values in U.S. industry remains intact. Therefore, stocks should continue to be appropriate long-term investments. But some selling of stocks may be appropriate for any of the following reasons: 1) part of one’s holdings represents amounts needed for personal expenses within the next three to four years; 2) it appears, after thorough analysis, that a company’s future prospects do not justify its current price; or 3) that in the interests of one’s psychological well-being, some reduction in stock market exposure is necessary.
We regard the current market decline as an appropriate and healthy correction of an over-priced market and an opportunity to improve the quality and stability of our clients’ portfolios via selective selling and buying that should improve future rates of return.
CHEVIOT VALUE MANAGEMENT