Wednesday, November 19, 2008

Been There Done That

Over the past month as the market roiled and the economy slipped more decisively into recession I have listened as many have used words like, "unprecedented" and "uncharted waters." In fact it is neither. In the last decade investors have been assaulted with pronouncements of how this time it is different and how productivity and technology and countless other items have made history irrelevant. Now that the same people are trotting out the other side of the proverbial cliche' coinage it is time to consider the sources.

We have all from time to time been beguiled by a story which keeps making our own seem out of sync. We only have so much intestinal fortitude when our own theses are being assaulted by daily contradiction.

It is important at a time like this to consider what equity prices are. With so many publications and programs creating a roll the dice mentality, it is easy to forget, or even never consider, what the price of a share represents. It is the claim on a very long term cash flow of the underlying entity. Implicit is the riskless alternative investment, U.S. Government bonds, the expectation of inflation and the risk premium of the equity investment.

Each of these is of course too dynamic to pluck from the headlines as the basis of a long term investment strategy. For a long term strategy long term perspective is needed.

As emotion as well as a dismal reality take hold, it is worth stepping back to the true concept of equity ownership. There is a series of issues worth considering:

1. Equity ownership is the acceptance of risk for the prospect of greater return than in a risk free investment. Currently that risk is the lowest in decades.

2. In the present environment to consider any specific company secure from the real pressures of economic realities is a greater leap of faith than we have seen in many years. General Motors and Merrill Lynch have given a serious dose of harsh reality that is possible.

3. The capitalistic model of commerce and economic growth will endure as it has since the first souk where mercenaries traded plundered wealth for camels.

4. The first order importance is return *of* capital rather than return *on* capital.

5. We should normalize earnings to smooth out the noise of quarterly earning of the market since the focus on momentary earnings will provide a target moving too quickly to be useful. Since market earnings must track closely GDP I use GDP for historical perspective.

1790 to 2007 GDP growth was 5.30 annualized

1885 to 2007 GDP growth 5.98% Dow Industrial Average 5.01%

1932 to 2007 GDP growth 7.55% DJIA 7.38%

1949 to 2007 GDP growth 7.04 DJIA 7.69%

1991 to 2007 GDP growth 5.75 DJIA 9.85%

2003 to 2008 est GDP growth 5.11% DJIA -9.63%

As one can see GDP growth is a relatively steady event. Market performance over time tracks slightly above or below economy performance. In the multibubble era since the early 1990's the stock market delinked from the economy; a logical impossibility in the long run. Now again it has delinked although this time with the market lagging as it has quickly unwound decade long excess.

The credit bubble which began decades ago will not be dismissed easily or quickly. Having said that, the fall in the equity market in the past year have brought the valuation based on normal growth of the economy over the long term more reasonable than seen in many years.

The market action is terrible. Calling the bottom of the market is impossible. However buying a call on the future earnings of the economy at a low price makes far more sense than paying an excessively high price. We will be legging clients back in slowly over the next months and year.

John Barnyak