Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 4)

• IRON100
• July 25th, 2010

 After getting a couple of questions via e-mail, I have decided to quickly in this post discuss one more dour piece of "long-term" investment news for those with the "buy-and-hold" strategy. I do not do this just to frustrate optimists, but simply to set up the discussion of how to invest in various segments of market cycles. This kind of analysis is always helpful in navigating the often tortuous environment of equities. I find this very apropos this morning, as I just watched David Gregory quiz Treasury Secretary Timothy Geithner about the possible future "less than adequate" investment returns to be offered by stocks. (I know I should not throw my opinion in here, but please do not think that Timothy Geithner, David Gregory, or ME for that matter, are genuine experts in investing. What you should do is gather evidence, as I do, and do your own planning based on YOUR own risk tolerance. It is the only way that you can truly become your own financial planner, which I believe everyone should be.) 

1) Once more for the record (from the research provided on page 80 of Unexpected Returns: Understanding Secular Stock Market Cycles, by Ed Easterling, Printed in 2005), no secular bull market in the last 110 years has ever begun without price earnings ratios in the mid to upper single digits.  I need to dig out some other historical references from my library, but existing data from prior to 1900 adds another decade to that list, making it nearly 200 years. 2) As discussed in this article "The Truth About P/E s" which is written by Mr. Easterling's organization ,Crestmont Holdings, LLC, the net returns in markets over a coming decade will largely be determined from how far P/E (price earnings ratios) are from their average (for the data shown here, roughly 16.0). When that distance is great above that average, returns tend to be subpar (as can be shown by the scatter plot in that article), when the distance is great below that average, the returns tend to be superior (which would tend to favor a buy and hold strategy). What typically drives that ratio is the rate of inflation. If inflation declines from a very high point (from the Consumer Product Index perspective) to a low value (as we did for nearly all of the early 1980s) U.S. equity markets tend to rally in secular bull markets. If inflation is low and becomes deflationary, or becomes hyperinflationary (as it did during the 1970s) returns are sideways or negative, making it difficult to invest in equities. The swings in equity prices are also quite dramatic and volatility is high during these periods. A document with this data is included here. So where do we stand today with this type of analysis. Well, those of you with apocalyptic visions of disaster may be disappointed with the fact that we are right in the middle of the range as shown here. But note that as we are supposedly slightly undervalued relative to the model which I discussed from Mr. Easterling's research, one should note his own advisory information. We are slightly undervalued as long as we are not undergoing a hyperinflationary or deflationary period of economic activity. There, ladies and gentlemen, is where the real rub is right now for anyone attempting to buy and hold this market, or reposition a portfolio deftly though a secular bear market, which is often filled with upswings and downswings ( that is, crazy volatility).

We have a politically motivated Congress and Federal Reserve which is, despite the trillions in bailouts and stimulus, continuing to keep money cheap and interest rates low. These entities are still spending rather freely and printing money despite the harrowing complications associated with the destruction of the U.S. dollar via inflation. Because joblessness has not allowed money to flow freely into the economy as it did during the 1980s and 1990s (and even the first half of this decade), inflation has not raised its head.  Yet, because entitlement spending remains an issue and any economic uptick would force that money to chase prices and wages, the trigger point is quite hairpin going forward. High inflation could cut that 16 P/E back to 8, and (by simple math), the $SPX from 1100 to 550. Remember (as we discussed last week), even earnings numbers do not really impact aggregate P/E. And if one doesn't think that the $SPX could not be cut in half, just go look at the period from 1972 to 1974. It was really ugly then (and I was there to watch it). A major correction, should inflation hit, is likely going to be brutal. So what does one do to mitigate that risk? 

Stay tuned next week as I discuss strategies that can work and also demonstrate some strategies that worked for me in those eras (taught to me by the folks who wrote about them). There are times when buying and hanging on work like magic, and times when those kinds of strategy returns are tragic (sorry for the poetry).  I will investigate them as we try to figure out how to stay properly invested based on the economic cycles of the day. Thanks again for supporting DieBrokeBlog! We really appreciate it. If you have questions, send them to buffalotrader100@gmail.com

Tickers: buy and hold, deflation, earnings prospects, future price appreciation, inflation, price earnings ratios, price earnings ratios compared to historical averages

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