Long Term Investing?

by Larry Levin

Today I want to share portions of a newsletter from John Mauldin that was titled: Buy and Hope Investing. You know I believe Buy and Hope is dead, so I was surprised to see this title and what was written below it. And although we may see a substantial rally soon (after this current sell-off?), the ideas I have shared with you, as well as Mr. Mauldin's, still hold true.

Quick review: It is my contention that the initial valuation of the stock market when you invest plays an enormous part in your subsequent long-term returns. This is clearly borne out by the data. Let me reproduce one table below. This is a critical point. It clearly demonstrates that the lower the valuation of the S&P Index in terms of the price to earnings ratio (P/E), the greater your subsequent 20-year returns.

I think most people think 20 years should be considered long-term. Looking at the S&P 500 over the past 109 years, you can find many 20-year periods where returns were less than 2-3%. And if you take into account inflation, you can find many 20- and 30-year periods where returns were negative!

So, knowing where we are in terms of P/E ratios today is very important, as it gives us a small clue as to what our prospects for returns are in the next few decades.

My good friend Peter Bernstein (who at 89 is still one of the most insightful and important analysts in the world) wrote a very insightful essay in the Financial Times called "The Flight of the Long Run." Let me quote a few selected paragraphs:

"The cold statistics have hardly been encouraging for the traditional [buy and hold] view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts.

"These data are not to be taken lightly. If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent a year.

"But does this history really tell us anything about what lies ahead? Neither the awesome historical track record of equities nor the theoretical case is a promise of a realized equity risk premium. John Maynard Keynes, in an immortal observation about the future, expressed the matter in simple but obvious terms: "We simply do not know."

"Relying on the long run for investment decisions is essentially relying on trend lines. But how certain can we be that trends are destiny? Trends bend. Trends break. Today, in fact, we have no idea where any trend lines might begin or end, or even whether any trend lines still exist. (Emphasis mine)

Gentle Reader, pay special attention to this next paragraph: "... There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realized."

For those of you who invested in 1997, with expectations of 15% forever, you can sadly confirm that last sentence.

We are in an economic period unlike any other we have faced. I think we are likely to have a long, slow recovery after the recession ends some time (hopefully early) next year. However, to suggest that corporate earnings are going to show the same type of resilience in 2010-2012 that they have after every other recession since WWII is ignoring the macroeconomic picture surrounding the potential for earnings growth. "Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical."

We are in a synchronized global recession. Yes, we will recover, but the causes are not those of the typical business-cycle recession. We are seeing massive debt deflation, deleveraging on a scale never witnessed, a financial industry that has to be rebuilt, and a housing industry that is reeling all over the world. We created a lot of excess in a number of industries. We decimated the savings of a generation that was hoping to retire soon, and now will have to work longer and save more.

This is not a typical recession. And for any analyst, writer, or pundit to trot out past historical data to demonstrate that the stock market is going to rebound at such and such a time and at such and such a pace simply ignores the fact that the future is unlikely to look like the past for at least the next 2-3 years. We are in a brand-new world, macro-economically speaking.

In short, whenever a low is finally put in place, it will almost assuredly take many years of consolidation (no up trend) to work through the current and future problems.

There will be tradable bullish rallies, especially in individual stocks, but as I said yesterday: don't let that fool you into believing a mega-bull has been reborn.


Previous Day's Trading Room Results:

Trade Date: 3/3/09

E-Mini S&P Trades*
(before fees and commissions):

1) OTF sell @ 11:00am at 696.75 = +.75 & -1.75 (2-lot)

2) OTF buy @ 12:00pm at 696.50 = +.75 & -1.75 (2-lot)

3) OTF buy @ 2:00pm at 703.00 = b/e (1-lot)

4) VA buy @ 2:15pm at 701.00 = +1.25 (1-lot)

5) Algorithm positions (8)...combined SofT and Algo total...+2.75


Electronic (YM) Mini-Dow:


1) No trades today



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