Market Fluctuations

The financial news is filled with panicked advice. Reporters were warning that you should be checking all of your investment balances. One anchor exclaimed, “If you have any money in the market, you lost a bunch of it this week!”

As you know, I do not take investment advice from TV commentators. I distrust the headlines. In fact, I usually tell my clients to disregard the market hype generated by the talking heads. They are just trying to grab something interesting to say and tomorrow their logic will be just the opposite. But after a week like this past one, it can be hard to ignore the headlines and sound bites. It is hard to avoid a knee jerk reaction.

With this in mind, I’m sending this quick letter to remind you of a few of our key responsibilities as your financial advisor:

1. I take the volatility of the stock market very seriously, but I don't allow emotions to dictate our strategies. This is just as true when the market is flying high as it is when we see sudden sell-offs. In a year like this, when we have seen record highs as well as major drops, discipline is critical.
2. Personal investment goals do not usually change with the whims of the market. I have established a logical plan that is designed to help you achieve your dreams. Your long-term plan takes into account short-term uncertainty.
3. It is your money. We don't treat our clients' portfolios like they are stock market statistics. Numbers are easy to talk about; your investments have a specific purpose. You worked hard to accumulate them. They deserve our careful attention.
4. Lousy markets can affect the way you feel about risk. In our individual client review meetings, we regularly discuss risk. I try to understand how much volatility you can tolerate. After all, no investment strategy is worthwhile if you cannot sleep at night. We also know that in times like these, your comfort level can change.
5. There is nothing wrong with a little hand-holding. When the financial news seems gloomy, our clients sometimes need a little reassurance. That's why we will be calling you from time to time. As your financial advisor, I know you may have specific questions about your investments. If you need to talk sooner, please call me.

Overall the market is acting within the boundaries I anticipated. Here are a few comments I made in my past two quarterly reports.

“After the crash of 2000 to 2002 I promised myself I would let people know my inside thoughts on the market and not be brashly optimistic at all times. I believed last quarter and still believe now that we will end the year with an overall positive return, but volatility could give us a ride in the short run.” “The bottom line - The market has been on a great run since 2003 but the day is coming where it will stumble.”

“Overall, I believe the stock market is fine but I have been noticing some deterioration in key variables that I monitor now that we are entering the traditionally slower summer months. We could actually see the stock market pull back 10 to 15% in the near term. This does not mean we will finish the year down but I have some concerns as we roll into the summer period.”

I have actually been holding my breath waiting for a toppling event. In reality it is very difficult to time the market on a short term basis. I normally say that playing the market for the short term is a foolish game. A few of my clients pulled a portion of their portfolios out of stocks in late May and early June. My wife’s IRA represents around 25% of our total portfolio and I pulled this out of the market as well. Then the market continued to go up. This was looking like a wrong move until this past week.

Here is my current position:

1. There are valid concerns about a credit crunch. Sub prime mortgages and corporate borrowing will tighten causing a slowing of economic activity.
2. Real GDP remains solid - 3.4% last quarter and is projected at 2.5% or above for the rest of this year.
3. Corporate earnings growth has been above expectations at 8%.
4. Inflation data has been mixed. Core inflation trends are moderate and declining. Energy and food prices are adding upward pressure.
5. The price of high quality bonds have risen dramatically. There has been a flight to quality and any bonds other than the highest quality have fallen in price.
6. Valuations of corporate stocks are reasonable and are priced at 16.3 times the profit being generated.
7. Valuation Model. There is a theory that the 10 year bond yield should approximately equal the forward corporate earnings as a percentage of the average stock price. This is not a good basis for valuing stocks on a short term basis and is only a rough guide. The expected operating earnings yield for the next year is 6.2% and the 10 year note is around 4.75%. This simple model suggests that stocks are undervalued by approximately 20%. I wouldn't use this model for my investment decision by itself but it does suggest that stocks are at least not overvalued.
8. The market has pulled back around 5% and could drop some more but even 10% to 15% corrections are a normal gyration of the market. In the long run (of at least 10 years) the stock market always makes more money than secure investments like CDs and bonds.

The market tends to get on a momentum course either positive or negative. True value is somewhere plus or minus 10% from where we are now but emotions will drive the market price above and below this level. I personally believe the market had pushed itself above its true value and we are now pulling back to a normal valuation level. It might even drive below a reasonable value for a while.

Based on the indicators I have been watching, my current market viewpoint is neutral. Neither aggressive nor fearful. Current investors should hold their course and new money should be placed into the market cautiously.

I hope you are enjoying your summer. Try to ignore the headlines and sound bites. Rest assured that I am working hard on your behalf.

Sincerely,

Ron Dickinson, CPA, CFP MPA-tax