While acknowledging that events in the future, including the eventual path of the stock market, remain subject to unknown happenstance, I feel more confident than usual that the prospects for stocks remain good.
Predicting in advance the results of an upcoming sports match-up may be a good analogy to anticipating a positive or negative outcome in the stock market: While which side will win can never be known for sure ahead of an actual match, available past performance data as well as knowledge of the current backdrop can certainly give good reason to believe that one competitor will likely prevail over the other. While such data can result in setting odds in a particular direction, events in real-time or unanticipated surprises, can crop up to alter expected outcomes.
If I were to base my predictions primarily on the stream of facts as well as commentary regularly reported in the financial world, such as high unemployment, excessive debt, political and global uncertainties, and well, you name it, it would clearly lead me to have a far more pessimistic view of what appears to lie ahead for stocks. Red warning flags would most likely predominate, although some might, at best, be yellow. Green or go-ahead flags, I'm afraid, would not likely be part of the picture at all.
So why do I think the prospects for stock investors seem much more positive than one might otherwise conclude?
The overall market and most categories of stock funds are still in an uninterrupted long-standing bull market.
Two months ago in our Sept. Newsletter, we wrote how the stock market as a whole was in danger of entering a sustained 6 mo. period of negative returns. We pointed out whenever the stock market remains down over an entire 6 mo. period, there is a danger of a downtrend stretching out on average over another 6 mos., or perhaps for another full year or more.
Since the end of Aug., the unlikely has happened: Stocks have nearly erased their 6 mo. losses. Specifically, the S&P 500 Index, having gone down 17% between Apr. 26, 2010 and July 1st, has now come back exactly 17% and even a little more if you take into account its dividend payments.
However, when viewed on a longer-term basis, it can be clearly seen that stocks have been continuing to rise off of the even more significant March 6, 2009 lows in a truly herculean manner, a period now stretching over nearly the last 20 mos. The rise from the lowest point of 2009 back to where it is now at the end of this Oct. has been an astounding 77.5%, not including dividends.
In fact, the same can be said for all 9 of the "Morningstar grid" categories which range from Large Growth through Small Value, as well as the International Large Blend category, only in many cases, the gains have actually exceeded 100%!
In the event you may not be aware of the extent of this bull market for fund investors, you need only to examine how much prices (NAVs) have risen since the Mar. '09 lows:
Net Asset Values (NAV) for 10 Vanguard Index Funds
Representing the Major Fund Categories
Since Their Mar. 2009 Lows
Mar. 2009 Oct. 29, '10 Large Growth
16.73 29.74 Large Blend
12.47 21.85 Large Value
11.20 19.50 Mid-Cap Growth
11.02 22.22 Mid-Cap Blend
9.03 18.80 Mid-Cap Value
9.18 19.72 Small-Cap Growth
8.89 19.63 Small-Cap Blend
14.26 31.62 Small-Cap Value
6.66 14.81 International
Note: Prices for fund categories funds are shown by Vanguard index funds.
The percent gains one could calculate do not include the effect of distributions which would add a small additional gain to the result.
Thus, in spite of the observably high level of apprehension about the economy and stocks among the public, the media, and even seasoned investors, you could easily miss the fact that we continue to be riding an extremely powerful upturn in the markets.
Normally, given such huge gains in fund prices, one should rightly be extremely cautious in plowing any new money into stock funds. In fact, in our Feb. Newsletter, we pointed out that selling some of your position in stocks after each 25% gain in price would have helped investors beat the S&P 500 Index over the 2000-2009 decade. Also on a cautionary note, it now appears that the Index's rise of over 77% happened in a significantly shorter time than most other similarly sized (or even eventually very long) bull markets. For example, after the stock market crashed in '87, it also proceeded to gain a similar amount (about 80%), but the time entailed to do this was over the next 32 mos. vs. occurring in only 20 mos. this time. Thus, given the speed of the current gain, it well could prove to be a case of "too much, too soon."
However, when accompanied by the data below, we feel further justification for our view that more gains continue to be likely.
Each of the measures we have designed as indicators to either BUY, SELL, or HOLD show that while a period of extreme undervaluation (i.e. BUY) has already passed, except perhaps for specialized real estate funds, nearly all fund categories remain in the range which we consider reasonable valuation, or HOLDs.
As presented in our earlier Newsletters, categories that we call HOLDs are nearly as likely to do well as those that are BUYS. Reassuringly, no categories are currently regarded as SELLs, save for stock funds that are invested solely, or nearly so, in China or Latin America. (Note that our signals are designed for relatively long-term investors which means that while these two SELLs, or even our current HOLD designations, might well not prove accurate over the relatively short-term, they, hopefully, will show to have been accurate on a longer-term basis.)
While these action-oriented classifications of stock fund categories may appear to anyone reading this as no more unique than three common brokerage house words, and therefore, just reflecting often flawed, subjective opinion, our BUY, SELL, or HOLD recommendations were developed statistically through an empirical research approach. They were designed to reflect how different categories of stock funds, as well as investors themselves, tend to respond to the prior ups and downs of stock prices under a variety of economic conditions and over the many years we have closely studied such behavior.
When we first presented our research-based categorizations for helping to make investment decisions in Aug. 2008, there was no forward-looking track record on which to judge whether they would be effective. Since our research was empirical in nature, we devised our methodology from an analysis of how fund categories, as well as the overall stock market, had performed going back several decades. However, we were confident from our observations of prior market cycles that the same kinds of data that prevailed previously would continue to be true in the future.
We now have more than two years of evidence suggesting that our BUY, SELL, and HOLD designations are indeed showing strong indications of being able to help anticipate upcoming positive as well as negative performance results within a 6 mo. to two year time period. Hopefully, as we move into the future, the signals will prove accurate for longer periods as well.
So, for example, back in Aug. '08, the signals we provided readers looking ahead were all negative (SELL). Then, as of the end of Jan. '09, all major categories became classified as HOLDs with the exception of Small Growth which we identified as BUY. This turned out to be approximately 5 weeks before the end of the prolonged bear market. And in the early Oct./mid-Nov '09 time frame, all our remaining signals became BUYS. One has only to look at the performance of each of these categories since we made these calls to judge that, thus far, they have proved considerably successful.
Our final reason for being optimistic: The Fed, while its actions in helping keep money market and bond interest rates at extremely low levels may not be perceived as doing much for the average person, has certainly helped to increase the returns for anyone who invests in stocks and most bond funds. We anticipate that their actions will continue to keep doing so for the foreseeable future.
Here's how the Fed's actions have already helped investors, and likely, will continue to do so:
With cash, CDs, and short-term bond yields at next to nothing, many conservative investors are feeling pressured to get into investments that have better yields, and therefore, better potential returns. Thus, intermediate, long, and high yield funds are seeing greater demand, leading to higher prices for existing investors. Some previously reticent investors are even taking the plunge into stocks, ETFs, and stock funds, with the same effect.
It is highly likely that the Fed's past and assumed upcoming purchases of bonds ("quantitative easing") is resulting in a weak US dollar. This is quite advantageous to nearly everyone who invests in international stocks (or bonds) as stronger foreign currencies mean higher NAVs when foreign performances are calculated. Further, a weakened dollar means that US companies that do business abroad profit more and can export their products at a competitive advantage as compared to similar products manufactured in the receiving countries.
By creating higher asset prices, the Fed hopes to re-create "the wealth effect," which means that investors will feel secure enough to start spending more money. And by enabling interest rates to drop even further, they hope to reinvigorate borrowing, especially within the housing market on which a good deal of the economy depends. By getting consumers to spend again, it is assumed that employers will again be willing to take the chance of hiring new workers. And by attempting to actually create more inflation, companies may be able to raise prices (i.e. profits) and people may be more prone to buy things rather than wait if they expect prices to drop further.
Finally, here is something to ponder which we have no way of proving, but which we suspect may be part of the Fed's thinking:
While officials at the Federal Reserve Board, especially Chairman Bernanke, might be regarded as functioning like academics, committed to making accurate and totally objective forecasts, we think it must always be remembered that their primary role is to perform one specific function: to foster the goals of both low unemployment and maintaining relatively low inflation (although not "too low").
Since both these goals are in some doubt right now, this means that the Fed will likely be willing to do whatever is necessary to try to succeed. One way to accomplish this is to attempt, including even by artificial methods if necessary, to instill a greater degree of confidence among consumers so that consumers will hopefully begin getting back to their former ways of spending rather freely.
They may, therefore, be prone to continue to confidently project more future growth than appears to be realistically likely. (Why else would they have forecast, as recently as June, GDP growth of 3.5 to 4.2% in 2011?) Further, their words may be crafted to confidently project that their actions will indeed create more jobs and spending, when this remains a great unknown.
Other experts, including Nobel Prize winning economists, are not at all sure any new Fed actions will have the desired effects. But since so much depends upon consumers getting back into a more positive frame of mind, it is not unreasonable to assume that the Fed is willing to try a little "just trust the experts" approach to create more confidence than otherwise is warranted by using its regular announcements to somewhat falsely project a relatively rosy scenario. At any rate, so long as most people are prone to accept the Fed pronouncements, and if the policy works, the effect should continue to enhance stock market returns.