Looking Beyond Recent Declines

Looking Beyond Recent Declines
April 4, 2009 phillip_toews_1p9l0e9h

Last November when the market declined sharply, a number of managers declared that the stock market had hit the bottom. Despite those declarations, stock market indices continued their descent to new lows in the first quarter of this year. From its peak in October of 2007 to its low in March of this year, the S&P 500 index fell over 54%. That makes it the second biggest drop in the past century. In the context of this decline, we ask two important questions. First, “are we at the bottom?” Second (and more relevant), “how has the market reacted in the past following similar declines?”

Answering “are we at the bottom” is extremely difficult. We estimate that stocks are currently priced at or below their fair market values, which would indicate that stocks should move higher. However, in previous bear markets stocks fell well below their fair market values. While we can’t say that we’ve reached a bottom, it is fair to say that for long-term investors now is a good time to be invested in stocks due to their relative “bargain prices.”

It may be more important to focus on the second question: What happened in the aftermath of these declines? To answer this question, we tallied all declines greater than 30% since 1928*. How did the market react?

We found 7 prior instances of 30% or greater declines in the Dow since 1928. Unsurprisingly, once the stock market did reach a bottom, the gains were decisive and significant. On average, the Dow rebounded 90.7% before peaking, with the average duration of those bull markets lasting just over 2 years (See table below).

* Based on the Dow Jones Industrial Average excluding dividends. Past performance is no indication of future results.

Market historians understand that the best time to invest in the stock market is just after a significant decline. Yet, after steep declines investors have a strong urge to leave the stock market. Why? This tendency is what behavioral economists call the law of small numbers. The law of small numbers refers to an inclination for investors to draw conclusions based on small amounts of data and then erroneously extrapolate those conclusions to assume that they always occur, or over very long periods of time. After big declines, investors conclude that “the stock market generally, or always, moves rapidly lower.” As a result, investors leave the stock market. Although few in number, we have had several investors call our offices to request that their portfolios be moved out of stocks and held in a cash position.

The clearest result of declining markets can be seen in the value of investors’ portfolios. However, one way to help avoid selling at what may the one of the best stock market opportunities in generations is to focus on the price of stocks. Stocks have a price just like any other good or service. There is a powerful inverse relationship between prices of other goods and services and their sales. As the price falls people have a greater desire to buy. The more the price falls, the higher the sales. At extreme low prices sales surge.

While the stock market has nuances that differentiate it from other goods and services, the way we view prices of stocks should be the same. The history of stock market moves validates this perspective. In the past when stocks have been on “sale” (just experienced drops of 30% or more), the rebounds were impressive. Of the 7 stock market rebounds since 1928, the smallest rebound was 59%, the largest was 128%, and the average move higher was 90% as stated earlier. Another way to think about this is that there have only been 7 times in the past 80 years when stocks have been “on sale” at these levels.

When viewed in this context, the answer to the first question, “are we at the bottom”, becomes less relevant. Should stocks move lower, stock prices will improve even more creating an incentive to buy not to sell.

Prior performance is no guarantee of future results and there can be no assurance, and individuals should not assume, that future performance of any of the portfolios referenced will be comparable to past performance.

There can be no assurance that Toews will achieve its performance objectives.

This document refers to the performance of the majority of Toews portfolios to illustrate the effect of Toews management on US and intl. stocks and high yield bonds. Performance of individual accounts varied based on the client’s investment risk profile and their specific investment funds. For your individual account performance, please refer to the enclosed quarterly statement or the quarterly statement recently sent you. In addition, not all model portfolios were referenced in this letter. It is not, nor is it intended to be, a comprehensive accounting of Toews asset management. There are other portfolios that Toews manages that performed differently than what is referenced in this letter.

This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”

This article is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice. Please contact your investment adviser, accountant, and/or attorney for advice appropriate to your specific situation.