What to do in a Falling Market

All the pundits are lining up this week with advice for investors in a falling market. Many suggested shorting financial stocks or hoarding cash until the "right time." For long-term investors, all this chatter matters little. It's hubris if not outright folly to think anyone knows the right time. If there is someone out there that can predict market moves with any degree of accuracy, I guarantee you that they are not sharing it with the masses. They are quietly making millions of dollars.

Whether you are making your own decisions or using an investment professional, your portfolio should contain investments that reflect your financial goals and tolerance for risk. If the market drop made you want to sell, you were not honest about your appetite for risk in the first place. If this is the case, it's time to rethink the stock-bond balance in your portfolio.

Dow 18000?

Ken Fisher, Forbes columnist and founder of a $39 billion fund, thinks the market is undervalued by 40%. "The earnings yield (the inverse of the P/E rati0) for the S&P 500 is 6.7%. Companies can borrow at 3.8% after tax and buy back shares yielding 6.7%. At nearly 3%, this spread is historically huge."

This is the driver of all the share buybacks and private equity activity we've been seeing recently. As long as this spread persists, leverage will be the weapon of choice. Read the whole thing.

http://members.forbes.com/forbes/2007/0521/035.html

Oil and the Dollar

Gas prices are once again north of $3, and politicians have wasted no time addressing the issue. Some blame "big oil" for price gouging. Others say it's the increased demand of the summer of driving season coupled with lower refining capacity. Still others point to a terrorism/war premium. Unfortunately, none of these politicians seem to understand enough about the oil market to identify one of the primary causes of oil's upward trajectory. Namely, the falling dollar.

The three current oil markers are all US dollar denominated: North America's West Texas Intermediate crude (WTI), North Sea Brent Crude, and the UAE Dubai Crude. The two major oil bourses are the New York Mercantile Exchange (NYMEX) in New York City and the International Petroleum Exchange (IPE) in London. As the value of the dollar falls, it makes perfect economic sense for OPEC producing nations to raise the dollar price of oil to make up for monies lost when dollars are converted back to local currency. Politicians can continue to blame all sorts of mysterious and unquantifiable sources for high gas prices. In reality, the weak dollar policies of the US Government- namely huge trade and budget deficits - are a primary and often overlooked cause of the problem.

The Price Earnings Ratio

The price to earnings ratio on the S&P 500 is currently sitting at about 16, roughly equal to its long-term average. This means that investors are paying $16 dollars for every $1 of profits earned by companies in the index. To put this in perspective, the P/E ratio prior to the 1929 stock market crash was about 28. Prior to the dot-com crash in 2000, the S&P traded at an all-time high P/E of 42.

This doesn't mean the market can't go down. It simply means that by historical standards, the market is not the house of cards that some analysts would have you believe. Earnings would have to remain flat while stock prices dropped 40% before we see, for example, a P/E of 10. This type of market valuation hasn't been seen since inflationary pressures clobbered the economy in the 1970's (before being reigned in by Fed Chairman Paul Volcker in the early 1980's). Unless we see the return of the Misery Index (Unemployment + Inflation) on the front pages of the Wall Street Journal, I don't see a P/E of 10 arriving anytime soon.

Long-Term Market Perspective

Tuesday's 3.86% decline in the S&P 500 left pundits from all corners listing the reasons for the sharp decline. The primary explanations:

• Alan Greenspan uttered the word "recession." Never mind the fact he said he didn't actually expect a recession. He simply declined to rule one out. Has there ever been a time in the history of US economy where a recession in the upcoming year could be "ruled out?"
  
• The sub-prime mortgage market meltdown is about to spill over into the broader economy.
  
• Corporate earnings are moderating. Solid explanation, but didn't investors know this already?
  
• We are simply "due" for a correction. Why? Well, according to many analysts the bull market has simply gone on too long by historical standards.
  

Nobody really knows where this market is headed with any degree of certainty. As my grandfather used to say, "a broken watch is correct twice per day." As a long-term investor, you simply need to ride out the volatility. You can't avoid the down days, and you can't afford to miss the up days. The 3 best days in the market over the past 5 years provided 75% of annual returns.

What Social Security Problem?

George Gilder, senior fellow at the Discovery Insitute, makes the case for an open U.S. economy in Tuesday's Wall Street Journal. A few excerpts:

The key is keeping the economy open to oustide investors as our population ages and as the productive center of the global economy shifts to Asia. Social Security can become a crisis only if we try to stop this process by raising taxes and regulations, debauching the dollar and enacting gimrack spending cuts that focus on defense.

His prescription: Lowering taxes on paryolls and incomes and pursuing the opportunities of global economic growth. Although it's politically expedient to enact policies designed to "protect the American worker," I have to agree with Mr. Gilder. There's no turning back the complex machine that is the global economy. Any efforts to the contrary will only stifle growth and excacerbate any future Social Security shortfall.