What Should Investors Do Now?

After bone-jarring drops in the equity markets, investors naturally ask if there should be any modifications to an approach of “be patient and don’t get scared out of stocks.” While recent investment losses have indeed been very painful, we firmly believe that a consistent and methodical basis for making decisions is paramount at times like these.

We recommend that investors:

  1. Maintain their portfolios’ broad diversification.

  2. Reject the false allure of market timing.

  3. Look for opportunities to take some investment losses to offset future taxes (if applicable).

  4. Rebalance their portfolios to reduce those assets that have performed relatively well and purchase those beaten down in price. This approach forces something that most investors lack the discipline to do: buy low and sell high.

Examining the decisions of successful, long-term investors can help to shore up investors’ resolve. So what has famed investor Warren Buffet been doing recently? On September 18, Buffett's MidAmerican Energy Co. bought Constellation Energy Group for $4.7 billion in cash, a discount of nearly 60% from levels at which the power firm's shares were trading two days prior to the deal. On September 24, he invested at least $5 billion in the investment firm Goldman Sachs. Finally, late last week, a Berkshire Hathaway Inc. subsidiary announced that it had acquired a 10% stake in a Chinese producer of rechargeable batteries, electric cars and car parts. These large financial commitments echo Buffett’s famous quote: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

The following three illustrations reiterate our perspective that investors should not abandon their discipline:

Historical Lesson #1:  Fidelity Investments recently released a report on investors’ failed attempts to try to time the U.S. equity market. In October 2002, following a devastating 50% decline in stocks over the prior two and a half years, investors’ holdings in conservative money market funds reached a near-all-time high of almost 35% of mutual fund assets. Although a new bull market began that October, investors kept an above-average level of cash until February 2004, when stocks were 30% higher. As a result, investors who kept their long-term assets tied up in cash missed out on considerable gains. 

Historical Lesson #2:  According to the University of Michigan, consumer sentiment hit a 28-year low in June 2008. The last time that sentiment was so low was in 1980, when inflation was 14.4%. While inflation has been 5.4% over the last 12 months, it should come down rapidly as energy and commodity prices have collapsed. In addition, unemployment was at 7.7% in 1980, versus 6.1% today. Interestingly, stocks thrive following these pessimistic scenarios. Since 1975, the S&P 500 returned an average of nearly 23% over the 12 months following troughs in consumer sentiment. While sentiment could get worse, it has already improved since its low last June.

Historical Lesson #3:  JP Morgan conducted a study of stock market performance in periods of rising unemployment. Since World War II, there have been 19 instances where the unemployment rate jumped a full half-percent or more from one month to the next. The most recent jump was from 5% to 5.5% earlier this summer. Remarkably, the average return in stocks in the subsequent 12-month periods was +28.2%. The smallest 12-month return after such a jump in unemployment was +17.6% in 1960. While the current economic environment may be different, negative news about sharply rising unemployment has been an indication that it is a better time to purchase, versus sell, equities.

The financial markets may continue to experience extreme volatility until the economy and credit markets begin to stabilize and improve. In all circumstances, we believe that the most successful long-term investors are those who remain disciplined and rebalance their portfolios to improve their long-term returns. In the words of Warren Buffett: “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

Scott Middleton, CFA

Senior Consultant

September 30, 2008