New Fed Numbers

Last week, the Federal Reserve announced updated figures concerning the direction of the U.S. economy. Alarmingly, Ben Bernanke announced it is "very likely" the unemployment rate will be above 8% soon. Most Fed officials project unemployment to reach 9% by the end of 2009.

The Fed revised previous positions and stated the U.S. economy will contract by .5 - 1.3% in 2009 (the previous estimate was a contraction of .2 - 1.1%). Additionally, the Fed anticipates inflation rates to average between 1.5 - 2% as the economic decline shifts into recovery mode. This has some Fed officials worried about the risk of deflation.

However, Bernanke's speech wasn't all doom and gloom. On the positive side, the Fed stated the U.S. GDP is expected to increase by 2.5 - 3.3% in 2010, and by 3.8 - 5% in 2011. It seems the Federal Reserve sees a U.S. recovery in the cards.

Is Investing Now Like Trying To Catch A Falling Knife?

Due to the treacherous equities markets of the last 16 months, many individuals are afraid to invest new dollars at this point. Most would prefer to wait until the outlook is clear and the crisis is over before diving back into the market.

However, waiting until the outlook is clear is frequently very costly for investors. Reviewing the beginning of 22 bull markets, the Leuthold Group found that bull market gains have been front-end loaded. The average gain was 18.1 percent in the first three months of a bull rally, 26.4 percent in the first six months, and 45.8 percent in the first year.

An investor who waits a year before getting back into the market may miss half the total bull market gain, as the average bull market gain amounts to 83.6 percent.

Almost perversely, it seems the investor who waits for the knife to fall harmlessly to the floor may be hurt the worst.

Keeping the Downturn in Perspective - The Stock Market

I'd like to pass on a "back-of-the-envelope" calculation performed by Mark Coffelt of Empiric Advisors, a fellow NAPFA member:

Ten years ago, the S&P 500 yielded about 1.4 percent. The price-to-earnings ratio was close to 28 times. Earnings over the decades have grown about 6 percent per year. To calculate the expected return 10 years ago, we would take the dividend (1.4 percent) plus the earnings growth (6 percent) plus the change in valuations. Given that stocks historically sell at 18 times earnings on average, a change in valuations from 28x to 18x implied an expected loss over the decade of 36 percent in valuation, or about 3.6 percent loss per year. In total, a reasonable expected return would have been about 3.8 percent per year (1.4 percent yield + 6 percent earnings growth - 3.6 percent valuation change). Since the decade ended with valuations at only 12x earnings, investors didn't even make the low expected 3.8 percent return. Rather, they lost about 1 percent per year.

What about the decade ahead? The dividend yield is currently 3.3 percent. Let's assume the same historical 6 percent earnings growth. With the price-to-earnings at 12x, the market is selling below normal valuations - a 33 percent discount. Using the same process, the decade beginning 2009 should provide reasonably good returns of roughly 14.3 percent per year (3.3 percent yield + 6 percent earnings growth +5 percent in valuation change).

Does 14.3 percent annualized return sound okay with everyone? As always, speak to an independent financial advisor with a fiduciary responsibility to their clients to position your investment portfolio for the future.

Increased Volatility

Unfortunately, most individuals who have assets to invest are hesitant during this market pullback and many individuals who see this market lull as a buying opportunity don't have funds to invest. This is a common scenario during periods of increased market volatility, and often stretches out the duration of stagnant equity markets.

How volatile is this investment environment? As measured by the S&P 500, the market moved more than 3 percent in either direction during a single day only once between 2004 and 2007. By comparison, the market moved at least 3 percent in one day 40 times in 2008, and most were near the end of the year. Further, moves of 2% to 3% occurred 28 times in 2008.

For those who see no end in sight for this volatile market, remember: we have been here before! Between 2001 and 2003, the market moved between 2% and 3% an average of 20 times per year, and that was over a three year period. We then moved on to enjoy a relatively stable period between 2004 and 2007. Thus, history indicates that the increased volatility we are seeing in the market is not the "new norm" and we should expect volatility to subside at some point, creating a more reasonable investment environment for all.