Steve Butler Speaks Out- A Return to Investment Fundamentals

by Stephen Butler

It's always disappointing to lose money in the stock market --- especially when we were doing so well there for a while. However, it's the fear of the unknown that can cloud our judgment and compound our problems. At times like this, it helps to review some investment basics.

Fundamental #1 --- A Company and its stock are Two Different Animals

First, there are economic conditions that prompt a total disconnect between stocks and the underlying companies they represent. The value of anything is based upon what a willing buyer will pay a willing seller. A large company can be making a product, employing people, selling their product, and making a profit. It may also own outright a lot of capital assets and real estate. Taken as a whole, this company may be worth a lot of money and a willing buyer might pay a substantial sum for the entire operation.

Now, let's look at the shares of that same company that are for sale on the stock market. The supply and demand for those shares can be buffeted for reasons having little to do with the company's underlying value. Right now, hedge funds and mutual funds are forced to sell their shares in stocks to generate cash for clients who want to cash out. Buyers are reluctant to buy because they are waiting to see how low those shares will drop. This heavy supply of shares for sale weighed against little demand for them is causing the share prices to drop. Share prices throughout the entire stock market have dropped to about half what they were a year ago. However, the underlying companies that the shares represent are just as valuable as they ever were. The companies haven't dropped in value by half --- just their stocks.

How can there be such a disconnect? Simple. On a given day, our financial system values all outstanding shares of a public company based on what a small percentage of the total shares happen to sell for from moment to moment on the stock exchange. The term for this practice is "marked to market." It means that all share values are based on whatever the market dictates for those that happen to be bought and sold. On a slow stock market day, if shares happened to sell for a ridiculously low price --- like a ten percent drop from the previous day --- all the shares in the entire company would be valued based upon that selling share price even though the vast majority of shares were never for sale --- they were just held by mutual funds or individual investors. Unfortunately, those of us sitting on shares that are not for sale will see a paper loss triggered by shares that are victims of heavy selling pressures on Wall Street. There are times when selling pressure on stock markets is not a reflection of the profit potential of the actual companies we own, and this happens to be one of those times.

Fundamental #2 --- We Don't need Banks --- Let them Eat Cake

Today, the financial services industry is in a state of disarray, but not all companies in this sector have been mismanaged. Many are in great shape and are falling over each other to make loans and buy weaker banks. Casey B. Mulligan of the University of Chicago writes in the New York Times, "Who needs banks anyway? Their contribution to the economy is overrated." There are always pension funds, college endowments, venture capital firms, private individuals and a variety of other institutions like foreign sovereign wealth funds that supply capital to the economy.

Banks may not trust each other right now, but they certainly want to loan money to companies like IBM whose earnings like those of a majority of companies, have been higher this year than in the same period last year. We are in a financial crisis but not necessarily an economic crisis. Companies across American are making money hand over fist. Farmers (and their suppliers) haven't had it this good in a lifetime. Less than 4 percent of the American work force works in the financial services industry. Their layoffs will hardly dent our relatively low current unemployment rate of 6.1 %. After all, 5% is considered to be normal "full employment."

Fundamental #3 --- Market Rebounds are Sudden, Surprising and Substantial

The market will rebound sooner or later. Since 1970, there have been five major market "breaks" and the average 12-month rate of return following the lowest point was 19.5 percent. Within twelve months of the bottom, over fifty percent of the previous loss has been recovered. Most investors who throw in the towel and bail out after losing, say, fifteen to twenty percent, are traumatized and rarely have the stomach to jump back in at the slightest hint of a turnaround. However, acting on that slightest hint is what earns people most of that 19.5 percent, because the bulk of the gain happens close to the bottom. Selling out locks in losses forever, and human nature stands in the way of ever gaining the money back. That's why a buy and hold "mantra" has served most people so well for so long. Trying to time the market leads to disaster.

Fundamental #4 --- Long Term, We're Not in Bad Shape

"Wagner’s music is not as bad as it sounds," said Mark Twain, and the same could be said about the stock market today. The S&P 500 represents 70% of all available public stock and the share price of a typical 500 Index fund has risen at a rate of 7.3 percent per year from April of '87 through April of '08. During that period, reinvested dividends averaged about 2 percent per year, so the total average annual gain was about 9.3 percent. In a few situations, graphing the return of that investment created a line way above what would have been a straight line illustrating a 9.3 percent return. For four years in a row during the late '90’s, the 500 index gained over twenty percent per year. Again, in September of 2007, after four terrific years, the 500 index reached its all-time high --- again way above the 7.3% line.

It's easy to forget how much of the past twelve-month loss was a result of giving back some of what had been higher than normal gains back in September of 2007. Those historical expectations, however, give us an amazingly resilient track to run on. One big "bump" like the 30 percent rise we saw in just eight months of 2003 is all it will take to be back on track to meet our long-term investment goals based on an assumption of 10% per year. Sooner or later, that "bump" will happen and history will repeat itself.

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