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Mid Year Market Commentary June 25, 2010

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Navigating the "calamity decade" & perspectives from the father of value investing

After 2008's sharp decline and last year's recovery in stock markets, many had hoped that 2010 would see a return to relative normalcy and stability.

And certainly, the year started on a positive note, as stocks turned in one of the strongest first quarter increases on record.

Then, in rapid succession came:

• The intensification of the budget crisis in Greece in February, with the risk of contagion across Europe
   
• Concerns that European budget cuts would slow down economies, with spill-over effects globally; this is especially problematic in light of the need to compete with a devalued Euro
   
• Growing fears about a housing bubble in China
   
• The April 22 sinking of a BP oil drilling rig that had exploded and caught on fire in the Gulf of Mexico
   
• The May 6 "flash crash" in which U.S. markets plummeted in a matter of minutes without explanation
   

Looking at these events, it's tempting to ask what the next catastrophe will be. In fact, based on these last six months, historians may view this as "the calamity decade," even though we're only 5% into it.

In talking to clients about how portfolios should be positioned in light of this, I like to point to the principles of Benjamin Graham, who is considered the father of value investing.

Starting in 1926, Graham taught at Columbia University and wrote on investments for 30 years, bringing a new level of rigor to security analysis. His views and approach shaped a generation of money managers, among them Warren Buffett; he enrolled at Columbia with the explicit goal of studying under Graham and joined his firm after graduation. In fact, Buffett describes Graham's book, The Intelligent Investor, as the best book on investing ever written.

Recently, financial journalist Jason Zweig unearthed a 1963 talk by Graham, which he posted on his website. Titled " Securities in an Insecure World," Graham's talk reminds us of guiding principles that investors always need to bear in mind.

In chaotic times like those of late, I particularly focus on three of Graham's principles.

Principle 1: Invest in stocks and bonds only so far as you can live with fluctuations in prices.

The first principle is based on the idea that investors have to understand their own ability to live with volatility.

This is something that investors were reminded of in 2008-many investors discovered what their true risk tolerance was in that market.

In the concluding remarks to his 1963 talk, Graham mentioned an old Wall Street adage that whenever clients asked an advisor to recommend stocks to buy, he'd answer by saying: "Do you want to eat well or sleep well? That will determine what I recommend."

Graham went on to say that he believed that by following sound policies, almost any investor should be able to eat well without losing any sleep-even in the insecure world of 1963, shortly after the Cuban Missile Crisis.

I share Benjamin Graham's view on the need to both eat well and sleep well. My goal with every client is to tailor a portfolio that achieves these dual and sometimes contradictory objectives. To help retired clients maintain peace of mind during periods of volatility, I normally recommend that three years of cash needs from savings be kept in liquid, safe investments.

Principle 2: The price you pay when you buy stocks is key.

There are many factors that determine how investments perform over time, but few are more important than paying a reasonable price when you buy. After all, people who bought companies like Cisco, Intel, and Microsoft 10 years ago have lost half their money-not because these aren't exceptional companies, but because the price they paid was too high.

In his talk, Benjamin Graham said that investors should always have an allocation to stocks, bonds, and cash. The minimum level for stocks should be 25% and the maximum 75%. The amount should be determined by each individual investor's time horizon, income needs, liquidity needs and risk tolerance. In general, as one gets older, the portion of the portfolio that is invested in fixed-income securities should increase.

In his speech, Benjamin Graham outlined a methodology for valuing markets that would suggest that fair value for stocks today, given current low interest rates and depending on your assumptions, could be as high as 23 times average earnings over the past ten years.

By contrast, the most current data based on the last 10 years of earnings for U.S. stocks, adjusted for inflation, from Yale economist Robert Shiller puts this multiple at 20 times. This would suggest that the market is fairly valued, and if we see a continuation in profit increases as the economic recovery continues, today's prices may end up being viewed as quite inexpensive.

Principle 3: Long-term goals demand long-term thinking.

Benjamin Graham's student Warren Buffett has said that it only takes two things to make money-having a sound plan and sticking to it-and that of those two, it's the sticking to it part that most investors struggle with.

Markets like we've seen of late create understandable stress and can lead to short-term decisions. This New York Times article from May talks about the cost to investors of acting impulsively:

Read The New York Times: Resisting the Urge to Sell Low

At the risk of repeating a timeworn cliché, our experience bears out the view espoused by Graham and Buffett that the only way to invest successfully over time is to maintain discipline and a long-term focus-to have a plan, ensure it is the right plan, and then to stick to it.

Since 1926, U.S. stocks have had average annual gains of over 9% before inflation and more than 6% after inflation.

Hard as it can be at times—and at the occasional loss of a client who disagrees-I've found the only approach to investing that works over time is to keep that long-term view, modifying portfolios as circumstances warrant but never losing sight of the fact that long-term goals demand long-term thinking.

In closing, let me reiterate my appreciation for the continuing opportunity to work together. As always, I welcome your calls and questions and would be happy to talk at any time.

Sincerely,

Kim Mailey
Director, Wealth Management
Senior Wealth Advisor
The Mailey Rogers Group
Personal Wealth Management
ScotiaMcLeod

P.S. If you're interested, you can read Benjamin Graham's 1963 talk, Securities in an Insecure World