The Globe and Mail, Report on Business
Published August 20, 2011
By Tom Bradley
“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett
“My best trades turned out to be the ones when my hand was shaking as I gave my trader the blue ticket.” – Bob Hager, co-founder of Phillips, Hager & North
In light of the recent weakness and volatility in the stock market, both statements are particularly poignant. It’s easy to agree with the logic and simplicity of Warren Buffett, but not so easy to behave like him. My former partner’s shaking hand reinforces just how hard it is to buy at uncertain times, and how rewarding it can be.
With markets in serious fear mode, investors with a time horizon of five years or more need to ask themselves, “Am I hiding under my desk or excited about the opportunities? Am I giving up on stocks or getting prepared to buy like Messrs. Buffett and Hager?”
I’ve talked before in this space about being "approximately right," which is what my firm calls our approach to asset allocation. Approximately right means keeping your portfolio stuck on its long-term asset mix (strategic plan) most of the time. This part of the process is dead flat boring, even when rebalancing is required. But approximately right also means taking advantage of extremes in the markets – extremes in terms of valuation (cheap or expensive) and investor sentiment (fear or greed). This is the more interesting, and dare I say, challenging part of the process.
Eight months ago was one of those times when we recommended that long-term investors move away from their strategic mix and build a cash reserve. We didn’t think stock valuations were fully compensating for the economic risks, and had concerns about the distortions caused by artificially low interest rates. In this column I wrote, “It’s a sellers’ market now, but as the extremes come back to earth, as they invariably do, suppliers of capital (buyers) will regain the upper hand.”
Well, we’ve gone a long way to redressing the imbalance. Even though the outlook for economic activity and profit growth has deteriorated (and is getting worse with every month of political dithering), stocks have adjusted, or over-adjusted, to the new reality. They’re factoring in bad news. With prices down and fear running wild, however, expected returns for stocks have gone up. As Tony Arrell, chairman of value manager Burgundy Asset Management, said to me on one of the particularly gloomy days, “these are opportunity-laden times.”
Meanwhile, uncertainty has driven interest rates down to unsustainable levels, such that bonds are less appealing. Safety is even more expensive than it was, while risk is back on sale.
This divergence in value between stocks and bonds reveals itself in the gap between the stock market’s earnings yield (the flipside of a price-to-earnings ratio) and bond yields. With the S&P 500’s earnings yield at 8 to 9 per cent and bonds at 2 per cent, the gap is as wide as it’s ever been (there was little or no gap throughout the 1990s). For it to narrow, I suspect that both numbers will move toward each other – bond yields will rise over time and earnings yields will move down to more normal levels.
Nobody knows where the market is headed in the months to come (and if you hear someone talking as if they do, politely excuse yourself so you can do something more useful). But we can be confident that buying securities at below-average valuations when investor sentiment is flashing FEAR will be profitable in the medium term. We can be almost certain that buying bonds with yields between 1 and 3 per cent will provide a negligible return. And we know absolutely that in this context any adjustments to a portfolio should be made within the constraints of a long-term plan.
To be clear, investors shouldn’t expect their stock purchases to go straight up in price like they did in March, 2009. Indeed, they may get a chance to buy more at even lower prices. Mr. Buffett’s investing tenet is not a precise timing tool, nor is my valuation work. They’re both simply a way to get it approximately right as opposed to exactly wrong.