Monday, December 17, 2012

For Long Term Investors, Here's the 'Lucky' Case for Stocks ... Heads We Win, Tails We Win

An interesting way of looking at potential returns on stock investing is looking at the economy's future prospects. It seems the the worse conditions are expected to be down the road, the better returns for investing in stocks will be.

Counterintuitive, of course, but investment returns are all about what happens in the future versus what current market participants expect will happen. So if gloom and doom prevails in the present, current stock prices will be lower than if a happy days are just ahead attitude is in vogue among today's investors.

The best case is a poor outlook for the future combined with a better future. That's my take anyway.

U.S. Stocks: Look Out Below? tells the buy low, sell high story of successful long term investing well:

"Is the U.S. a "submerging" market?

An eminent economist and a leading money manager have independently concluded that the U.S. economy will expand in the future at only half its long-term historical average. These predictions match the dark mood of many investors who already have given up on the U.S. stock market.

How could a bad economy possibly be good for stocks?

But the most striking aspect of these negative forecasts of economic growth ultimately is that they make a positive case for buying and holding U.S. stocks. Doubt and fear lower investors' expectations, making stocks cheaper—and thus raising the potential for higher returns in the future.

The first skeptic on growth is Robert Gordon, a professor at Northwestern University and a renowned authority on macroeconomics.

The second is Jeremy Grantham, co-founder of GMO, a Boston-based investment firm that manages more than $100 billion. Mr. Grantham is no slouch as a seer, having sidestepped both the Internet bubble of the late 1990s and the near-death of financial stocks in 2008 and 2009.

In a recent research paper, Mr. Gordon argues that the pace of technological innovation is doomed to falter. He also lists six "headwinds" that are bound to slow down U.S. economic growth. Among them: an aging population, increasing global competition and uncontrollable household and government debt.

As if that litany of woes weren't depressing enough, Mr. Grantham offers another. Oil prices, he says, will stay high indefinitely—driving up the costs of other commodities as well.

Since the Civil War, the U.S. economy has grown an average of 2% annually, adjusted for inflation and population growth. Mr. Gordon says the future average rate will be below 1%. Mr. Grantham foresees 1.4% at best.

Mr. Gordon contends that earlier breakthroughs—railroads, electricity, the telegraph and telephone, the automobile and air conditioning, along with computers and the Internet—provided a much bigger economic boost than most of today's innovations will.

But what about 3-D printing, genomics, nanotechnology, big data and all the other burgeoning developments in laboratories and companies around the country? "There's still lots of innovation," Mr. Gordon told me this past week. "But how fundamentally important will it be?" He says these technologies are likely to make only "incremental" differences to the economy.

Mr. Grantham told me that humans always have been innovative, but only the availability of cheap coal and oil in the past 150 years made our modern technologies possible. "The idea that we can overcome all our problems depends completely on our access to unlimited quantities of cheap energy," he told me.

Others disagree—not least because the U.S. appears to be moving rapidly toward self-sufficiency in producing energy.

"You don't have to have an Industrial Revolution to get revolutionary innovation," says Laurence Siegel, director at the Research Foundation of the CFA Institute, which educates financial analysts. Mr. Siegel sees the opposite of a slowdown: "I'm more worried about too much growth than too little," he says.

It is intriguing that Mr. Gordon and Mr. Grantham are as bullish on U.S. stocks as Mr. Siegel is. Mr. Gordon says he has "at least 80%" of his assets in stocks. Mr. Grantham says high-quality large U.S. stocks are likely to earn about 5% annually (plus inflation) over the next seven to 10 years, regardless of how slowly the economy grows.

How could a bad economy possibly be good for stocks?

Many studies have shown that the stock markets of countries that are expected to rise fast tend to do poorly, while those in countries with projections of slow economic growth typically end up earning higher returns.

That is because investors chronically overpay for the hopes of a bright future and put too deep a discount on the prospect of slow growth. Over the past 15 years, for instance, the Chinese economy has expanded far faster than those of Latin America. Meanwhile, Latin stocks earned an average of 8.2% annually, while Chinese stocks averaged less than a 1% annual return, according to index data from MSCI.

U.S. stocks aren't the extraordinary bargain they were in, say, 1974, 1982 or 2009. But the Standard & Poor's 500-stock index sells at 14.5 times its companies' operating profits, says analyst Howard Silverblatt of S&P Dow Jones Indices—well below the average of 18.9 over the past quarter-century.

The ironic lesson at the heart of what Messrs. Gordon and Grantham are saying: The grimmer the future seems, the more optimistically you should invest.

With billions of dollars leaching out of stock funds every month, the weak hands—those people who can't bear to hold on to their stock investments in the face of bad news and wretched returns—are being shaken out. But the strong hands, those who can cling to their holdings no matter what, should be rewarded in the end."

Summing Up

So there you have it.

Owning stocks makes sense in all kinds of 'weather,' rain or shine.

That said, it's best to buy when it's raining. It's less expensive that way.

One curiosity about stocks is that generally we like to buy when things are on sale. Lower selling prices tend to bring out the buyer in most of us.

Except, that is, when it comes to buying and selling stocks for most people. Then fear overcomes solid reasoning.

But as legendary investor Warren Buffett put it so well, we should buy when others are fearful and sell when others are greedy.

It's all pretty simple, even if it is counterintutive.

But then again, didn't our parents warn us against following the crowd? It was good advice then, and it's good advice now. So try to stay calm during periods of stock market volatility.

Do your own thing, and you'll truly be able to buy low and sell high. Will Rogers had it right all along.

Thanks. Bob.

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