Newsletter February 9, 2008

InvestorsFriend Inc. Newsletter February 9, 2008

Is now a good time to invest? or a bad time?

Will stock prices fall?

The Dow Jones Industrial Average is down 8% since January 1. And it is down 15% since its October peak. It’s no fun to lose 15% in the market.

With stocks down, is this a great time to scoop up bargains? Or is time to run for the hills?

Around the third week of January stocks were all over the news. On January 22, the DOW closed at 11,971, down 10% or 1,294 points in the brand new year! There had been several days when the Dow plunged a few hundred points in one day!

Oh doom and gloom! There were calls for immediate FED action to halt this. January was off to its worst start in many years, and looked to be headed for its worse performance ever! And so-goes-January, so-goes-the-year, according to some people.

In Canada we had a one-day 605 points plunge in the Toronto stock exchange index on January 21. Now that is eye-popping and headline grabbing!

CBC television ran a spot where a young Mom was having second thoughts about investing in stocks for her child’s education. (The fact that a dip in markets is actually beneficial to new investors was totally lost on the CBC).

Around this time it seemed like the market was set to continue to plummet.

But then the FED lowered interest rates, bargain hunters stepped in and soon the markets had quickly rebounded several percentage points. Stock investors breathed huge sighs of relief and the media moved on to other topics. In more recent days the markets again lost some ground but remain several points above the January 21 lows.

So… were those lows in January wonderful buying opportunities? Or was the subsequent rally simply a “sucker rally” and are we headed back down?

The reality is that no one can accurately predict where markets are headed in the short term.

There is always a risk that markets will fall in the short term. And right now with the probable recession in the U.S. it is certainly quite possible that markets will fall, and that we have not seen the bottom yet.

But that does not necessarily mean that investors should shun stocks. In the long run stock market investments tend to provide good returns. And you can’t benefit from that if you are not in the market.

It is a mathematical and irrefutable fact that buying stocks now will provide a higher return compared to having bought (and held) stocks at the significantly higher prices that prevailed in October (back when there was a lot less fear about markets and when the mainstream media was paying no attention to stocks).

We can’t know where stock index prices will head in the short term. We do know that in the long term stock index prices rise. (Absent buying a stock at the height of a bubble peak, history suggests that the index will almost certainly be higher after say 10 years.)

A more reasonable question to ask is whether or not stocks, on the basis of probabilities, appear to offer good value at this point in time.

Logical Analysis of Stock Market Valuations

Right now, the P/E ratios on the broad North American stock market indexes seem moderate. They are well above historic lows but also well below historic highs. Given today’s low interest rates we would not expect P/E ratios to get as low as they did in the late 70’s early 80’s.

You should not invest in a stock index unless you expect that stock index to rise, at least in the long term. (Dividends are normally low and making an adequate return in a stock index is only possible if the stock index rises over time.)

Stock indexes will rise if earnings rise or if the P/E ratio rises, and will fall if the opposite happens. (It’s all very simple really, although hard to predict.)

I would argue that right now there is little basis to expect P/E ratios to either rise or fall very much. The trailing P/E ratios right now are: DOW 14.9, S&P 500 16.0, Toronto index 16.4. These ratios are reasonably close to where we might expect them to be in the long term assuming that interest rates do not rise dramatically.

If the P/E ratios are not expected to change much then the stock indexes can only be expected to rise in the long term if earnings are expected to rise in the long term.

In the short term, earnings on broad stock market indexes can rise or fall, but in the long run they tend to grow at about the rate of growth in GDP. Reasonable projections for growth in nominal GDP are in the range of 5% (3% real growth plus 2% inflation).

Therefore a reasonable expectation for a long-run growth in stock market indexes is about 5% per year. Combined with a dividend of about 2.5% this produces a long-run expected return from stocks in the range of 7.5%. This may sound low by recent historic standards but it does compare very well to 10-year government bond yields that are roughly 3.8%.

The overall conclusion from this analysis is that, based on probabilities and rational analysis, now is a reasonable time to invest in stocks. The return should be expected to be volatile (including being negative in some years) but could logically be expected to average roughly 7.5% in the longer term.

Warren Buffett has often advised “be fearful when others are greedy and be greedy when others are fearful”.

For your benefit, I have applied the above analysis in detail to each of the DOW index. The S&P 500 index and the Toronto index. Please click the links to access these short articles. Please remember that this is a longer term analysis. Even when stocks are expected to return about 7.5% per year in the long term that certainly does not preclude a a drop of say 25% in any particular year.

Mortgage Life Insurance

CBC’s Marketplace suggests that if you buy mortgage life insurance from your bank there is a chance that they will refuse to honour the insurance if you should die. (Which really defeats the purpose!). Marketplace claimed that they do this by having medical information forms with a long complicated medical question that is almost impossible to understand. For example they might refuse to cover your death by cancer simply because it turned out that you had high blood pressure but you had (wrongly) indicated on the form as part of the log complicated question, that you had not even been tested for high blood pressure.

Clearly, the bank and insurance company have a right to know your medical condition before providing life insurance. But they should not design a form in such a way to entrap people into mis-stating their health and that is what Marketplace implied that they do.

Rather than incurring the cost of investigating whether each customer qualifies for the life insurance, the banks apparently only check out the facts after a death and then can very well refuse to pay the claim even on what might amount to a technically.

Wow, if there is any truth to what Marketplace claims then this is truly sleazy.

My practice has always been to refuse life insurance on loans and mortgages. I can obtain far cheaper coverage through a group life insurance plan with Manulife that I qualify for. If banks are sleazy about honoring their life insurance contracts then that is all the more reason to refuse to buy it.

I believe that people should obtain sufficient life insurance through their group plan at work or from a large life insurance company. I would far prefer to fill out the forms with a licensed life insurance broker (and pay the associated fees) rather than buy life insurance as an after-thought on a loan.

In my experience, life insurance should be taken out when you are young and healthy. After that if there is no increase in the coverage amount, no further medical tests or questions are required, in my experience. Life insurance is cheap when you are in your 20’s and 30’s. That is the time to take out and maintain probably more than you really need. That way when you are in your 40’s and 50’s and beyond, when your income is higher and you may feel you need a lot of coverage you will have it without the need of medical questions or tests. As you build up your net worth and as any children become independent you should have less need for life insurance in latter years. At that point it will also be expensive and you can drop your coverage to a lower level. (This is not meant to be advice about life insurance, just some thoughts, for advice consult an insurance broker).


Our Web Site includes an extensive bank of proprietary articles. These are mostly based on mathematical analysis of historical data and can help both beginning and experienced investors better understand markets, risks, returns and related topics.

Next Newsletter

Around the end of February, Warren Buffett will come out with the latest edition of his famous annual letter to shareholders. He is sure to have some interesting things to say about the sub-prime crisis and stock valuations. I will highlight some of what he says in the next newsletter.


Shawn Allen, President
InvestorsFriend Inc.

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