The Greatest Risk We Face: To Again Falling Into a Recession

The Problem

A spate of frightening headlines has led to two troubling declines in financial instruments.  The first, of course, is the decline in equity prices that has everyone worried about their financial futures.  This drop in stock price is in everybody's face and therefore commands prime time attention by the media.  Of course, the more the media reports it, the more frightened investors become.

The more investors worry, the worse the situation becomes.  And this, ladies and gentlemen, in my humble opinion is the greatest risk of our economy falling into another recession.  Lack of confidence in our future is more likely to produce the bad economic outcomes that everyone fears, than any of the problems the so-called pundits are so fond of pontificating.  This is known as self-fulfilled prophecy, and I contend that it is avoidable.  All we need do is change our minds.

However, behavioral economists have been telling us that people experience the fear of loss 2 1/2 times greater than the joy of gain.  Consequently, one thing that I have found most frustrating in talking with investors recently is their belief in total loss is high, while they find it unbelievable that stocks could rise.  In other words, investors today tend to believe that they could lose all their money, even though this is a virtual impossibility.  On the other hand, they refuse to believe that their stocks could rise 30%, 40%, 50% or more from these levels, which is mathematically a realistic assumption.

This is realistic because the irony with all this is that in general terms stock valuations have reached extreme low valuations.  These aberrantly low business appraisals suggest significant long-term opportunities for investors with the courage and insight to take advantage.  If you are fortunate as an investor to have available cash, the buy signals are flashing in neon lights.  By me, buy me, my valuation has rarely been so low and my business so strong.  But if you don't have the cash, and own great businesses whose stock prices have fallen, you need to fight the flight response.

Selling a valuable asset for 50%, 60%, or even 70% of their intrinsic value is a major mistake.  A comment on August 12, 2011 by Liz Ann Sonders, Chief Investment Strategist, for Charles Schwab & Co. in her On The Market commentary says it better than I:

 "Fear is not an investment strategy and can be just as dangerous to your investment goals as greed.  We encourage investors to keep their long-term investment goals in mind and potentially use the recent selloff to add to equity positions if needed to maintain recommended allocations; while looking to potentially take some profits in some fixed income securities that have benefited from this recent risk-off activity."

This offers a segue opportunity to introduce the second troubling decline in financial instruments, namely the unprecedented drop in Treasury bond yields.  This is troubling because frightened investors are fleeing to the safety of Treasury bonds at the precise time when the risk of owning them has perhaps been the highest in recorded history.  This is especially true for the long bond, but also applies to shorter-term bonds.

If bond yields were to move back to historical normal levels, the market value of longer-term Treasury bonds could easily be cut in half.  In other words, investors could stand to lose half or more of their money if they sold.  True, this is a liquidity trap, because if investors held on they would eventually receive the return of their money, at least in nominal terms.  However, even that would mean earning an unacceptably low return on their money over a very long period of time.  The following table taken from Google Finance shows how absurdly low bond rates have become:

In the meantime, the common stock of Johnson & Johnson (JNJ), a company who now has a higher credit rating than the US government, is trading at its lowest valuation in more than 20 years.  Consequently, this Dividend Champion that has raised their dividend every year for 49 years running currently offers a dividend yield that is higher than the interest yield you can receive on a 30-year Treasury bond.  When you consider that the Treasury bond's yield is fixed while Johnson & Johnson (JNJ) offers a legacy of growth yield (increasing yield on cost), the choice seems so obvious.  Nevertheless, it's the Treasury bond that investors are currently flocking to.

 Johnson & Johnson (JNJ): an above average AAA rated company

The following F.A.S.T. Graphs™ put the above words into vivid pictorial form.  Johnson & Johnson only has 14% debt on their balance sheet, trades at a blended historically low PE ratio with a potentially annually increasing 3.6% yield.  This graph clearly shows that this great company is currently on sale.

The associated performance report with the above historical graph shows that this AAA rated equity has outperformed the average company as represented by the S&P 500, even though they started out with the disadvantage of being overvalued, and are currently undervalued.

The Average US Company: The S&P 500

To be fair, Johnson & Johnson (JNJ) is an extremely high-quality company, and as the above graphs validate, an above-average selection.  Therefore, let's look at the S&P 500 through the same lens of the F.A.S.T. Graphs™ (fundamentals analyzer software tool).  The orange line on the graph represents the 150-year normal PE ratio for the S&P 500 of 15.  The blue line represents the more recent 20-year average PE ratio of 20 for the S&P 500.  This higher 20-year average PE ratio is a function of significant overvaluation during this time frame as the graph clearly shows.

It is crystal clear from the below graph, that the black monthly closing price line sits significantly below the orange earnings justified valuation line for the first time in more than 20 years.  The $98.81 estimate is taken directly from Standard & Poor's website.  There are some who were arguing that stocks were overvalued prior to this recent decline. Many of those arguments are based on esoteric historical analysis using five-year earnings averages, etc. The difference between those statistical references and the graph below are profound.

The graph shows valuation in reference to the S&P 500's actual earnings yield, based on a blend of historical, current and close forecast earnings.  Since all investments derive their returns from the amount of cash flows they are capable of generating for their stakeholders, we believe that this is a more realistic and relevant view of the market's valuation.

The current earnings yield for the S&P 500 based on the 2011 consensus forecast is 8.8%.  To put that into perspective, the earnings yield in calendar year 2000 when the market was so massively overvalued was only 4.4%.  An earnings yield of approximately 7% would indicate fair value.  This is just another indicator of the incredible opportunity in so-called riskier assets, especially if a recession is avoided.

The Solution to the Problem

The thing that I detest the most about all of the negative headlines and doom and gloom predictions that seem so gleefully offered by so many pundits and journalists, is their lack of offering any solution to the problem.  Therefore, not only do I feel that merely stating the problem is nothing more than complaining and bellyaching, I strongly object to the fact that they also contribute to the problem.  Frankly, I find it irresponsible to state a problem without simultaneously offering a solution.

The main problem cited in this article, is the potentially self-fulfilling prophecy of negative investor sentiment towards our economy and our financial markets.  Furthermore, I believe that if one truly examines all the facts they would find that we in truth do have a thimble full of problems, but we also have a mountain of positives.  However, it's as though human nature was to turn its back on all of our economic strength and potential while focusing and obsessing on our problems.

The truth is that economic activity is greatly influenced by consumers.  If consumers are so frightened that they are driven into a cocoon of worry and trepidation, their consumption habits can become greatly curtailed.  When this happens, economic growth will surely suffer and our self-induced prophecy fulfilled.  Therefore, the solution is to live up to our legacy.  Running or hiding from a problem has never solved it, and never will.  To win, we must face our fears and meet the challenges before us with the courage and faith that our great nation, with the most productive economic structure that has ever existed, deserves from us.

If we act as we always have, we will not only meet this challenge but also any future challenges that may confront us.  We'll end this article with the final stanzas of our national anthem:

Praise the Power that hath made and preserved us a nation.
Then conquer we must, when our cause it is just,
And this be our motto: "In God is our trust."
And the star-spangled banner in triumph shall wave
O'er the land of the free and the home of the brave!

Disclosure:  Long JNJ at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.