Market Update Letter
January 23, 2008

To: All Stapp Financial Investment Clients
From: Stapp Financial Planning, PLLC
Date: January 23, 2008

The significant recent declines in the stock market reflect investors’ growing fear that a recession may be imminent. Many investors are wondering if it makes sense to become more defensive to avoid any further volatility and potentially further declines in stock prices. Others are wondering about when the declines might lead to compelling investment opportunities being created. We are writing this letter to provide perspective to our clients about what the difficult recent market environment may mean, and how it impacts our investment strategy.

Our perspective on the current market environment is most relevant when considered in light of how we manage money, so first we want to remind our clients about several of the basic principles of our investment approach. One is that in the short term, markets can be driven by emotions like greed on the upside and fear on the downside (right now markets are clearly driven by fear). But because short-term drivers of emotion are inherently difficult to predict, it is impractical to base an investment strategy on doing so. Fortunately, it is not as difficult to analyze longer-term business and economic fundamentals with more confidence, and history has demonstrated that fundamentals and stock prices will converge over time. By basing a strategy on longer-term fundamentals and valuations, we can look beyond short-term market declines that might trigger some investors to become defensive at inopportune times. In some asset classes, short-term declines can become significant enough to create a compelling buying opportunity that increases our odds of outperforming our benchmarks over the long term.

Meanwhile, another core aspect of our approach is risk management. It is also important to know each client’s financial and psychological capacity to assume risk, and so we also have 12-month loss thresholds for all of our client portfolios, based on various risk profiles. While we can never make guarantees, we can say that we manage our portfolios in a way that we think makes it unlikely that we will violate these loss thresholds. But when markets decline sharply, we realize that it can be difficult for investors to prevent fear from driving their investment decisions—even if their portfolio is not exceeding the maximum loss they understood could occur.

Given the recent stock market sell-off, by many measures stocks now look cheap. The problem is that most valuation metrics are based (partly or mostly) on what companies have already earned rather than on what they will earn going forward. Slower earnings growth going forward, or an outright decline in earnings (an earnings recession) would mean stocks are not as attractively valued.

As we’ve been pointing out for quite some time, profit margins have been extremely high relative to history, resulting in earnings that are way above their long-term historical trend. In the past when earnings spiked above trend they have always come back at least to trend, and in many cases, have temporarily gone below trend. This strongly suggests that currently, the earnings numbers used to measure valuations are unrealistically high, and the resulting valuation measures are misleading.

So how do we assess valuation for the market given the earnings uncertainty? One way is to assume that earnings fall back to trend over our five-year investment horizon. If that happens, and if at that point in time the market is selling at what we would consider to be fair value, then the implied return for stocks from today’s level is in the high single-digit to low double-digit range per year based on our valuation model. That suggests that the market decline we’ve experienced has taken stocks back to a fair-value level—one where earnings revert to their long-term trend. We think this is a reasonable expectation, but it does not warrant a tactical overweighting to stocks in our balanced portfolios. We would want a bigger decline before we would move to an overweighted position. If earnings don’t revert all the way back to trend, stock returns would be higher (assuming the same metrics listed above), but we aren’t willing to bet on this.

No doubt many investors are increasingly concerned about recession and are now reducing equity exposure below their normal targets. But recognizing the economic weakness as it becomes apparent is the easy part. Identifying it before the market recognizes it is far more difficult, yet this is the only way that reducing equity exposure will actually add value. In fact, predicting the timing of recessions with respect to the stock market is very difficult and attempting to do so often detracts from long-term performance.

If we believed that the stock market was not discounting a level of earnings weakness we thought was likely, we would underweight stocks. But right now, we remain at a neutral stock allocation primarily because we don’t view stocks as expensive and the sell-off we have seen is already discounting a lot of economic weakness. If we are in the midst of an earnings recession, stocks are already discounting some damage. Whether they are adequately discounting the potential earnings decline requires a level of forecasting accuracy that can’t be done with confidence. However, our earnings-trend work suggests that prices are roughly in line with where they should be if we assume a reversion to a historically normal level of long-term earnings growth. Moreover, stocks have already fallen quite a bit from their peak, and in most previous cycles, patient investors who buy after declines of this magnitude do well over the multi-year period that follows.

We noted in our recent commentaries that we have a little less of a pure recession hedge in our balanced portfolios than we would if we were at our neutral allocations. This is because our positions in commodity futures and emerging-markets short-term local-currency bonds are funded from a reduction in our domestic investment-grade bonds, which provide a more reliable recession hedge. In addition, one of the bond funds we own (Loomis Sayles) is not as defensively postured as our core investment-grade fund (PIMCO). It is possible that this could lead to a period of moderate underperformance relative to our benchmarks if the U.S. recession leads to significant overall global weakness or a global recession. But if emerging markets hold up reasonably well (as PIMCO and others expect) then our tactical positions are more likely to add value. Moreover, there are powerful macroeconomic forces at play that support these asset classes (which we’ve written about in previous commentaries). We are willing to keep these tactical allocations even though we realize that we may be giving up some of our recession hedge because, based on our scenario analysis, we believe our long-term performance will be better, and we do not think we are likely to violate our loss thresholds.

As the market environment unfolds, we will continue to re-analyze valuations in light of a range of possible economic scenarios that we think could occur, to help us identify at what point we would want to overweight stocks in our balanced portfolios. We have not yet reached that point, but given the level of emotion in the market and the magnitude of declines we’ve already seen, it is possible that it could happen quickly. With bond yields very low, the gap in longer-term return potential between stocks and bonds is already wide. So we may be fairly close, both from the standpoint of time and market levels, to an initial entry point. On the other hand, the thought of reaching those levels obviously highlights the possibility that we could see further declines in the stock market in coming weeks and months. Further, if we do overweight stocks on the basis that further declines create a compelling long-term return opportunity relative to bonds, we will probably be early, since calling a bottom is not something that can be done except through luck. As painful as this would be in the short term, it would set up long-term investors in our balanced portfolios to capture higher returns by holding a higher equity allocation prior to the start of a new market cycle.

Unfortunately, we can’t say with confidence what the coming months hold for the economy or the stock market. We are confident, however, that by maintaining our investment discipline and focusing on a multi-year time horizon—including taking advantage of any opportunities that are presented to us—we improve the odds that we will beat our benchmarks over the long term. As always, we are watchful for these opportunities.

Should you have any questions or concerns, please feel free to contact us directly.

Stapp Financial Planning, PLLC

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