Wednesday, October 22, 2008 0 comments ++[ CLICK TO COMMENT ]++

This Is More Than A Housing Bust...But Good Time To Invest

UPDATE: Gurufocus also has a post looking at potential future returns. I think it's worth checking that out, along with Geoff Gannon's more nuanced look.

It's very important to keep in mind that we are not just facing a housing bust. The problem is much bigger and is essentially a credit bust. The media and some in the market seem to be concentrating on the housing market but huge swaths of the credit market won't return--ever! If you follow this thinking, the implication is that a recovery in housing will not necessarily improve the economy or your investments. Don't get me wrong: housing is very important. But it's only a big piece of the crisis. Nevertheless, it's starting to be an attractive period for investments.

Many also seem to ignore the fact that risk premium was unsustainably low over the last 5 years (conversely, this means asset prices were unsustainably high.) This means that some of the spreads/yields/etc won't return to what they were 2 or 3 years ago. If anyone is waiting for things to go back to what they were a few years ago, they are going to be waiting forever.

None of this means that you should or should not invest. All it means is that one should be conservative and consider the implications of a credit bust. For example, there was a takeover premium built into the market in the last few years. The heavy activity from private equity, sovereign wealth funds, and foreign buyers meant that the market was pricing in a premium. Right now, you cannot bank on these strategic buyouts. Or even if you did, you cannot assume the buyout premiums will be anywhere near what they were before.

As Warren Buffett has alluded to, it is actually a good time to invest since valuations are becoming very attractive. Geoff Gannon has a good write-up pointing out that the DJIA has finally hit valuations consistent with the long-term average. It's a good article and I urge everyone to read it.

In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.

As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.

We were in unchartered territory.

Not any more.

Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.

So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.

So, at current valuations, you are looking at around 6.5% per year. Anyone that invested in the 80's or 90's might be dissapointed but that's what we are looking at. But it's also better than the return in the last 10 years, which is very close to 0%. Of course, if you are a good stockpicker then your returns will be much higher...


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