A History of Resilience

The economic news has offered some rays of hope in the past few weeks — surprisingly good bank earnings, unemployment declines, improved capital-raising conditions for corporations — and the markets have responded. Whether the next few weeks will provide the same hopeful signals, however, remains to be seen.

But whatever the short term brings, the U.S. will recover from the current crisis and move on to new heights — that’s one of the key issues I delve into in this week’s Validea Hot List newsletter.

This isn’t blind optimism. It’s based on extensive historical data, much of which has been provided by gurus like David Dreman and Jeremy Siegel, both of whom have done a tremendous amount of research into the economy’s and stock market’s ability to recover from crises — some of which have been worse than the current credit crisis.

In addition to their research, I also discuss the findings of Ben Inker, director of asset allocation for GMO (Jeremy Grantham’s investment firm). Inker’s research finds that economic productivity and dividend streams — the latter of which drives the stock market’s “intrinsic value”, according to Inker — have been quite stable and mean-reverting throughout history. Similar trends occur in other countries. In the U.S., Inker shows, GDP was crushed in the Great Depression years, but eventually reverted to the mean as though the Depression hadn’t occurred. The same even happened in Japan and Germany following the devastating hits they took in World War II.

The reason for this mean reversion is that an economy is in reality based on some pretty stable things: “The productive capacity of the economy comes from the skills and size of the workforce and the country’s accumulated intellectual and physical capital,” Inker says. “If GDP were to fall by 5%, it would not be because our ability to produce goods and services had fallen by 5%, but because aggregate demand for those goods and services had fallen. When the demand returns, the economy will be able to ramp up production quite quickly.”

Inker says this crisis won’t destroy us, and I agree. And, if you believe that we’ll make it through this crisis without some sort of irreparable harm, the question for the long-term investor thus centers on one thing: value. And I continue to see quite a bit of it in the market. Could valuations get cheaper? Of course. While stocks are cheap based on measures like the 10-year P/E ratio, stock market value/GNP ratio, and Tobin’s Q, they are not as inexpensive as they’ve been at the bottom of past downturns, such as 1932 or 1982. Many are waiting for stocks to turn back down and reach, or come close to reaching, those all-time low levels. Will they? It’s a close-to-impossible question to answer, particularly in light of the fact that this downturn involves an unprecedented multi-trillion-dollar government stimulus plan, the full impact of which is yet to be seen. In addition, the issue of just how cheap the market is remains up for debate — a topic I also highlight in this week’s Hot List.

I thus will continue to take the good values the market is offering, rather than waiting for even better values that might never arrive. Could that mean some short-term losses if the market does, in fact, turn around and head lower? Yes. But to me, the alternative — missing out on a big chunk of a bull market surge — is a far more dangerous proposition.


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