Learning From the Past, Present and the Unpleasant

by Henry J. Herrmann

In the early 1970s, we struggled with issues of war and unsteady peace, oil prices, political change and, much to the chagrin of those of us who were there, some interesting fashion choices.

Now, 35 years after the birth of this magazine, our sartorial preferences aside, you could say that most of those issues have not changed. But look again, and you’ll see that, like ripples of a rising tide, change is constant.

That is rarely more evident than it is in the financial markets, where we manage money and adapt financial plans by evaluating change. And, while the past isn’t prologue in this industry, it does provide some valuable perspective.

Across 1973 and 1974, the market lost nearly 42 percent, as measured by the S&P 500 Index. At that point, we were facing double-digit inflation, oil embargoes, the Watergate scandal, and a troubled exit from Vietnam. The Federal Reserve was forced to raise interest rates to battle inflation, President Richard Nixon resigned, and economy cars took on new popularity .Despite the gloom, the S&P 500 rose 37.20 percent in 1975 and rose 23.84 percent in 1976. Those who sold in despair in late 1974, at the depth of a downturn, lived to regret it.

In 2008, amid a credit crisis of historic proportions, one that has reshaped the foundation of Wall Street, we saw a steady flow of negative developments, with a backdrop of war, unsteady peace, and political change. By early December, the S&P 500 had declined nearly 45 percent since its high in October 2007. Are we now revisiting the early 1970s? Will things turn around? The answer to the first question is no, especially given that the inflation rate is much lower, and the Fed is more aggressive. As to the second question, there are no guarantees, of course. But with the unprecedented breadth of policy initiatives put forth by the Federal Reserve and the U.S. Treasury, we’re starting to see some positives take shape.

While the negatives are well known [we’re in a global recession; access to credit around the world remains limited; the housing market in the U.S. is under great price pressure], the emerging positives aren’t well recognized.

Foremost, and at last, is the fact that everybody from investors to the world’s central bank leaders understands the severity of the problems. To achieve solutions, it is helpful when everyone is focused on and understands the challenges.

In addition to the $700 billion highly publicized “troubled asset relief program [TARP],” the Federal Reserve initiated numerous other major assistance programs, designed to help replace the credit creation function of the private sector, which, due to a loss of public confidence, has ceased to function properly. So far, the Fed’s dollar commitments add up to a staggering $3 trillion. Certainly it will take some time for these dramatic policies to work, and there simply are no silver bullets. But it is my belief that they will work.

Given the magnitude of recent declines in the financial markets, it’s safe to say that distressed selling and extraordinarily negative sentiment are at hand. I personally experienced the major bear markets of 1973-74. Today’s emotionalism is very reminiscent of that atmosphere. Volatility tends to breed fear, which breeds more volatility. Right now, fear has driven a large amount of assets to the sidelines.

Today, like 1974, equity valuations are quite attractive. Stocks are cheap, using standard benchmarks such as price-to-earnings, dividend yield, price-to-sales and price-to-value.

The breadth and force of supportive policy being initiated around the world is very powerful. As the effects of that policy play out, things will slowly begin to stabilize, piece by piece. At some point, investors need to turn away from the present, and begin to look toward the future.

As an investor, stay focused on your financial plan. Financial asset prices now are comparatively quite low, historically speaking. When the price drops lower on other items, do you buy or sell? I think I know the answer. Do likewise with your portfolio holdings.

 

Henry J. Herrmann, CEO/Chairman,Investment PolicyCommittee,Waddell & ReedFinancial, Inc
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