Strategist Urges Investors To Hang In There

June 19, 2002
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GRAND RAPIDS — A lot of people have sold stocks since the Sept. 11 terrorist attacks on New York and Washington. And that’s the problem with the stock market right now; it’s an event-driven market.

Though there’s widespread uncertainty about the future of the economy and financial markets, John Connallon, managing director and equity strategist for Salomon Smith Barney (SSB), brought a surprisingly upbeat message to an auditorium full of investors at the Gerald R. Ford Museum recently.

The message was simple: Stay calm and stay put in the stock market; over and over again the U.S. economy and financial markets have shown impressive powers of recovery.

Connallon advised investors to put aside their emotions, hold on to their existing portfolios and ride this one out because history shows that the stock market has a long tradition of rallying from initial setbacks and that the market can change direction quickly after absorbing the blow of an unforeseen event.

“The market is having an emotional reaction and when that happens people do dumb things,” he said. “I am absolutely convinced that the short term course of the stock market is going to be much more dependent upon how our country reacts to this terrorist attack than on what dividend yields or interest rates are.

“So I and every other financial consultant has no idea where the market is going over the next week or two. But we do know that over the long run the market is the place to be and in times of trouble we’ve been better off being buyers than being sellers.”

History suggests that major market downturns are triggered by fundamental underlying economic trends rather than by a national or international crisis or disaster, he said.

That has proved true in a number of crisis situations over the last 60 years, including: the attack on Pearl Harbor in 1942; the invasion of South Korea by North Korea in 1950; the Cuban Missile Crisis in 1962; the John F. Kennedy assassination in 1963; President Richard Nixon’s resignation in 1974; the stock market crash in 1987; the U.S. launch of Operation Desert Storm in 1991; the coup attempt in the Soviet Union in 1991; and the Asian Financial Crisis of 1997.

The exception was the Arab countries’ announcement of an oil embargo in 1973, an event that had direct impact on economic fundamentals.

The average first-day decline in the Dow Jones Industrial Average after those events was -4.3 percent, and in seven out of 10 cases, the market moved higher the following week. The average rise in the Dow after one year each “catastrophic” event was 12.7 percent.

“Avoid compounding the problem by panicking and getting out now,” Connallon cautioned. “Our stock markets have taken pretty big losses and 12 months later the bright people were the ones that hung in there.

“Most investors right now should be enjoying a good, brief sit. Unless your personal circumstances have changed dramatically, I would tell you to hang in there.”

In the past 204 years, the market has continued slowly but surely higher. This dip, like every dip in the last 200 years, represents a “terrific opportunity to put money to work,” he said.

According to SSB, there are other reasons to expect the market to recover relatively quickly:

  • Both the Federal Reserve and the world’s other major central banks have indicated their willingness to provide ample liquidity to the banking system to ensure normal functioning of financial markets.

  • Market declines of the last year have eliminated most, if not all, of the overvaluation that existed in some sectors. The market’s earnings yield has fallen below the yield on the 10-year Treasury bond.

  • During the past several months the central banks — the Feds in particular — have drastically reduced short-term interest rates in response to a weakened global economy. The Feds lowered the federal funds rate by another 50 basis points to 2.5 percent on Oct. 2, the lowest rate since 1962. Additional cuts could contribute to an economic rebound in time.

“Right now our firm is saying we think things look pretty good for higher stock prices and it’s real easy to understand: interest rates, interest rates, interest rates. There has been no single better indicator of higher stock prices ahead,” Connallon stressed.

Reviewing how the markets have fared over the last 70 years based on interest rates, he said the rule of thumb is buy when rates go down and sell when rates go up.

“Anytime in the last 70 years when the Feds have lowered interest rates, when the lower interest rate cycle ended, the stock market has always been higher.”

Over the last 70 years the stock market has compounded investors’ money at about 11 percent a year. Historically, when the Feds lower interest rates, that money is compounded at about 25 percent a year. That presents a “terrific opportunity to put some money to work,” Connallon said

The Feds have lowered rates 13 times in the last 70 years and the market has gone up in each and every instance, he observed. The strength of the period lasts between 12 and 18 months and the average gain for the total period has been about 25 percent.

Lower interest rates will get things started but getting the markets to move higher requires money, Connallon said. The good news is there is more money available today than at any time in history.

If investors want something to worry about, the biggest worry right now is valuation, he said. Over the last 60 years, when the market is low, stocks have traded at six times earnings and will pay a 6 percent dividend. The average over the 60-year period was 15 times earnings and a 4 percent dividend. The highest valuation the market has seen in those years has been 22 times earnings and a 3 percent dividend.

That’s the “valuation envelope” in which the market has spent 90 percent of the last 60 years, with the exception of the last five, he observed. Where’s the market today? The price earnings ratio is the highest it’s ever been and the dividend yield is the lowest it’s ever been. Based on dividend yields and price earnings ratio, the stock market is more expensive, he said.

“I promise you stocks are a better value today than they were a year and a half ago. Yet a year and a half ago clients were stampeding into the market.”

Prior performance is no guarantee of future performance, Connallon emphasized. SSB believes things have changed dramatically and continues to believe that the demographics of baby boomers are driving the markets long term; the boomers are the single biggest force ever to impact the U.S. economy and markets.

Beginning in 1996, 10,000 baby boomers daily, or nearly 4 million per year, turn age 50. That will continue for the next 12 years. So look to the companies that cater to the boomers as they move toward and into retirement. Connallon is putting his money on the health care companies, financial services companies and retailers.

Connallon has worked in investments since 1975 and has been with SSB since 1982. He’s frequently quoted on Dow Jones and Reuters News and is a regular contributor to the New York Times, The Wall Street Journal, Barron’s, USA Today and WCBS National Radio.

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