Long-Term Investors Will Be Rewarded

12/06/2011 9:30 am EST

Focus: MARKETS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

The US economy is continuing to prove remarkably resilient, as it pushes forward through some very strong headwinds at home and abroad. Now, if only political leaders could get their act together the way that businesses have, the economy could really begin to gain some traction, writes John Reese of the Validea Hot List.

In the past few weeks, several economic reports have continued to show that the economy is expanding.

Industrial production, for example, increased by 0.7% in October, according to new data from the Federal Reserve. The manufacturing and mining sectors showed solid growth, gaining 0.5% and 2.3%, respectively, while the utility sector was basically flat for the month. Capacity utilization is now 10.5 percentage points above the 2009 low, though it remains 2.6 percentage points below the long-term historical average.

The American consumer, meanwhile, continues to show resilience. Retail and foodservice sales increased 0.5% in October, according to a new Commerce Department report. It was the fifth straight month that sales have increased. They reached a new all-time high, and now stand 19.5% above their 2009 low.

We also got some decent news from the housing sector. Housing starts were close to flat in October, according to new Commerce Department data, but building permits for new housing jumped 10.9% in the month. Permit issuance is now 17.7% above year-ago levels, while housing starts are 16.5% above their year-ago levels.

The National Association of Realtors also reported that existing-home sales rose 1.4% in October, while total housing inventory dropped 2.2% as we continue to eat away at the huge overhang of supply caused by the housing bubble. Median home prices were down 4.7% from year-ago levels, however.

Finally, regional manufacturing reports are indicating that the sector has continued to grow in November. The Federal Reserve Bank of Philadelphia said its manufacturing index remained in positive territory for the second straight month, and its six-month indicator of future activity jumped sharply. And the New York Fed’s manufacturing index edged slightly back into expansion territory after five straight months of contraction.

But while the fundamentals of the economy continue to improve, investors continue to focus on two broader issues: the European debt crisis and the US’ own debt issues. In Europe, the situation drags on, and questions have arisen not only about the debt problem itself, but also about the political will to fix it.

In the US, meanwhile, politics continues to get in the way of solutions. In what sadly was not much of a surprise, the deficit (not-so) "supercommittee" failed to come to a compromise on a plan to cut the nation’s deficit. By not reaching a deal before its deadline, the committee will trigger fairly drastic automatic spending cuts in defense and domestic programs.

There is still hope that a more palatable resolution will be reached before the automatic cuts go into effect in 2013. Regardless, yet another failure of our elected leaders to put the country’s needs above politics has unnerved investors and the market.

NEXT: New Research from a Market Guru

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New Research from a Market Guru
As Hot List readers know, our investment process is driven by data—particularly long-term historical data. We don’t invest based on short-term trends, the latest big macroeconomic headlines, or gut feelings on a particular day. History has shown that such emotional, short-term thinking is a recipe for failure.

The gurus whose approaches inspired the Hot List, meanwhile, have proven that a rational, long-term, stick-to-the-numbers approach often leads to success in the market.

One of the gurus who has compiled the most data on long-term investment strategy is James O’Shaughnessy, whose book What Works on Wall Street forms the basis of two of my strategies. O’Shaughnessy recently released an updated version of that excellent book, and this one includes a plethora of new data on long-term stock returns and strategies. I’d like to share some of the more intriguing observations with you now.

For O’Shaughnessy, one of the biggest problems investors face is the tendency to focus on recent events. In the introduction to his book, he discusses how some began calling the "abysmal" returns of the past decade the "new normal", even though it wasn’t that long ago that commentators were declaring that the Internet had ushered in a "new era" of perpetually rising stock returns—a declaration that proved to be horribly wrong.

"It seems that the one thing that doesn’t change is people’s reaction to short-term conditions and their axiomatic ability to perpetuate them far into the future," O’Shaughnessy writes.

But while many investors are assuming that the poor performance of stocks during the 2000s is the start of a new era of poor returns, O’Shaughnessy says history shows something entirely different. He looks at the worst rolling ten-year returns for equities since 1900; the period ending in February 2009 was the second-worst over that span, with ten other ten-year spans ending in 2008, 2009, or 2010 cracking the top 50 (his data goes through 2010).

What did he find? Well, he found that equity returns following those awful ten-year periods tended to be outstanding. In the year following the 50 worst ten-year periods, stocks averaged a real return of 20.47%. The average three-year real compound return following the bad decades was 14.53%; the average five-year compound return was 15.78%, and the average ten-year compound return was 14.55%.

Since stocks bottomed in early 2009, we’ve seen that pattern play out, to an even greater degree. The S&P 500 gained 68.57% in the first year after its March 9, 2009 bottom; it averaged 39.68% gains in the first two years. (These S&P figures are before inflation is factored in, but the main idea should hold true.)

"Historically, we have always seen reversion to the mean," O’Shaughnessy explains. "After stocks have had an unusually great ten or 20 years, they typically turn in subpar results over the next ten or 20, and after bad ten- to 20-year stretches, the next ten to 20 tend to be above average."

Why is that? O’Shaughnessy astutely notes that it’s largely about valuation—stocks get overvalued after good decades, and undervalued after bad decades.

Undervaluation is certainly what appears to have happened after the 2008-09 market crash. And nearly three years later, even after stocks have risen significantly, valuations remain attractive. Sentiment, however, remains low, which is not surprising after having had two big market crashes in a decade.

With all of the negative headlines, it’s hard to stay focused on the valuations. But O’Shaughnessy’s research shows that that’s what good investors have to do.

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