Seven Reasons Not to Panic

Weak economic data. S&P downgrades US debt. Eurozone in crisis. Gold soars above $1,700.

Stock markets tumble around the world, and the S&P 500 has lost more than 11% since the end of April.

Suddenly the world doesn't look very friendly for investors, but what should be done?

I've been getting lots of calls and emails, as you might imagine. Here's what I have been saying:

1. The S&P downgrade has symbolic significance but little else. Interest rates will move based on investor perceptions of value, not on ratings. Even this morning, after the downgrade news, yields on bonds have moved sharply lower.

Japan has been downgraded by S&P a couple of times over the last decade, and they are still able to borrow at rates around 1%. Canada was downgraded in the mid-1990's, and not only did interest rates move lower but their stock market soared as well;

2. In fact, a short piece written by Dimensional Fund Advisors (referenced by Ron Lieber of the New York Times on Saturday) notes that some of the best stock market returns were found in markets that were consistently rated below-investment grade*;

3. We just completed an earnings season in which roughly three-quarters of the companies listed in the S&P 500 exceeded expectations.

To be sure, guidance was cautious by most managements, but "setting the bar low" has been common over the last few years;

4. Several economic indicators are actually showing signs of improvement.

Last Friday's employment report was better than most expected. Money supply growth has been exploding in recent weeks, which often can lead to strong market gains. The gauge of leading indicators released by the Conference Board continues to point towards continued growth. These data points get less media attention but are useful nonetheless;

5. Valuation of stocks is attractive on both an absolute as well as relative basis.

For example, the S&P 500 now trades a 10x forward price/earnings, well below the 15.2x average of the last 10 years. The dividend yield of the Dow Jones Industrials is higher than the 10-year Treasury note. And the earnings yields (the inverse of the P/E ratio) is 4x the yield of the Treasury market;

6. Other than gold, commodities in general have been falling. Oil, for example, is down -14% since the end of April. Falling commodity prices should help the economy;

7. Falling stock prices do not necessarily indicate the beginning of a new bear market. John Dorfman, chairman of Thunderstorm Capital LLC, a money management firm in Boston, notes that:

There have been 93 corrections of 10 percent or more since the beginning of 1928, according to Ned Davis Research, Inc. In 25 cases, those downturns developed into full-fledged bear markets, as defined as a decline of 20 percent or more. So the historical odds suggest that the chance of the present correction turning into a bear market are 27 percent. It would be unusual for a bear market to start when corporate earnings are healthy and interest rates are low - but not impossible.

*"Sovereign Debt and the Equity Investor" http://www.dfaus.com/2011/07/sovereign-debt-and-the-equity-investor.html

Finally, at times like this, it is worth remembering Warren Buffett's axiom to "Be greedy when others are fearful, and fearful when others are greedy".

When you see so-called smart money investors stashing funds in Treasury Bills yielding 0%, or even paying custodian banks like Bank of New York Mellon a fee to place deposits, you have to believe that a lot of bad news is already priced into the markets.

In my opinion, for the longer term investor, stocks represent the best combination of yield and potential capital appreciation.

I see little or no value in shorter maturity bonds yielding less than 1%.

While I admittedly missed the upward move in gold this year, I still don't understand the investment case for an asset that has little practical value and is worthless as a medium of exchange (i.e. try taking your gold coins to the supermarket).

It's going to be a bumpy ride, but with the S&P off less than -5% year-to-date I think this is a time for patience, not panic.