I’ve heard it all, and have to say I agree as I’m feeling the pinch too. I watch my contributions disappear and my portfolio continue to erode, however, there is one important thing to keep in mind; If history is a good indicator, things will turn around and you will recover most if not all of your losses in just a couple of years, and certainly more than you’ve lost in most cases. In a previous article I wrote about the last 10 bear markets and the most recent one back in the early 2000’s lasted around 2 and a half years and saw a nearly 50% loss in that time period that ultimately recovered all losses and added gains. Most of the people fretting over this are newer to investing or haven’t really paid attention in the past.
To truly understand what is going on now, and why it is important to stay course, you must understand how markets and sentiment work. Moreover, you must understand how this economic recession is no great depression, rather a normal economic cycle.
For simplicity in understanding the impact of investor sentiment (as well as consumer sentiment), you need a brief understanding of what a stock price really represents, but before you can understand that, you must understand how a stock is created and sold. For a better explanation than what I will provide below, I have written another article that explains the process a company takes in “going public” in order to raise money to operate their business.
Why would a company want to go public? Because they know (or think they know) they have a business model that only needs more money to make a bunch more money. Take a hot dog vendor for example; Say the man has one stand on the corner of a street in downtown St. Louis, and his one stand does so well that he can’t keep up with all the business. He knows if only he could afford to open more, he could make much more money. The only problem being, he is limited in his ability to open multiple stands, because he only has the cash flow from selling hot dogs at one stand to support one stand. He knows though, if he were able to get a loan, he could open many more stands and become a millionaire. Now, your idea has to be good enough that investment bankers are convinced going public would be a better option than simply seeking private investments, but that is a different conversation all together.
After the decision to go public is made, the company sells shares at a price they think will sell to the general public. After they have completed selling their goal, or as close to it as they can, they collect the proceeds and issue shares of the company. From there, secondary traders (you and me and our mutual fund companies and investment banks) buy and sell those shares between ourselves. In essence, we are buying and selling them based upon future expectations. What the stock was purchased for originally has little to do with the price of the stock you see now, because many things have happened to the business, as the management maybe managed the initial public offering money well, or not, and the economy may have gotten better or worse. We are constantly changing our perception of the companies stock value based upon multiple factors, and in many cases that is based upon fear, rather than fundamentals.
My point in saying all of this is that there are numerous companies if not a good majority of them that are ran really well, consistently making money, that are even selling for less than the money they have in the bank. Moreover, a large portion of the stock market and it’s associated value is simply down because of investor fear and ignorance. The majority of what you see as a loss in your portfolio is simply a result of people pulling their money from the stock market, and putting it into government and other bonds because they feel like it is safer. Instead of looking at the businesses and its value as it relates to stock prices, people illogically jump ship and hurt themselves, the stock market, and employment.
One great indicator of how under or overvalued a stocks price is as it relates to its future earning power or future value is to look at P/E ratios (price to earning ratios). Below, you will see what a particular number would indicate, below that I will show you the P/E ratios of a number of publicly traded companies as an average based on the Dow Jones, to prove they are mostly all currently undervalued, because of fear in the market.
N/A A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be mathematically determined.
0–10 Either the stock is undervalued or the company’s earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets.
10–17 For many companies a P/E ratio in this range may be considered fair value.
17–25 Either the stock is overvalued or the company’s earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
25+ A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.
Now to understand boom and bust or economic cycles (or stock market cycles) you have to have a greater knowledge of economics than you probably care for. So, I will make you use some common sense and real life examples to help you understand, if you want a greater explanation, here is a quick and excellent article from investopedia, and also more information from wikipedia. I want you to think of the economic cycles like a product cycle. Don’t worry, this is easier than it sounds. Take a company like Apple, and their recent product the iPhone, this product will have a life cycle of probably no more than a year or two, due to technology. When the product was first launched, they couldn’t keep it on shelves, so they produced more and more, eventually the vast majority of people whom wanted the iPhone and who could pay for it got it, then Apple had saturated the market and the supplies they had left had to be sold at a discount or risk not being sold at all. So, the product was hot, then not so much. However, Apple surely has something else up their sleeve, and the next big thing will launch before you know it, and go through the same cycle. Now, the stock market faces the same challenges, as new companies pop up and become sensations, their stock prices will go up and then down, depending upon a multitude of factors. Apple, like the other companies on the stock market, will grow over time, expanding and contracting in size, with an overall continued growth over time. Just look at the market over the last 80 years below, you will see many ups and downs, but over the long haul, these companies accumulate wealth, and either continue to grow or are sold to companies that do.
Now, you’re asking me how can I say this is not the second great depression in the making? I can say that because it seems we have learned from history. The response to the 1930’s recession led to the great depression, and we’re not making the same mistakes twice. Hoover and Roosevelt raised taxes, while the government allowed thousands of banks to fall, all while tightening the money supply. This was a recipe for disaster, as markets essentially froze and companies fell one after another, contributing to massive unemployment. Now, this may sound similar to today, however, what is happening now has happened multiple times without us entering into another depression. The fact is, US regulators and the Federal Reserve have ensured tax cuts, helped ailing financial institutions stabilize, and have helped keep unemployment at much more reasonable levels so that consumers can help reverse course and avert disaster. Here is an excellent article with more detail on this subject.
I hope this helps squash some of your fears, and realize that it is simply a matter of time until a rebound, so don’t move your money and take those losses, leave it alone it will come back!