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Perception vs. Reality

posted Aug 8, 2011, 2:11 PM by Sam McPherson

Yes, on the surface things seem grim:  Standard & Poor's has downgraded the U.S. government’s credit rating, unemployment is high, and it’s still a little too hot outside.  However, I would argue that things are not as dire as some of the pundits would have you believe.  Keep in mind that news organizations make money from financial drama, and should not be a source of investing advice.

 

That said, it’s completely natural to feel unsettled in the current economic environment.   However, here are some facts that may help keep things in perspective:

 

  • Only one agency out of three downgraded the U.S. debt. (I also would like to point out that the rating agencies are not always infallible – consider the high ratings of mortgage-backed securities – perhaps S&P is trying to make up for its easy grading policies in the past?)
  • Corporate balance sheets are still strong: According to Brian Rogers, T.R Rowe Price’s chairman, “There’s a lot of bad news out there, but corporate America is in great shape financially.  Companies are growing earnings, buying back stock and increasing dividends.” (T.Rowe Price Report, Summer 2011)
  • Another way to look at this is to view the value of the entire stock market in context by using the classic measure of price to earnings, otherwise known as the P/E ratio.  As of the market close on August 8, 2011, the cyclically-adjusted P/E ratio for the S&P 500 was 19.3.  This is just slightly lower than the average of 19.4 over the past 45 years.  What this means is that stocks were slightly overpriced before the recent correction, but are now fairly priced.

 

So, while some short-term volatility is to be expected in the coming weeks and months, I advise you not to panic and certainly not to take any rash action.

 

So, why shouldn’t I take any action?

 

  • If you consider how dollar-cost averaging works, the stocks you are buying now are essentially being purchased at a discount.  So, now is not the time to get out of the stock market.  It would be like running away from Macy’s in the middle of an amazing sale.
  • It is in the nature of markets to be volatile and if you are out of the market, you won’t profit from the upswing when it happens.
  • Also, if you’ve followed our advice, you are properly diversified, and stocks consist of only one part of your portfolio.  If you haven’t followed our advice, please feel free to contact us about your asset allocation.
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