In early 2007 we wrote an article summarizing the risks in the U.S. stock market. The article cited a study by legendary value investor Jeremy Grantham in which it was shown that, on average, long term stock market returns have corresponded quite well with valuations at the time of investment.

Here we reproduce Grantham's study with updated data and a variation or two, followed by some thoughts about where we are now in the markets and what to do about it.

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This article is adapted from a letter to investing clients originally written on January 9, 2008.
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Going into 2007, we already knew that whenever the economy slows down, the government floods the system with money in an attempt to "reflate" asset prices and economic activity. This is accomplished via monetary policy, which when all is said and done effectively entails printing money, and fiscal policy, which effectively consists of the government spending money it doesn't have. We knew this would be the policy response because that's exactly what the powers that be did during the prior downturn, and because those actions were considered to have been a huge success in keeping the prior recession mild (despite all the imbalances that the reflation efforts eventually induced).

What we didn't know was just how panicky and violent the policy response would be at the very first sign of trouble.

We have some thoughts on what may take place in 2008, but first we want to review the major predictions and observations we made in 2007.

Looking back over the articles we wrote last year (of which there were embarrassingly few -- something we intend to change in 2008!), the major themes we discussed largely turned out to be correct.

Back in March, we wrote an article in which we outlined a possible financial market roadmap -- a sequence of events that we thought the markets were likely to follow. Here is the roadmap we spelled out at the time:

An important aspect of our investing approach involves identifying big-picture trends to help us understand what's been happening in the financial markets and what's likely to take place in the future. To that end, we've outlined what we believe to be a possible "roadmap" to chart out where the financial markets have been and where they are headed in the months and years ahead.

It is often noted that in the long-run, stocks are the best asset to own. It has also been noted that “in the long-run we are all dead.” So the question becomes how long an investor must wait for that attractive long-term performance to be realized. If one is not careful, it could be a long time.

Our investment objective is simple. We strive to outperform the market indices over longer time periods, after all fees, while taking less risk. While it’s easy to spot bubbles or buying opportunities in retrospect, there is no such clarity “in the moment” and we are forced to make prospective decisions about where to be invested. Without the benefit of hindsight, market risks are of paramount concern to us.

Holders of cash and its equivalents (CDs, T-bills, and the like) may not earn much in the way of interest, but they are at least certain to get all of their principal back. For this reason, many people assume that holding all cash is the safest and most conservative possible investment stance.

But there is a hidden threat to cash holders: while they are assured of getting all their money back, the money they get may be worth less than it was when they first deposited it. This is what's known as "purchasing power risk."

We believe purchasing power risk to be a serious issue for today's cautious investors.