SERIOUS MONEY:OCTOBER IS almost over and investors have been treated to a horror show. The pain is being felt not just by equity investors but also by those with their money in credit instruments, commodities and even precious metals, writes Charlie Fell.

Forced liquidations on the part of hedge funds have contributed to a host of valuation anomalies, but do these represent a nasty trick or a delightful treat?

The US stock market has fallen almost 46 per cent from last year's high to the recent low, a decline that has sent prices back to levels last seen in early 1997.

The sell-off has been so intense that almost 10 per cent of all listed companies are trading below the value of their cash holdings, while roughly 40 per cent of all stocks are trading at eight times earnings or less.

The damage to long-term performance is telling. Ten-year returns rank among the worst of the past 200 years and are comparable to those of the 1930s.

The despair is evident everywhere. Not surprisingly, internet searches for "Great Depression" have soared as bullish sentiment has evaporated.

Investors would do well to remember that this is not the 1930s. The authorities have taken considerable measures to ensure the stability of the financial system and to avoid the money supply destruction that led to economic collapse during that harrowing period.

Now is not the time to despair. Investors should heed the words of Dean Witter, contained in a letter to clients close to the market bottom in 1932: "There are only two premises which are tenable as the future. Either we are going to have chaos or else recovery. The former theory is foolish."

Investing is a game of chance and, for the first time in more than two decades, the odds have tilted in favour of equity investment. The valuation of stocks at roughly 14 times trend earnings equate to expected real returns of 7 per cent per annum over the next 10 years or nominal returns of almost 10 per cent per annum.

The expansion of valuation multiples is no longer required for investors to generate respectable returns in the future, though a modest two-point rise in the price/earnings ratio could see those who accumulate stocks now double their capital within five years.

Investors may fret that stocks could fall further and there is certainly no guarantee that new lows will not be registered. However, it is important to note that a well-calibrated probabilistic analysis shows that expected returns are now firmly in positive territory.

The probability of stocks generating positive real returns in the decade ahead has reached more than 85 per cent, while the odds of equities lagging Treasury bonds has dropped to 20 per cent.

Although the favourable probabilities have little predictive ability when it comes to timing a market bottom, investors are being presented with a considerable margin of safety when making stock purchases for the first time in almost two decades. Investors should also note that further downside beyond 10 per cent seems unlikely, while a rally of more than 30 per cent would only see stock prices return to their 50-day moving average. The limited downside is important given the negative impact of compounding on returns during a bear market. A 10 per cent loss requires a gain of 11 per cent to break even, while a dollar invested in US stocks a year ago at the market high needs a market advance of almost 80 per cent to return to par.

Risk cannot be eliminated completely, but a well-calibrated analysis can improve an investor's chance of success.

The world's most successful investors typically base their decisions on probability-weighted outcomes or expected values. Warren Buffett notes that he and Charlie Munger "take the probability of loss times the amount of loss from the probability of gain times the amount of the possible gain", and only invest in positive expected-value outcomes.

Buffett's own analysis has seen him advocate the purchase of US stocks for the first time in years, with echoes of his famous bullish call close to the bottom in 1974.

Stocks are excellent value at current levels but investors should also cast their eye towards investment-grade bonds, where current valuations bear little relationship to fundamentals.

Opportunities abound, and expected returns of 9 per cent to 10 per cent can be garnered at a time when inflation expectations are imploding.

Investment-grade bonds typically outpace both stocks and high-yield bonds at similar points in the economic cycle, but forced selling has seen valuations divorce from reality.

There are pundits who argue that returns will be lower in the future due to deleveraging and changing attitudes towards risk. Such views are backward-looking and far too late, as the rich valuations of the recent past have been eased and have rarely looked more attractive.

It's time to put money to work.

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