In light of the increased turmoil in the financial markets, investors would be wise to remember a few fundamentals.

While the news about AIG, Lehman, Merrill Lynch and others is serious, the U.S. financial system has a natural balance to it by tending to go to extremes in one direction before correcting itself.  It is akin to a self-righting boat in stormy seas.  We'll get tossed around a while, but things will eventually calm. 
 
Investors need to remain focused on the long-term.  Our system is washing out issues which need to be washed out.  It is not unlike the excesses of the technology bubble of the late 1990's.  It is best to build and manage well-diversified portfolios using individual stocks and bonds chosen from across many industries and economic sectors.  It is this type of strategy, along with a long-term focus, that can help investors ride out the storm and mitigate risk.

Anyone familiar with our intellectual foundations knows that we believe consumer price inflation is a key factor in common stock investing. In short, the trend in stock price earnings (PE) ratios is dramatically related (inversely) to the trend of inflation.

When you purchase a stock you are essentially paying for the present value of all future earnings where the discount rate to bring future earnings back to present value is the rate
of inflation.

If you wanted to measure inflation momentum through time, that is a measure of inflation that was not volatile year to year nor even volatile when a 10 year rolling average was calculated, it would be a measure so that when inflation momentum hit a top or a bottom it was a trend shifting top or bottom ... not just a spurious fake for a top or bottom. Given such a measure, you would see how the stock market as embodied in the Standard & Poor's 500 stock index performed in the decade after a major top or bottom in inflation.

The stock market has a long history of a total return in the vicinity of 10 percent per year compound average annual return. This is essentially made up of approximately 6.5 percent per year from earnings growth and 3.5 percent per year dividend yield.  Actually, the return on any stock over any period of time is:

Return = Earnings Growth Rate + Dividend Yield +/- Change in PE

Sometimes the PE change has a positive additive effect such as in the late 1990's, while at other times it has a negative effect that occurred in the 1970's. The actual mathematical equation is slightly different but the concept is embodied in this equation. Anyway, over a very long period of time the PE effect falls away.

Over five to ten years PE changes can have a dramatic effect on stock returns. The 1970's and 1990's are good examples of this. The point to be made is that while the long-term average return is 10 percent the market never spends much actual time at 10 percent.  It seems to spend about half the time below 10 percent and the other half above 10
percent. 

In tracking inflation momentum since 1915 there are three tops and three bottoms when comparing the average annual total return for the Standard & Poor's 500 stock index over 10 year periods. This includes price changes and dividend yield.

In general, when inflation momentum peaked the following 10 years was generally good for stocks. That is, a period where the market was on the high side of its 10 percent per year average. Conversely, when inflation momentum bottomed the following 10 years was generally sub-par for stocks.

Historically, whenever inflation has gotten a good toehold in the economy it was generally difficult to reverse its course.  Recently, the Federal Reserve has let inflation move up unchecked as it lowered interest rates time after time in hopes of avoiding an awful recession brought on by the sub-prime loan fiasco as well as other things.

In general, stock returns tend to be sub-par for a number of years after inflation momentum has gone through a major bottom. Consider a 30 year period where stocks return 10 percent per year.  In one instance, assume stocks return 5 percent per year for the first 15 years and then 15 per cent per year for the next 15 years.

In the second instance reverse it so the 15 percent per year comes in the first 15 years then the 5 percent per year. With annual withdrawals from the portfolio you are much better off at the end of 30 years where the higher returns come first.

One cannot change any of this. However, it is good to know what you are up against as pertains to potentially higher prices caused by inflation and potentially lower stock returns. Then, there is the possibility that our thesis will not work this time and/or the Federal Reserve will quickly get inflation under control.

Further, investors often sell or "get out" at precisely the wrong moment.  Nobody is smart enough to time the market with consistent success.  Don't make knee-jerk reactions that could harm your long-term investment results, in exchange for a short-term solution to a bump in the road.

Matthew S. Eads, CFA, is a portfolio manager and securities analyst at Atlanta-based Eads & Heald Investment Counsel, www.eadsheald.com.