Hanging On and Looking Ahead
November 17, 2008
It has been a little over a month since our last formal communication. During that time we have continued to witness remarkable stock market volatility. In just the past four weeks we have seen two days with one-day returns of greater than 10% and numerous days with declines of 3% to 5%. Moreover last Thursday we witnessed an 11% rally within a matter of just three hours. Considering that the long-term average annual total nominal return for U.S. stocks is 10.5% dating back to 1900 we are witnessing a whole year’s worth of gains or losses within a trading day! I’ve had the Mylanta handy at all times – I’m just hoping they come out with some new flavors soon to provide a little variety. Anyhow Mike and I would like to take this opportunity to give you an update on our thinking and how we plan to handle these market conditions going forward.
First and foremost we are fully aware of the highly unfavorable economic conditions around the globe. The credit freeze that took hold in late September wiped out normal economic behavior for the better part of three weeks. The problems we are living through today have been largely caused by excessive and misapplied leverage in the markets and real estate however there are plenty of legitimate uses of leverage (credit) that is the blood of the economic system and for days that activity was severely constrained. Anyone who has ever run a business or served on the board of a non-profit can attest to how important it is to have daily access to working capital lines of credit – funding payroll is an essential activity. There were a few days in October that major multi-national organizations were pulling from their backup lines of credit since the commercial paper market was unavailable. Needless to say you can’t stop the flow of blood through the system for days then expect to avoid collateral damage. The U.S. GDP for the 4th quarter absent a heroic effort from consumers during the holiday shopping season will be decidedly negative. Macroeconomic weakness is likely to extend into at least the first quarter of 2009 and could last longer.
Second there has been substantial intervention and actions taken by governments and central banks around the globe. It will be years before we know the ramifications of such actions let alone their effectiveness at dealing with the core issues, but we are supportive to some extent of the willingness to take action. That said, keeping history in mind, we think a bigger risk going forward is government over-reach which suffocates the private sector and prolongs the agony (think Japan for the most current example). While free-market capitalism has its booms and busts and is by no means a panacea, no other economic system tried by mankind has every done more to improve standards of living and create prosperity and we hope governments don’t lose sight of this fact. Yes regulations and a consistent set of rules is necessary to make markets work which need to be refreshed from time to time but this should stop short of abandonment. Quite frankly financial markets around the globe are trying to assess not only where the authorities stand on this particular issue but also whether the system itself is permanently broken. This is the $64,000 question.
Third we are also aware many of you are chomping at the bit to jump in with both feet to take advantage of the “buying opportunity of a lifetime.” We are too – however given the underlying fragility of the economy and the uncertainty regarding the direction of future fiscal policy (what’s good for the market vs. what is perceived to be good for the masses) we feel it is prudent to leg in cautiously. Furthermore the investment can extend beyond stocks to a variety of asset class because everything but short-term U.S. Treasury Bills has fallen sharply over the past ten weeks. Stocks may look cheap compared with where they were at this time last year but nobody knows how bad the economic conditions will become. Consensus analyst estimates for revenue and earnings growth have already been cut as has management guidance but the question is: Have they been cut enough? If not, even with the dramatic sell-off we have already experienced share prices can still go lower. The activity of the past four weeks seems to be testing levels of roughly 840 on the S&P 500 and roughly 7800 on the Dow Jones Industrial Index. Those levels have been hit three times with meaningful volume and so far have held. From a technical perspective some argue these are firm bottoms for a brief rally - this may be true but there is an 800 pound gorilla in the room that is capping the upside: hedge funds!
During October a significant amount of daily market volume was driven by forced selling coming from hedge funds of many stripes as they faced margin calls from brokers and banks. Margin calls come about when you have used borrowed money to invest in financial securities. Once the value of the underlying security falls by a fixed amount you either need to post additional capital (cash) or sell securities to get back to the required ratio. With banks no longer willing to lend and many hedge funds facing large redemptions due to lackluster performance they had no other choice but to sell. Making matters worse, because many of their holdings were in securities whose markets were no longer actively traded they sold their most liquid holdings which in many cases were blue chips stocks around the globe. By some market experts roughly two-thirds of the estimated margin call activity has already flushed through the market but more of this selling could be ahead especially if more redemptions are made now.
The managers of these funds wait until the market begins to rise before selling aggressively but once it does they move en masse and push levels back down again. There is good news in all of this. In the short-term the day will come when this activity does not represent big enough volume to constrain rally attempts. Looking farther ahead, the hedge fund industry was due for consolidation; having the marginal players out of the game likely for an extended period will eventually remove volatility as more capital in the market is committed to long-term growth.
So how do we plan to move forward? With about six weeks left in 2008 we will be looking to clean out and rebalance portfolios to take advantage of tax losses and reposition allocations into the assets and securities in which we have the highest confidence looking ahead to the eventual market recovery whenever that materializes. Second we want to revisit everyone’s short and long term goals and their risk tolerance. In this environment there is no single correct answer. How you should be investing your money is unique to your personal circumstances, time horizon and goals. Third we want to make sure we are seeing good cash on cash return (meaning dividend and interest payments) on as much of the portfolio as possible. Fourth we want to look at extinguishing outstanding debt where it makes sense. Finally we need to think in terms of a whole new global economic model – one in which the U.S. consumer is no longer the growth engine around which the whole world revolves. Instead we should consider a model that focuses on the predictable needs of hundreds of millions of emerging middle class citizens in Asia, Latin America and to lesser extent the Middle East and Africa. While many in Washington continue to look for ways to re-start the consumptive past we need to move on to the world that will be not the world that was.
In closing we know that the past fourteen months have been a lot more than any of us bargained for. Significant declines in even the most conservative of assets have been the norm rather than the exception but it is critically important to not panic. At this point the vast majority of losses are unrealized. What matters is the recovery potential over the next several years. It would be nice to see the market come roaring back to the 2007 highs but that is likely not in the cards at least in the short run. There is much in the press these days about the failure of buy and hold investing and asset allocation. True the past decade has given U.S. shareholders virtually no return but we must remind everyone that it wasn’t all that long ago (circa 1999) when we were hearing that investing in anything other than technology stocks was a sign “you just don’t get it.” So while it may be tempting to join the crowd we think it wiser to understand the short, medium and longer term cycles in play and manage accordingly. Robert Baur, Chief Global Economist for Principal Global Investors, recently made a statement that we think brings home the perspective we are maintaining: “You shouldn't bet on this being the end of the world, because it only happens once and it will be hard to collect.”
Despite the decline in portfolio values we all have many things to be thankful for. As the Thanksgiving holiday approaches look at the blessings you have with your family and friends and for the enjoyment you have in your life and be grateful. The day will come when the problems of the past fourteen months (and likely some new ones on the horizon) will be part of the fabric of history. The opportunities to enjoy each day of your life are fleeting so we suggest not to worry about the market but to be joyful for what you have.
Michael Joyce, CFA, CFP
President & CEO
Jack E. Payne, CFA
Chief Investment Officer