|
|
|
|
Market Insight- Third Quarter 2008
In the few weeks since the end of the quarter, it feels as if the world has turned upside down several times for investors. A plethora of concerns get the blame for an historic drop in equity markets around the world: housing industry woes globally, frozen credit across world economies, mark-to-market accounting, global recession and the November election in the United States. The media has fed the discomfort investors have been feeling in October, from daily local newscasts to newly anointed market ‘gurus’ such as Jim Cramer and Suze Orman. Clearly we were early last quarter in our
belief that financial headwinds were easing. Where are we now? The enclosed
Market Commentary discusses our current outlook, but the short answer is that
global economies are probably facing a recession while frozen credit markets are
slowly thawing. Massive coordinated government responses to current financial
strains around the world will slowly restore investors’ confidence and stimulate
seized credit markets. The good news is that we feel equity investors can
breathe a little easier and consider increasing their commitment to stocks as
appropriate to their respective asset allocation. There is no way of knowing if
we have hit the bottom but we believe that equity markets have priced in much of
the bad news from the financial crisis we are experiencing as well as the
prospective recession.[top] Of most concern to many investors is the sharp decline in the equity markets which began in October 2007 and has dramatically accelerated since late September. As we write this in mid-October, the S&P 500 index is down an astounding 40% in the past 12 months. Declines of this magnitude are usually once in a generation bear markets and need to be put in historical context. Looking back on four significant market declines we can point to the 1929 crash which ushered in the Great Depression, the 1973-74 bear market, the 1987 crash, and the technology bust of 2000-2002. Each one of these market routs began with valuations stretched to very high levels. The 1929 and 1987 declines began with the entire market at lofty levels – levels not previously achieved. The 1973-74 decline was the unraveling of the “Nifty 50” stocks, many of which lost 90% or more in value, while other companies saw much smaller declines. The 2000-2002 sell-off was clearly led by technology companies in general and the “dot-com” companies in particular. The current decline is different. It began with the stock market as measured by the S&P 500 selling at a mere 15.5 times forward earnings estimates – well below the levels at which the other declines had started. The difference this time is a crisis in confidence. As risk began to be better appreciated by investors, it was repriced in many securities and confidence began to decline. What began as a sub-prime mortgage problem became a wider credit problem which spread its tentacles to all areas of the financial sector. In the most recent leg down which began in September, non-financial companies began to see their stock prices decline precipitously as investors lost confidence that they could sell the commercial paper and other debt instruments needed to finance their daily activities. Confidence is described in the dictionary as “a state of being certain, either that a hypothesis or prediction is correct, or that a chosen course of action is the best or most effective given the circumstances. Confidence can be a self-fulfilling prophecy, as those without it may fail or not try because they lack it.” It is clear to us that investors and many citizens have lost confidence. They have lost confidence in the markets, in their ability to hold onto their jobs, in their political leaders, and many have lost confidence that the economy can get back to normal functioning in a reasonable period of time. News media, both print and television, have been comparing this turmoil to the Great Depression. We believe this fear-mongering is detrimental to restoring confidence in America. Looking back at the 1929 market crash, over six bleak trading days, the Dow Jones Industrial Average lost a third of its value. At the time, a senior New York Stock Exchange official said, "it was a panic where all at once, the inconceivable terrors of the unknown and the unfamiliar are thrust upon the public mind; confidence is paralyzed, and until it is restored, chaos reigns”. While this decline is nowhere near as large as
the 1929 crash, we continue to remind our clients that we've been through tough
times before. The dot-com bust was almost as extraordinary as the 1929 crash.
Between early 2000 and late 2002, the tech-laden NASDAQ index fell almost 80%.
The country witnessed almost 2,000 bank failures between 1987 and 1991, and the
Dow Jones Industrial Average plunged 22.6% in a single day in 1987. While none
of those were pleasant to experience, we came through them and went on to new
levels of prosperity. The Great Depression came at a time when we had an
inattentive Federal Reserve, no FDIC deposit insurance, limited financial
disclosure among companies, and 25% unemployment at a time with no unemployment
insurance. In addition there are numerous structural differences in place today
that didn’t exist in the 1930’s, many of which were instituted specifically to
prevent a repeat of those dire times. In the current crisis, the Federal Reserve
and the Treasury have taken seriously their role as the "lender of last resort”
and introduced numerous liquidity measures currently totaling about $1.5
trillion. While investor fears are real and to a certain extent justified, what
is not justified is the fear that we are on an economic path similar to the
Great Depression. The economic data released over the past few months have been disheartening to say the least. The Case-Shiller Home Price Index decreased 16.3% on a year-on-year basis. However, the rate of decline has slowed recently from its worst levels at the beginning of the year. The ISM manufacturing index dropped to 43.5, which is close to recessionary levels. Labor market indicators are also deteriorating; initial jobless claims, which are a leading economic indicator, rose to nearly 500,000 and non-farm payrolls fell 159,000. These measures clearly indicate that the economy is close to, if not already in, a recession. While second quarter GDP rebounded from the low levels of the prior quarter, these were boosted by the tax rebates paid out during the spring months. GDP growth will likely remain near zero on an average basis through the first half of 2009 before rebounding later next year. Nevertheless, we also believe in the
discounting mechanism of the markets, which generally focus on when fundamentals
trough. Given that equity markets consistently rally six to nine months ahead of
a turn in the fundamentals, we are optimistic that the equity markets are
searching for a bottom. With slack consumer demand, pricing pressures have eased
and thus low inflation should also be supportive of equities. In our last letter we wrote to you about two portfolio actions we had taken. Our analysis of economic activity and valuations caused us to reduce our sector weightings in both financial and energy companies. We explained our thought process to you in our prior letter and we continue to believe those actions were timely, prudent, and correct. Financial companies have been battered by a myriad of events that have gone well beyond the sub-prime crisis. As it became clear that many companies could not properly quantify their risk levels, we sold some financial companies and moved to an underweight position in the sector. Our decision to reduce our holdings in the Energy sector also helped our relative performance during the past several months. Oil prices have declined by almost $70 per barrel in the past three months. This precipitous slide has caused energy stocks to decline significantly, although our focus on multi-national integrated companies helped dampen the decline. We have generally maintained above average cash
positions in client portfolios as we await signs that the market decline has run
its course. This cash not only helped lessen overall portfolio declines, but
gives us the ability to move quickly when buying opportunities present
themselves. As we enter the fourth quarter, we continue to hold meaningful cash
positions in client accounts. During the quarter, our clients’ equity portfolios significantly outperformed the return of the Standard & Poor’s 500. While this achievement is one we are proud of, in a declining market, portfolios still saw valuation losses. We note that our clients who hold balanced portfolios have experienced losses of much less than half the S&P 500 decline due to our asset allocation decisions. Client fixed-income portfolios continued to outperform their benchmarks due to our focus on safe investments in shorter-term U.S. Treasuries, Agencies and high quality municipal bonds. A few of our individual equity holdings showed large swings in price during the quarter, but our determined focus on risk control helped to diminish the volatility of the portfolio as a whole. In closing, we understand these are truly trying times. Your senior investment professionals face the current market environment with an average of 35 years investment experience. We have been through times like this before and have done extensive research on historical declines of this magnitude. Excluding the 1929 bear market which led to the Great Depression, each time we saw a decline of this magnitude, it marked a buying opportunity where meaningful gains were recorded within a few years. We acknowledge how difficult it is to remain rational and calm when the daily news stories lead with negative economic and financial news, but continue to counsel a long-term approach to investing. As always, we continue to maintain a risk-averse strategy with a blend of different investment styles. While this occasionally causes us to modestly lag the equity markets on the way up, it has again served us well during this sharp decline. We remind you of Sir John Templeton's advice to the typical investor: "the only investors who should not diversify are those who are right 100% of the time". We have to be prepared for volatility and protect against it by holding a well-diversified portfolio for the long run. Diversification is what allows you to withstand the downdrafts but also be opportunistic to make changes when the environment calls for action. We will get through this turmoil – the U.S. economy will resume its growth, our leaders will find the correct tonic to stabilize our banking system, and investors will regain confidence in the markets. We advise you to stay the course with your investments. It goes unsaid, but this is a time to return to basics, to live within ones means. It is a time to reduce debt. But most importantly it is a time to continue saving and investing. When the cycle turns - and it will - you will be glad you did. We remain convinced that brighter days for the U.S economy, the financial system, and equity markets in general lie ahead of us. [top] |
home investment team investment strategy market insight contact us
Contact Dumont and Blake
with questions or comments about this web site. |
