February 2008 |
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As investors look over their January statements and reflect back on the ongoing volatility around the world, this article's aim is to look deeper at the anatomy of this market. To begin, it is safe to say that anybody who believes that all things need to be clear in order to invest with confidence will likely find themselves continually chasing their own investment tail. Fear is instructive as well as destructive. Investors need to learn how to discern between the two in order to achieve satisfactory results.
Now, sometimes this "shaking" process is instructive in that it signals a true misalignment of their portfolio's risk with their actual financial position. This kind of fear is entirely healthy at the end of the day.
Before I say more, if fear is gripping you as an investor, immediately talk about it so you can reach a comfort level. Sometimes, fear is an entirely mature reaction and sticking your head in the sand isn't. We can point to examples where avoidance ends up being pretty costly.
However, many investors are illogically tossed about on a lifelong financial roller-coaster ride that exacts a very heavy price. The gyrations of the market alter their decisions and force them to make mistakes - over and over.
These mistakes come in three main forms; (a) they sell good investments at the wrong time and at the wrong price, (b) they pay top dollar for so-called "safe" investments when they are most nervous and finally, (c) they freeze up and fail to take advantage of the markets negative mood by buying the fear of others.
So, with that said, in an effort to present a more concrete analysis of this market, we need to briefly look at the overall economy.
After years of economic growth following the recession in 2001, the primary accelerator of that growth was the housing market. It was fueled by amazingly low interest rates and was followed on by super easy lending standards. Money was easy to get because investors were willing to lend money at any price with little concern of the risks. This always ends and it often ends badly.
This "process of ending" is never comfortable and since July 2007 the stock market has seen violent mood swings as investors assessed the ultimate economic damage. First, the market fell 10% in one month's time and then it gained it back in another month's time. Then, under the weight of more bad news from banks and more worry about the fallout, the stock market fell back 10% by the end of November. All along the way, investors were simply trying to react to the oncoming slowdown in our economy. While wild, all of this is very reasonable.
To complicate matters, the GDP numbers (the main measure of overall economic activity) showed surprisingly strong growth during the July to October period. This data was backward looking no doubt, but it gave pause to the worriers out there. However, the constant drumbeat of bank after bank writing off billions in bad mortgage loans exerted its heavy influence on investors. During this entire period last fall, the Federal Reserve did step in and cut interest rates again and again and then yet again by mid-December. But, they showed hesitation as well.
Finally, the Federal Reserve sent the clear signal in late November that its hesitation to lower rates was waning and that they would cut interest rates again despite inflation worries. This drove the stock market up a good 7% off the second deep swoon from October to late November. Looking back, all in all, from July to mid-December, it was a wild ride with very manageable pain.
But then...January 2008 hit like a wave of worry.
In the first 23 days of 2008, the global stock markets plummeted around 15% across the board. After tacking on losses from the highs set in October, stock markets around the globe were off over 20%.
It was fast and furious with a crescendo of panic on the morning of January 23rd and then...the Federal Reserve jumped in with an emergency interest rate cut and followed that cut one week later with another deep cut that brought rates down 1.25% in that span of only eight days.
This was the most rapid interest rate cut in modern history and represented an "about face" for the Federal Reserve. Up until that point, one could convincingly argue that they were too slow to react to the ongoing credit crisis and were perhaps oblivious to the housing market depression that we see all around us. But, now, nobody can say they aren't reacting.
To top it all off, the US government got into the action and lawmakers are all but putting the finishing touches on an "economic stimulus package" of $150 billion. All of this institutional action constitutes an attempt to at least reduce the depth and duration of an economic slowdown.
So, that is the backdrop and the only thing that matters from an investor's viewpoint is how it affects their portfolios going forward. This is where our analysis of the anatomy of the market comes into play.
Investors' reaction to all of this upheaval and uncertainty is normal and we look to the 1990-91 recession as our guide to the future. It is important to note, no past period is a perfect guide to the future, but we feel 1990 holds some clues.
Like now, the 1990 recession had a banking crisis and a credit crunch, it had international unrest that resulted in rising oil prices and, yes, the housing market was pretty ugly - albeit the current housing market is far, far worse in almost all respects. But, nonetheless, 1990 points to some interesting signals about our current stock market.
Back in October 1990, about four months into the nine month recession, the S&P 500 index of large US stocks was down 15% from its peak. The Russell 2000 index of smaller US stocks was down about 25% from its peak. And, beneath the surface, consumer stocks and bank stocks were down about 25% to 35% from their highs.
By the time the '90 recession ended six months later, both of those beaten down sectors rose 40%. It was a swift recovery and investors who had the conviction to buy and own stocks in the middle of that uncertainty were amply rewarded.
As we look back at our January 23rd, 2008 low point, the S&P 500 was off about 20% from its peak and the Russell 2000 was down about 25%. And, as was the case in 1990, consumer stocks and banks were hardest hit and were down a similar 30% or more. We, once again, see now as one of those times to have the conviction to own these stocks at these prices.
We do acknowledge the worries out there and the entirely unique challenges of our present day economy. We also recognize that no two periods parallel one another perfectly.
This recognition and acknowledgment is to be expected and it does point to a level of humbleness and realism that all managers should have. But, since we are always constrained to operate in the fog of the present, we see the value and wisdom of looking beyond the negativity of now and diligently looking for the guideposts that point to what comes next.
What comes next is what investing is all about.