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First Quarter 2008 Quarterly Newsletter

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Bombs Away

By the time you see the flash and mushroom cloud, it’s probably too late to run from an atom bomb. Recessions and bear markets aren’t much different. When you realize you are actually in one, the damage is already done. By that time, you are undoubtedly closer to the bottom, and it is historically a good time to be in the market.

Bear markets are defined as 20% retracements from market highs. Using that formula, the broad U.S. market has not quite become an official bear as of the end of the quarter. However, that does not alleviate the unpleasantness of watching the monthly declines on your account statement. The first quarter of 2008 was the worst in the last 5 ½ years. After hitting a market high last October, virtually every month has been down.

The only thing worse than the stock market has been the news that has accompanied it. The bloodletting of the over-inflated US single family housing market, the frozen-credit mess that started with unregulated sub-prime mortgages, the continuing war in Iraq, the all time highs in precious metals and grains and oil, and lows in the dollar -- all have reasonable people considering giving up on their lives and joining a motorcycle gang, or monastery…or both.

But before you get too carried away, it is important to use some perspective whenever downside volatility gets a bit scary. Bear markets and recessions are normal occurrences. Periods of economic contraction, and market pullbacks, have occurred with frequency in all decades of the last century. It is a normal part of an economic cycle. All those excellent average annual equity returns you have read about over the last 30 and 50 and 70 years have included these ugly periods in their calculations. See the chart below showing all the 15% or greater market retracements from highs over the last 50 years:

As you can see, bull markets typically are longer in duration, and their gains typically dwarf the pullbacks of a bear. Our current market drop, on average, is certainly not an extreme one compared with the entire group.

Investors must understand that the only way they can be certain to receive the generous long term returns offered by equities is by owning them through the entire cycle. Why the entire cycle? It’s because the easiest returns (defined as the highest returns over the shortest period of time) are typically enjoyed in the first part of a new bull cycle. The only way to be fully invested at the start of the new bull is to be fully invested at the end of the bear. Even in the worst of bear markets, if the investor can patiently hold a diversified portfolio, they will find that their annualized return over a few year time period will be very satisfactory. Adding the sophisticated diversification found in a WAG’s Modern Portfolio Theory portfolios, you can realize even greater risk dampening and upside potential compared with merely the S&P 500 returns shown above.

Want proof? The chart below shows the month to month performance of the S&P 500 from the inception of the three most recent severe bear markets over a five-year period of time. To the right, it shows the five-year annualized return of those same periods for diversified, Modern Portfolio Theory portfolios that are 100% Equity, 60/40 Equity/Income, and 100% Income. Note all those red months. Even so, you can see that the five-year annualized returns for diversified portfolios, even in the toughest bear markets, have produced very respectable returns in each of the periods shown. Imagine how great the returns were for periods that did not include a bad bear market.

Lastly, the skeptics out there may say all this historical stuff is fine, but “THIS TIME IT’S DIFFERENT!!” But every bear market is different. Each severe bear has causes which are uniquely, and fearfully, its own. For instance, in the 1973-74 bear, we had the Nixon Wage and Price controls, skyrocketing inflation and odd-even gas lines. In the 1987 crash, we had the fear and prediction that derivatives and program trading were going to end the market as we knew it. In the 2000-02 bear, we had a backdrop of extraordinary market valuation -- a high tech/dot.com craze whereby the NASDAQ 100 index returned more than 500% in five years, only to fall nearly 80% by the time it hit bottom. In each example, investors thought the facts were very different from previous bear markets, and many believed that capitalism and the free market enterprise system might not be able to continue in this country.

The credit crunch, and its implications in the global financial system, is clearly the most unique problem facing the financial markets today, and its ramifications cannot be dismissed. However, rarely has a global problem been attacked head-on with such a unified force. All US government and business leaders have jumped into this issue with both feet, and both fists full of money. The Federal Reserve is putting its considerable power (and cash) where its mouth is, and is being as creative as it ever has been. The U.S. Treasury, the President and the Legislature have jumped on the bandwagon and are doing all they can to stimulate the economy (with taxpayer money, of course). Foreign governments are also pitching in by dovetailing their fiscal and monetary policies. The reason for all this camaraderie is simple – it is in everyone’s best interest to solve the credit crisis as quickly as possible. With the exception of Osama bin Laden, that North Korean leader with the bad haircut, and the two Castro brothers, just about everyone else on earth wants to see this problem solved. And it will be. So hunker down, stay disciplined, keep your long-term perspective, and soon you’ll be able to climb out of your bunker and enjoy the long term returns of equity investing.

First Quarter 2008 Asset Class Return

Needless to say, the quarter was a tough one. With a few exceptions, domestic stocks were whacked fairly evenly. Small Internationals out performed Large, and Value on both sides of the ocean did slightly better than Growth, reversing a year long trend. If you are looking for any positive signs, you may be able to find it in Real Estate. With all the negative news regarding real estate, many investors are surprised to find that it had a positive return for the quarter, and more impressively was up over 6% in the month of March. You may remember that Real Estate led the market downturn, starting early in 2007. The fact that it has bounced back could be evidence that the worst might be over for that asset class, and others as well. Also, Small Caps no longer appear to be leading the way down, and consequently could also point to a crescendo stage of this pullback.

Obviously, it is foolish to make too much out of any particular quarterly number. It will be interesting to see if the normal 6 to 12 month lag time is needed for the economic stimulating and credit loosening actions of the Treasury and Federal Reserve to take effect. Just remember that the stock market discounts all news, and most often bottoms well before the economic news does. As always, your Quarterly Performance Report accompanies this letter. If we have managed your portfolio for less than three months, you will receive a partial report, and a complete one will follow next quarter. The second quarter of the year promises more beauty, if not in our portfolios, then at least in the garden. Get outside and enjoy it.


Frederick F. Kramer IV, JD
Chief Investment Officer