As challenging as the second quarter of 2008 was, it was a walk in the park compared to what followed — the demise of the investment banking industry as we knew it, the failure of Lehman Brothers, government takeovers of Freddie Mac and Fannie Mae and AIG, shotgun mergers aimed to rescue large companies such as Wachovia and Washington Mutual, the locking up the global credit market, and a $700 billion government “bailout” that has received as much condemnation as praise. And all of this occurred in the space of a couple of weeks.
Could we have imagined that within three short months, the market’s concern would have shifted so dramatically from energy prices, the threat of 1970’s style inflation, a weak dollar and a tepid equity market to a seizing up the global credit markets, deflation, woozy bank balance sheets and a sharp decline in all markets?
Even now, the outlook is clouded by uncertainty. The government rescue plan may have addressed one important facet of the current crisis (mortgage securities), but has done little to help the root cause of most of the current problems – falling house prices. We are not convinced that the government should be the source of all solutions to economic and market problems, but we concede that something needed to be done to restore some level of confidence in the banking system. Without bank loans, much of the world’s developed economies cease to function. Money is the blood of capitalism and the banking system is its heart.
So how can investors cope with all of the turmoil in the markets and the uncertainty about the outlook?
Instead of invoking the usual bromides from the likes of Warren Buffett or Alan Greenspan, we will look to the time-tested wisdom of Victor Fleming. Most people will not find his name among the pantheon of great investment minds, because he was not a famous investor. He was a movie director. Although Gone With the Wind may be his greatest work, it is his 1939 immortal classic The Wizard of Oz to which we will look for inspiration and guidance.
Over the Rainbow
No doubt many investors feel much like Dorothy Gale (portrayed by Judy Garland) as she sang the award-winning song “Somewhere Over the Rainbow.” Kansas was in depression. The dust, drudgery of everyday life and sepia drabness only added to Dorothy’s personal depression. She felt like no one understood her, and when her dear pet, Toto, was threatened to be taken from her, she decided to run away. The song was her cry and hope for going to some better place.
Do we not wish to be somewhere else? Perhaps we can imagine a better circumstance for the market and the U.S. economy, but the pathway to this better place may be hard to see. In a recent poll, 60% of those surveyed thought the U.S. could enter a new depression, 1930’s style. Is not this really a cry for help? The reality is that the U.S. economy has been remarkably resilient in the face of major shocks and relentless waves of crisis after crisis. GDP growth has been positive for the first three quarters of the year. The unemployment rate, although at a high point for this cycle, remains well below the norm for most recessions and the positive impact of lower oil and commodity prices have yet to be seen. Many credible economists now expect negative GDP growth in the fourth quarter of 2008 and first quarter of 2009 and that the recession will be “normal” by most measures. If the recession occurs in line with this forecast, we think it is likely that the US stock market will do what it usually does in recessions – find its bottom. We expect that by the end of the first quarter of 2009, we could all find ourselves in a much better place.
I’ve a Feeling We’re Not in Kansas Anymore
As if in a direct answer to her plea, Dorothy is transported to another place, but not necessarily a better place. In this colorful new place (Oz), Dorothy finds herself 1) surrounded by unusual characters (munchkins and witches) who say things that mostly confuse her; 2) accused of a crime (witchicide?) that was totally beyond her control and 3) unable to get back home. She quickly discovers that “different” is not always “better.” Investors were not transported to a strange new place in a whirlwind, but the markets are clearly reeling from gale-force powers, which seem far beyond anyone’s control. In this strange place, they hear a cacophony of voices, which, in frenzied tones, tell them totally conflicting things (Jim Cramer – “Sell, sell, sell” or Warren Buffett – “Buy, buy, buy”). A strange “blame mentality” has emerged so that whenever the investors lose money, the implication is that something illegal has happened. And then there are the voices telling us in dire tones, we can never go home. The market will never recover and U.S. capitalism is dead. Of course, this too is fantasy. Any student of the U.S. capital market and economic history can point to past events that pushed the economy and the markets to their limits, but failed to break them. As unfamiliar as the current situation may feel, we can be comforted, to some degree, that people with the most market experience continue to urge investors to stick with their long-term investment plans.
Over the last few weeks, we have spoken to a large number of mutual fund portfolio managers. When we asked them what they were doing to cope with the current situation, they each replied in similar fashion – “nothing different, we are just doing what we always do.” Some were concerned about how their investors may react, but none of them seemed particularly worried about the market. They all understand that the equity market represents the best source of long-term returns.
And Your Little Dog Too
When the Wicked Witch of the West (played by Margaret Hamilton) discovers that Dorothy has killed her sister, the Wicked Witch of the East, she swears vengeance on Dorothy and her dear pet dog Toto as well. Interestingly, even in this new place far from Kansas, Dorothy finds herself once again facing the threat that made her run in the first place – danger to Toto. The parallel we wish to draw here is that this market has depressed nearly all asset classes – diversification has not been helpful in that all major equity markets have declined, as have all bond markets (except for Treasuries). This too is very unusual. Bonds and stocks rarely move in tandem, and this phenomenon provides evidence of the extraordinary strain on capital markets at this point in time.
To reference this, we have listed the results for the past quarter, year to date and past twelve months for the various asset classes:
|Index||3rd Qtr 2008||Year to Date||Trailing 12 Months|
|Dow Jones Industrial Average||-4.35%||-28.76%||-32.83%|
|MSCI EAFE Small Cap*||-20.63%||-43.90%||-44.49%|
|MSCI Emerging Markets||-22.71%||-47.40%||-48.64%|
|Lehman Aggregate Bond||-1.08%||-4.69%||-2.77%|
|Lehman Municipal Bond||-4.84%||-10.31%||-6.32%|
|Dow Jones AIG Commodities||-28.00%||-17.56%||-10.46%|
|D*Data begins December 13th, 2007|
If I Only Had a Brain
Dorothy is able to find a glimmer of hope when she learns about the great Wizard of Oz, who may help her to return home. Along the way, she meets up with other characters, each of whom has a unique problem. Dorothy convinces them that the Wizard may be able to help them as well. We all know how the story ends; each of these characters was never really deficient in the ways they thought they were. The Tin Man was compassionate, the Lion was courageous and the Scarecrow was wise if not outright smart. (How smart was he? Smart enough to say, “But some people without brains do a lot of talking, don’t they?”) They all just needed some positive outside reinforcement to recognize this fact.
So it is with today’s investors. In these challenging times, it becomes easy to second guess long-held, battle-tested investment philosophies (diversification or overseas investing) when they appear to not be working well for a quarter or two. In his book “Your Money and Your Brain: How The New Science of Neuroeconomics Can Help Make You Rich,” Jason Zweig shows how the feral, compulsive part of the brain often controls our thoughts and actions about investing. Instead of the cool, calculated conclusions one would expect from the cognitive part of our grey matter, we often get the impulsive “fight or flight” reflex from the reactive part of our primitive brain. This is perhaps why when we know (left brain) that we should maintain our long-term investment plan, another part of us (right brain) wants to sell after the market goes down 30%.
Lions and Tigers and Bears! Oh My!
On the way to meet the Wizard, Dorothy and her companions find themselves unexpectedly in the middle of a dark forest. They then begin to imagine the kinds of scary creatures that might inhabit the forest. Soon, they find themselves in a state of near-panic just by thinking about the dangers they might encounter. When they finally run into a real lion (Bert Lahr), they discover that the fear of the unknown was actually scarier than meeting the creature face to face. The current bear market may have sharper teeth and claws than Lahr’s character, but we have seen fear of the unseen become a powerful worry in the markets. This fear often manifests itself with the words, “What if…” What if the bailout plan doesn’t work? What if more banks fail? What if the equity market never recovers? And so on. We would posit that any dire “what if” scenario without some notion of probability or reason for the “what if” to happen, is similar to exclaiming “Oh My!” in a scary forest.
This is another manifestation of what we like to call “analysis by extrapolation,” which is simply observing an obvious trend and then concluding the trend must continue in its current direction to some distant end. We saw this earlier this summer when as oil prices reached $140/barrel, many market observers began to “forecast” oil moving as high as $200 or $250/barrel. We saw this in the late 1990s, when everyone began to assume that all tech stocks (and the market by extrapolation) could only go up. We are now seeing something like the mirror image of the tech bubble. These days, some people are beginning to think that the equity market can only go down. This is no more likely than the idea that tech stocks could only go up before Y2K. We continue to believe that the four scariest words in investing are “it’s different this time.”
Follow The Yellow Brick Road
Despite all the challenges along the way, Dorothy was able to finally reach her goal of meeting the Wizard of Oz by following the very simple bit of advice given to her when she began her journey – “Follow the Yellowbrick Road.” For our clients, their “Yellow Brick Road” is the investment plan we put together when we became your investment advisor. We spent time discussing your needs, wants and expectations about the markets, as well as your appetite for risk. We took into account your income needs, if any, and put together an investment plan that included an optimal asset allocation to meet your unique needs and situation.
As we proceed on our journey together on the “Yellow Brick Road” to your financial goals, we have encountered some unexpected detours and roadblocks that have prevented the path from being the well-paved super highway we would have preferred. This is not unusual. The capital markets will, from time to time, display this kind of unexpected volatility, and bear markets and recession will occur. The real question is “Has anything material changed?” We think that the pathway we constructed with you to your financial goals remains the same. The expected long-term returns for each major asset class remain the same. Our founding philosophies of diversification and value investing remain the same.
We wish we could wave our magic wand and make the uncertainty, pressure and stress go away. We wish we could make the policy makers in Washington smarter and more articulate. We wish we could go back in time and prevent people from making the bad decisions that led us here. But, alas, our magical powers are limited to a few card tricks. What we do have is a clear long-term vision of what the global economy will look like in the years to follow this one and how great the returns from the stock markets will be when we return to trend line growth. Until then we remain engaged, vigilant and ever searching for the next great stock or fund to include in our clients’ portfolios.
Your current portfolio holdings are listed in the enclosed Quarterly Portfolio Statement and your portfolio’s rates of return for the most recent quarter, year-to-date and past twelve months can be found in the Portfolio Performance Summary.
RDL Financial, L.C.