January 2009: Three Months That Shook the World
It goes without saying, the final quarter of 2008 will be characterized by historians as the worst global economic and financial market crisis since the Great Depression of the early 1930's. The full-year 2008 will stand out as one in which a devastating loss of personal wealth occurred, banking system liquidity exploded, lending standards tightened, the credit markets froze, Wall Street investment firms were forced to become real banks regulated by, and becoming part of, the Federal Reserve System, major bank and corporate bankruptcies were commonplace, and the world's most extensive Ponzi scheme blew up. The table which follows highlights some of the year's statistical debris; take a moment to review each line along with the footnotes. The emotional impact of all that has occurred in the year just ended is, of course, incalculable.
A Dismal Year!
(1/1/08-12/31/08)
| Decline in U.S. Stock Prices | -37% (1) |
| U.S. Stock Price Daily Volatility | ±2.57% (2) |
| Paper Loss in U.S. Stock Market Value | -$6.7 trillion (3) |
| Stock Price Decline in Non-U.S. Developed Country Markets | -43% (4) |
| Stock Price Decline in Emerging (Developing) Country Markets | -53% (5) |
| Oil Prices (from June 2008 peak) | -70% |
| Median Home Prices (Case-Shiller Index) | -20% |
| Jobs Lost | 2.9 million (6) |
| U.S. 3-month Treasury Bill Rate | 0.1 of 1% |
| Increase in U.S. Government-Issued Debt | $1.5 trillion (7) |
| Banks U.S. Government Now Partially Owns | 206 |
- S&P 500 Index
- 225% greater than the average daily standard deviation of past 81 years
- U.S. equity markets alone declined from $17 trillion total capitalization to $10 trillion: Wilshire 5000
- Morgan Stanley Capital International EAFE Index (22 largest Developed Country Markets ex U.S.)
- MSCI Emerging Market Index (36 Developing Countries)
- A decline of 1.9% of the U.S labor force (6th worst contraction since WWII). Total U.S. employment
- remains 143 million; unemployment rate up to 7.2% in December 2008
- Total U.S. Treasury debt as of 11/30/08--$7.8 trillion (60% of annual U.S. GDP)
As is well understood, the result of all this has been a debilitating loss of confidence in the investment markets, prompting a deleveraging of epic proportions throughout the world by institutions and individuals. Alternative investment approaches such as hedge funds (900 of which will have closed their doors during the past 15 months), private equity, or directly owned investment real estate, mostly illiquid and dependent on appraised valuations, have been/will be required to take extraordinary write-offs to reflect diminished market values which auditors will require be marked to market. The impact of this on personal wealth, retirement plan values and non-profit organization operating budgets, has been well chronicled. Harvard University faces an operating deficit of close to $240 million in the current academic year due to a 30% decline in the value of its endowment. Yale, faced with perhaps slightly more severe percentage losses, although on a smaller base, will be confronted with similar diminished cash flow problems.
The origin of all this has been variously identified as "a series of tail events," "the bursting of asset class bubbles," "random reinforcing occurrences," "black swans," and pundits and politicians have taken unlimited license to fashion endless explanations, place blame and second-guess. Those on the firing line (i.e., the Federal Reserve Bank, Treasury Department and other banking industry regulators) have been attempting spontaneous solutions, experimenting in real time, treating the symptoms while also applying palliatives to what appear to be the systemic causes, hoping to buy time while the investment markets and psychological forces play out and realign themselves. But as Ben Stein points out in last Sunday's New York Times, " . . . People with great résumés got us into this . . . and those charged with turning the credit markets around are just human beings who will be attempting to get it right, continuing the trial-and-error approach adopted so far . . ." While it appears the near-term effect of those recent measures was to contain the free-fall nature of the emergency, it is becoming evident it will take longer than expected for the realignment process to run its course.
The Investor's Dilemma
The basis for the world's current dire economic state has been that for very human and convenient political reasons during the past 10± years, at least in the U.S., people have been encouraged to increase leverage, spend beyond their means, and skew their portfolios toward real estate. The question of the moment is how much additional realignment of the economic and financial market equation must take place before reaching a new equilibrium?
Rising investment returns, the perception of ever-increasing personal wealth, as well as, until a few months ago, a media-reinforced sense of material well-being, triggers circuitry in the brain akin to that generated by hallucinogens and substance abuse. The reluctance to take the treatment, apply the breaks, and take pre-emptive action, is understandable. Withdrawal is painful enough; healing requires recognition of the problematic behavior and motivation to alter conduct to avoid repetition in the future. As illustrated in our October "tulipmania" e-mail, the pattern seems fairly consistent in the annals of human behavior and probably defies political remediation unless confronted by a crisis such as what we face today.
As Niall Ferguson, author of The Ascent of Money, says, ". . . Western financial models (e.g., Wall Street's financial engineering) have spread throughout the world, most projecting deceptively precise outcomes." Individuals, financial intermediaries and fiduciaries were lulled into a false sense of risk control by the exactness of these quantitative designs. The reality, of course, is that financial markets deal in random events and inexact futures daily, continually attempting to discount uncertainty (risk) in a dynamic probabilistic context. Looking back, the trap has been, as one probably should have anticipated, that all these financially engineered vehicles (computerized hedging techniques, quantitative stock trading models, etc.), have been based on historical statistical data, derived from periods when the global financial system was relatively unleveraged.
Even today we continue to make assumptions about the future based on our knowledge of the recent past and are no doubt probably over-confident of our assessment of present conditions, an approach quite consistent with patterns identified by academics in the field of behavioral finance. However, our current frame of reference, driven by the expanded magnitude of the numbers we are now required to deal with daily, has called into question many comfortable benchmarks, and a number of established norms seem discredited. Having borrowed excessively and overspent since the millennium, we are now told by government fiscal policymakers that we must spend our way out of what feels like an economic black hole. The orthodoxy of balanced federal budgets (an oxymoron of the first order) has quickly given way to the now quite acceptable political expediency of massive amounts of deficit spending to save/create jobs. At times of financial market stress like this, political contrivance, it seems, has trumped reasoned discourse.
Seeking the Way Out
When so much of today's financial market malaise is traceable to a lack of confidence in the efficacy of the markets themselves, what can investors do to rebuild their portfolios and improve their chances to benefit from the rebound which will eventually occur? When prospecting for an easy way to recoup, one first needs to summon the discipline to keep going, stay with the program. While media headlines trumpet "A New Way to Deal with Diminished Portfolios," "New Funds for the Turnaround," "Positioning Your Portfolio for a Rebound," etc., the instinct is to discover some unique approach to repair the damage. What seems like the antithesis of common sense at the moment remains the best course for most individual investors (i.e., following a diversified asset class and market sector equity-oriented balanced portfolio strategy).
In our view, for individuals, common stocks accessed through no-load mutual funds remain the best practical approach to building (rebuilding) wealth. A strategically balanced asset class mix, including a portion in fixed income securities, offers the most practical chance of regaining lost ground. Passive equity market funds continue to deserve a major representation in most client portfolios. In 2008, according to Jack Bogle, founder of the Vanguard Group, low-cost, low-turnover, S&P 500 index funds outperformed nearly 70% of all equity funds; bond index funds outpaced more than 80% of all taxable bond funds. A judicious, intelligent mix of actively managed and passive fund strategies periodically rebalanced still seems the desirable structure.
If the above strikes the reader as an exhortation to return to fundamentals, it may be just that. This is not the time to try newly packaged financial innovations. Facing what has happened during the latter part of 2008 is the first step toward recovery. For taxable accounts, the year-end tax loss realization programs, warehousing write-offs against potential future capital gains, we realize is small recompense for the paper losses incurred. But that process also facilitated the reorganization of a number of the actively managed U.S. small company, international large cap and emerging market fund holdings, strengthening the chances for a solid rebound in values once equity market psychology improves.
In the meantime, however, the economic and financial market news promises to continue depressing. The recession will seem endless and deeper than past downturns. The investment markets could be tested by other unexpected geopolitical events. But at the moment the markets (not yet the economy) seem to be in a bottoming process, stock valuations are at very reasonable levels, and the selling pressures should be abating soon. As the tone of the news begins to impress one as less negative, rather than a noticeable shift to unbridled optimism, the financial markets will begin to anticipate the shift back toward economic normalcy.
As ever, please feel free to call or comment by e-mail; we will be happy to respond.
Sincerely,
James L. Joslin
Chairman, CEO