Thursday, January 22, 2009

"The Worst Quarter Since 1931" - Q4 2008 Commentary

The tremors that began over a year and a half ago in the mortgage market came to fruition in the stock and bond markets this past fall. The fourth quarter of 2008 was the worst quarter for the stock market in the 308 calendar quarters since 1931. Diversification, that friend of investors through thick or thin, did little to avert the damage. Even uncorrelated investments moved lockstep in one direction: down.

During the quarter, panicked investors fled any investment perceived to have risk. Prices of stocks and corporate bonds, under more pressure from sellers than from buyers, dropped to valuation levels not seen in decades. By November, under the weight of perpetual political campaigns, shorter days, and longer lists of bailouts, investor panic heightened. An index that tracks stock price volatility reached a new high last quarter, a level not seen since October 1987. Even money market funds were perceived as risky.

And then, at 8:30 am on December 11th, two weeks before Christmas, the world was stunned by the news of the arrest of Bernard L. Madoff on charges of running the largest investor fraud ever committed by a single individual. “The Madoff affair,” wrote Thomas L. Friedman, “is the cherry on top of a national breakdown in financial propriety, regulations and common sense.”

So if you’re looking for the recipe for that pit in the stomach of the average investor, it goes something like this: add once in a lifetime stock and bond market losses, throw in an investor scam of mammoth proportions, mix it with unprecedented government intervention, add a dash of a bleak economic outlook and a pinch of bank failures, top it all off with a depressed housing market and serve it up on CNBC. That’s more than enough to make us sick, and we haven’t even discussed foreign markets yet!

Given all that has transpired we keep going back to the basics, our research, and our calculators. At the forefront of our research we remember that in the best and worst of economic times emotions, not fundamentals, determine stock market prices. In contrast, during ordinary times, the underlying business values determine stock market prices.

What’s an investor to do? Follow his heart? By no means! Regular readers of this commentary know that we often write about our admiration for Warren Buffett. His investment approach has proven successful in good markets and in bad. He recently made headlines for writing an essay in the New York Times encouraging investors to “Buy American.” He said:

“The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So ... I’ve been buying American stocks.”
Buffett is no cheerleader. A dispassionate investor whose primary job is allocating capital, Buffett has made serious comments about the market only four times in his career. The chart below demonstrates both his ability and his patience.

We agree with Buffett. We have seen businesses selling for less than the cash in the company – yet there are few buyers because buyers are fearful. When Wachovia Bank, an institution that did not close during the great depression, teeters on the brink of collapse and virtually eliminates their cash dividend, it’s hard to know whom or what to trust.

World governments have taken steps to improve liquidity and credit markets are beginning to function rationally. There is evidence the crisis is beginning to subside but the financial system is still fragile and the economic news is likely to be pretty grim for the next few quarters.

The question we have to answer is this: do we have the time horizon and patience necessary to hold a company’s stock until that company’s value is realized? When stock prices move up or down 25% in one day or even several days, it’s quite apparent that underlying business values aren’t driving those price changes; confused people are driving those price changes. At some point, panic will subside and investors will begin (again) to pay attention to asset values, and when they do, share prices will adjust. So far in 2009 we’ve already seen a number of stocks that have risen over 75% in just the first three trading days. This is a sign that panic is subsiding.

Going forward, we’re keeping in front of us the words of Nick Murray:

“Less than 5% of an investor’s lifetime total return will come from what his investments did versus other, similar investments. The other 95% will come from how the investor behaved, and the primary determinant of that behavior will be the quality of advice he got, or didn't get.”
We take seriously our responsibility to our clients and our responsibility for how we behave in the midst of a period of tumult. All of our research, experience, and instinct tell us that today is a day to be invested and not sitting on the sidelines. As Mr. Buffett said in the same op-ed piece, “A simple rule dictates my buying, be fearful when others are greedy, and be greedy when others are fearful.”

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