January 2009: When Will I Know the Worst Is Over?

January 20, 2009   

Looking Forward

2008 is Over (phew!)

This past year was very “interesting”, but not in a pleasant kind of way.  At its lowest point, on November 20, the Standard & Poor’s 500 stock market index was down more than 50% from just 13 months earlier.  However, by the end of the quarter the stock market had rallied an impressive +20% from the November low point.

Our client portfolios performed better than our benchmark of comparable balanced mutual funds and the stock market.  “Better” in this case was a matter of declining less.  We are grateful for the good relative performance but disappointed in a decline of any size.  We anticipate much better news in the coming year.

When Will I Know the Worst Is Over?

Does anyone really expect to receive a mailgram announcing that the worst of this financial crisis is over or that the stock market has bottomed out?  Of course not.  It will be months after the fact before we can know that the worst is over.  The stock market is a forward looking, anticipating mechanism.  It is a leading indicator that signals a turn in the economy before it takes place.  By the time the reasons for a rising stock market become clear, the stock market will have already advanced higher.

The stock market peaked in October 2007 but it was months later before we could look back and say “that was the top.”   Similarly, it will take months after the stock market reaches the bottom before we can look back and say “that was the bottom.”  The stock market began its descent before the reasons were apparent and it will head higher before the reasons are apparent.  From November 20 through the end of the year (2008), the Standard & Poor’s 500 stock market index rose 20%.  That’s a pretty good step in the right direction and may have signaled the worst is behind us despite an absence of clear reasons.

 “What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.  So if you wait for the robins, spring will be over.”
                       --- Warren Buffett

It will be months after the turning point in the stock market (November 20, 2008?) before you can expect to see tangible evidence of a recovery in the economy, and it will be months after that before it’s acknowledged.  For example, the current recession was underway for a full year before it was officially declared a recession. (The economy officially began a recession thirteen months ago in December 2007.)  You can expect that an economic recovery will also be well under way before the end of the recession is officially acknowledged.

Is the Glass Half Full or Half Empty?

The nature of the media is that they scream bad news and whisper good news.  Everyone knows that bad news sells.  Since there is no shortage of negative media pieces about how bad things are for the economy, how much worse they will become, or how scared everyone should be, let’s look at the opposite side of the picture and recount some of the positive things that are noteworthy:

• The Old and New Administrations are taking unprecedented measures to stabilize the financial system, stimulate the economy, create new jobs and, of greatest importance, restore confidence.  This is exactly what the economy needs to recover.

• The stock market is cheap by historical standards with ample room for potential double digit investment profits for years to come.

• Money Market fund balances are at record high levels.  This is the fuel that will drive stock prices higher.

• Credit markets that were virtually frozen to a standstill after Lehman Brothers bankruptcy last September are once again functioning smoothly (not to be confused with resuming loose lending standards and making bad loans). This is essential for businesses to grow and employment to rise.

• Ultra-low interest rates make stocks a relatively more attractive investment alternative. Interest rates for home mortgages are at their lowest levels in decades (for creditworthy borrowers).  Thirty year fixed mortgages are under 5% with the possibility of rates going even lower to 4½%. The federal government is proactively buying mortgages to drive interest rates lower to make homes more affordable and reduce foreclosures.

• The federal government is pushing lenders to restructure existing loans to avert more foreclosures.  For example, Bank of America modified 230,000 mortgage loans in 2008. Citibank modified 370,000 mortgage loans in 2007-08 to avoid foreclosures and recently announced it will reach out to 500,000 more homeowners to avert additional foreclosures.  Expect more accommodations and concessions from banks that have received federal bail-out money. These are very positive steps toward stabilizing the housing market.

• Many hedge funds have closed down or shrunk their asset bases.  This helps reduce market disruptions caused by hedge fund speculation and forced selling to meet investor withdrawals.

• Oil prices are less than one-third of their levels just six months ago.  Gasoline is under $2.00 a gallon.  The annual savings from the price of gasoline falling from $4.00 per gallon is $300 billion that households that can spend in other ways.  This is the equivalent of a windfall $300 billion stimulus package.

The federal government has made it very clear that they will do whatever is necessary to secure, rebuild and stimulate the economy.

The Home Stretch

“Trust, faith and confidence will prevail over doubt, skepticism and fear.”  
-- Greg Schultz & Bruce Grenke, excerpt from an Open Letter to Our Clients following the September 11, 2001 terrorist attack on the World Trade Center

Take a minute to reflect back on the somber mood and feelings of grave concern that accompanied the tragedy of 9/11.  Those feelings of discouragement and fear gripped our entire nation… but gradually dissipated.  Despite a blanket of doubt, the nation continued onward and life returned to normal.
Today’s fears and concerns from the financial crisis will similarly dissipate over time and the stock market and economy will recover.  The American people’s resilience and their ability to overcome adversity is often underestimated, but will pull us through this crisis just as it has in the past.  Even though the reasons why may not yet be clear, a resolution will emerge.

Neither you nor we can dictate or prescribe the way we would like the world to be.  As investors, each of us must play the hand we are dealt. The coming year will present additional twists and turns along the way. But, that’s always been the case in every year.

We expect more gyrations in the stock market in 2009, but not nearly as wild as the unprecedented volatility of recent months.  On a positive note, keep in mind that gyrating stock prices present fertile opportunities for our mutual fund managers to reallocate monies from bonds and cash to selectively buy stocks at low prices for potentially outsized profits.

The coming year will not be an easy year for investors that lack patience and emotional discipline.  Investors’ resolve to not panic and abandon their long term investment plans will continue to be tested in 2009.  Patience will continue to be a necessity, but the prospect of potentially earning five to ten years of bank interest in just a few months tends to make it worthwhile.  We envision a favorable and profitable outcome in 2009 for investors who are patient and disciplined.

Although no one can guarantee what the future will hold, the greatest returns can come out of periods of the greatest uncertainty, like now.  When investing is emotionally difficult, as it has been the past few months, the returns that follow are most likely to be great. 

Our investment strategy --- based on balance, diversification, moderation and patience --- will guide us through these difficult times.  We cannot promise we will prevail in each and every instance, but we can promise that we will be steadfast in our commitment and unwavering in our resolve to navigate your portfolio to higher levels. Thank you for your continued support, confidence and patience.  ***

Greg Schultz & Bruce Grenke
© 2009 Asset Allocation Advisors, Inc.