October 2009: Climbing a Wall of Worry

Open Client Meeting Review: October 2009

Climbing A Wall of Worry

The old adage about the stock market “climbing a wall of worry” couldn’t be truer than it is now. Today’s economy and financial markets are fraught with worries and apprehensions.  After all, the memories of last year’s financial crisis and resultant financial market meltdown are still painfully close at hand.  This is the norm, not the exception.  New bull markets arise before the problems that led to the stock market’s decline vanish.  Think of it this way --- if the problems didn’t exist, there wouldn’t have been a decline.  So, it’s not surprising that a reversal takes place before yesterday’s worries have cleared.

Market Math: Declines & Recoveries

The Standard and Poor’s 500 stock market index rose dramatically the past two quarters, gaining 34%.  (Note: The S&P 500 is up 56% since the March 9, 2009 low).  Our accounts, of course, are not invested entirely in stocks.  Therefore, our portfolios are not as greatly influenced by the rise and fall of the stock market.  We favor a balanced investment strategy, investing in mutual funds holding a broadly diversified mix of stocks, bonds and cash.  Nonetheless, the favorable impact of a rising stock market during the past six months helped us, too.  But, there’s a bit more to the story.

Earlier losses in the stock market were so substantial that a 56% gain since March 9th has only recouped a little more than half of the 57% decline that started nearly two years ago when the market peaked on October 9, 2007.

The Ugly Math of Market Declines

It takes a geometrically larger percentage gain to offset a percentage loss.  For example, a decline of 10% requires a gain of 11% to break even, a 20% decline requires a 25% advance, and a 33% decline requires a 50% increase.  A 57% decline (like the S&P 500 stock market decline from October 9, 2007 through March 9, 2009) requires a gain of 131% to get back to even.

The Standard & Poor’s 500 stock market index recently posted its best six month gain in over 30 years (March through August: +40.5%). Yet, notwithstanding this eye-popping six month surge, the stock market still trailed our typical managed portfolio for the prior twelve month period.  Recent outsized stock market gains, while impressive, were not enough to offset prior stock market declines from last fall and earlier this year.

When the stock market declined precipitously, our managed accounts, with stock allocations of only about 50-55%, held up much better than the stock market.  Conversely, our accounts did not rise as much as the stock market since March, either.  That’s no surprise.  It was a trade-off we willingly made – go down less in a declining stock market, and go up less in a rising market. The net effect is our typical managed account (income and dividends reinvested, with no distributions) is within striking distance of regaining the same value as when the stock market peaked two years ago.  The stock market has another 48% to go to get there.

Obviously, if and when that occurs can’t be guaranteed, but account values look a lot better today than just six short months ago.

Value vs. Growth

We and the mutual fund managers we have selected on your behalf mostly favor a value-oriented investment style over a growth-oriented investment style.  A value-oriented investment style seeks stocks believed to be priced below their intrinsic worth with the potential for gains if and when their worth is recognized in the marketplace.  A growth-oriented investment style seeks stocks believed to increase factors such as sales and earnings beyond consensus expectations, hopefully causing their prices to rise.

In the first nine months of this year, the overall U.S. market climbed 21%.  But, there’s more to it than that. Breaking it down between value and growth, value stocks rose 14% while growth stocks increased 32%. The more an investor relied upon value this year, the more their stocks lagged behind the return of the overall stock market.  That was our case.

We have always had a bias toward value investing and have no regrets for doing so this year, despite this year’s performance difference.  Value out-performed growth in seven of the past ten years (1999 through 2008), but not for the first nine months of 2009.  Keep in mind that neither growth nor value consistently out-performs the other year in and year out.  It’s expected that one style may lag the other significantly in any given year.  Our viewpoint, however, is that value investing appeals to our common sense and core beliefs --- it’s the equivalent of comparison shopping and buying merchandise when it’s on sale.  It just makes good sense.

The Process Continues

Investing is like tending to a garden; it’s an endless process.  You can’t forget about it, leave it unattended and expect it will be at its best.  It’s a continuous work in progress.  We constantly strive to improve our investment methods and tactics, learning from our experiences, increasing our knowledge and refining our judgment.

We are gratified that since revamping our investment strategy in 2004 our typical client portfolio outpaced our balanced mutual fund benchmark in 2005, 2006, 2007 and 2008.  We are also pleased that despite trailing our benchmark this year, we have still enjoyed an advantage over a longer term.

No one can reliably foretell what investment markets will do in the future.  However, we can find reassurance in the fact that the cornerstones of our investment strategy --- balance, diversification, moderation and patience --- offer a rational investment path that makes sense, meets the standards of a sound investment plan, and helped guide us through the most challenging stock market in decades.

Thank You

The past year has been very trying for investors.  We appreciate you and your business.  We are thankful for the trust and confidence you have placed in us, and especially grateful for the loyalty our clients have shown us during these difficult times.  Thank you. ***

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