I've had relatively little to say about markets since late early-to-mid March, mostly because rising markets - which almost all global markets have been since March 9th - tend to need little commentary to accompany then. However, given that this week marked the one-year anniversary of the failure of Lehman Brothers and the ensuing onset of a near panic in financial markets, I thought it might be worth a look at where we are today and where we've been over the last year or two.
Equity Prices and Returns
The last two years have been painfully difficult for most investors globally. Regardless of whether you owned equities, real estate, or commodities, all have had a very difficult stretch with peak-to-trough decreases of up to 60% or more for equities, 75% for oil and some other commodities, and 10% to 50% for real estate. Because of the asymmetrical nature of losses and gains, that still leaves global equities down 31% from their October '07 peak and 9% below where we were pre-Lehman (September 12th of last year), as of today's date. The good news on the price front is that equities have recovered substantially from their March lows, with gains of about 50% for the S&P 500 and 70% for some emerging markets . The Dow Jones Global Total Stock Market Index[1,2] is up 66% from its March 9th low, and, as I write this, is about even with its fall 2006 pricing level.
A significant part of this downturn has been due to a bank/lending crisis caused by bad housing loans, and the resulting slow down in credit has played a significant part in causing the crisis. Compounding the effect was a catastrophic drop in consumer confidence due to a decrease in housing and equity values, and this loss of confidence led to yet further deterioration in the economy. Although I don't necessarily agree with every action by the Fed and the government, the overall response has been remarkably effective and credit market indicators have generally reflected that since March of this year, with many of those indicators having returned to normal or close-to-normal levels.
US Gross Domestic Product (GDP), a measure of total US economic activity, shrunk almost 4% from peak-to-trough, assuming that the 2nd quarter of this year was the trough, which is seeming more likely by the day based on the continuing economic data. That's a far cry from the 10% sustained decrease necessary to be officially classified as a "depression" and a further cry still from the 30% or so that GDP shrunk in the early 1930s. However, this 4% drop in GDP - and the sharp rise in unemployment - still ranks it as one of the worst recessions since World War II, with only the post-WW2 downturn and the 1981-82 recessions rivaling it.
That said, the economic data coming out over the last several months has been almost uniformly better than anticipated, and tends to indicate that we are probably at a trough in terms of housing prices and economic activity. The Fed's Beige Book, released September 9th, would seem to confirm this reading, although it's likely that unemployment will continue to rise as it is typically a lagging, not leading, indicator during and following recessions.
Commercial real estate appears to be in the early-to-mid stages of its own downturn, and the effect of this on the bank and credit system remains to be seen, but this is not a new fact and you have to imagine, to some degree, that that is already factored into market prices. To be fair, though, I would have expected that same thing last August with respect to the housing crisis. However, a big part of last fall's panic was due to the unexpected collapse of Lehman Brothers and the possible collapse of others in the aftermath of Lehman. In hindsight, had Lehman not been allowed to fail, I think the collapse in confidence would have been substantially attenuated and with it the market downturn. Because of that experience, and because of the government's implicit promise to not allow other large, too-big-to-fail institutions to go under, I would be surprised to see a collapse in confidence due to commercial real estate comparable to anything we saw last fall.
One of the issues that has come up in several client conversations of late has been the risk of inflation given the government's current monetary policy. Two things are likely required for inflation to manifest itself in any meaningful way. First, the Fed will have to leave that money in circulation long enough for it to end up in the hands of consumers, and so far, most of it hasn't. Secondly, we'll have to see a substantial pick-up in economic activity - all of that "easy money" will have to end up chasing goods and services before we're likely to see a substantial price rise. However, while there is a risk of inflation with the Fed's approach, Fed Chairman Ben Bernanke has made it clear that the Fed does have an exit plan and intends to withdraw the excess liquidity at the earliest signs of inflationary pressures. That said, I think it's a difficult balancing act between encouraging growth and stifling inflation, and if we have learned anything from the last decade or so, it's that the Fed does NOT have a perfect crystal ball either.
In any case, there is a risk of inflation, but for the reasons I outlined above (and a few others which I didn't), I think it's likely a few years off. If you'd like to talk about inflation hedging strategies now, though, we can certainly do so.
Given the continuing news of improving economic conditions, it is likely that the recession, as officially defined, is at or near an end. As I said above, this would seem to be confirmed by the Fed's Beige Book report published last week. I also tend to agree with the forecasters who think that any recovery is likely to be a slow moving one and that hamstrung consumers, tighter lending standers, and hopefully a return to more prudence in general will yield the possibility, if not probability, of slower growth for a time to come.
On the equity side, given the extremely strong run-up in equity prices both here and abroad over the last five or six months - and much of that based on the anticipation of better news in advance of that actual news, I would not be the least bit surprised to see the markets cool off, or even retreat a bit, as investors wait for the economic data to catch up to the markets. Seeing the markets move 20% either way should never be a surprise. At the same time, I think that the lows we saw in the fall and in March of this year were panic-induced and largely reflected the fear of another depression far worse than the reality we've actually seen. If that's the case, I'd be surprised to see the market deteriorate to those levels again, although there are those who think that a possibility.
On Staying Invested
As I write this, the markets - both here and abroad - are about back to where they were late last September, just as the panic of 2008-09 was really getting underway. Although the period from late September/early October of last year through early March of this year was horrendously volatile, the major US equity indexes (S&P 500, DJIA) and the Dow Global Equity Total Stock Market indexes are all above where they were early last October, before the fateful week of October 6th. Although it's been a volatile year, there has been something to be said for staying put and not panic-selling out at a low point. Many who did sell out have since had a tough time identifying just the right time to get back in and have missed the substantial recovery of the last six months.
On the Predictability of the Crisis and the Markets
There has been much discussion in the financial press about just how predictable the events of last fall and early this spring were, and how actionable such predictions might have been for investors. More broadly, the question is this: how much confidence should we have in predictions in general?
My last car had a warning permanently etched on the driver's side door mirror. It said, "Objects may be closer than they appear." There's a somewhat similar and well-documented effect in behavioral finance (and in psychology in general) called the "Hindsight Bias." Hindsight bias is the tendency to remember our predictions of future events as having been stronger than they actually were, but only in those cases where those predictions turn out to have been correct. In other words, we give ourselves credit for having been more certain about our predictions when, in hindsight, those predictions were accurate. Conversely, we tend to retroactively discount the strength of our predictions when those predictions turn out to have been wrong. There's a fair amount of this going on right now.
Had it been crystal clear to all, or even most, market participants, say, last summer that things were going get as bad as they did, everyone would have panicked last summer, not last fall and winter. Much of the panic selling started when Lehman went under last September, which was not a foregone conclusion, and accelerated when the US House of Representatives voted down the $700 billion bailout later that same month, which was also not a foregone conclusion.
But what about the Cassandras who did predict the crisis? (Nouriel Roubini, CNBC's new favorite perma-bear comes to mind, as does EuroPacific's Peter Schiff, both of whom astutely predicted the structure and severity of the crisis.) Since Nouriel Roubini doesn't manage money for a living and avoided making specific investment recommendations, let's look at Peter Schiff's record, who does manage money and who made his thoughts well known in his 2007 book, Crash Proof: How to Profit From the Coming Economic Collapse. This certainly sounds promising, even in hindsight.
As Dougal Williams, a Chartered Financial Analyst, wrote in his August 18th Advisor Perspectives commentary:
"[Schiff] recommended investors pile into gold, commodities and high-dividend paying foreign stocks. As conditions in the U.S. economy and the markets deteriorated, his predictions brought him fame as an economic guru who could help shelter investors from the storm. Nervous investors poured money into accounts with Schiff's firm.
Sadly, for investors hoping to profit from Schiff's advice, 2008 made mincemeat of their portfolios. Many Euro Pacific customers attested to losing 50% or more, much worse than the 37% drop in the U.S. market. This was due, in part, to Schiff's expectation that the weakening U.S. economy would cause the U.S. dollar to depreciate rapidly, providing an extra boost to shares of international investments. Instead, the dollar advanced, magnifying the already steep losses in the international markets into which Schiff so aggressively steered his clients."
But what about the gurus who had a demonstrated and stellar track record? How much confidence should we have in their predictions? Had I posed this back in the '80s, many would have pointed to Joe Granville.
As Harold Evensky wrote in his August 2009 Financial Advisor article Maybe MPT Isn't Dead:
"What, you haven't heard of Joe Granville? Until the late '80s, he was the market guru. Like many gurus, he had absolute confidence in his crystal ball. According to Robert Shiller in the book Irrational Exuberance, Granville was quoted by Time magazine as saying, "I don't think that I will ever make a serious mistake in the stock market for the rest of my life," and he predicted that he would win the Nobel economics prize. In 1981, when he was grossing $6 million a year for his newsletter advice, his two-word "sell everything" warning to his subscribers triggered a massive market sell-off with a record number of shares trading around the globe.
Just before the 1987 crash, he again warned of a market disaster. He was obviously correct on that call and his picture was on the cover of major magazines and papers around the world.
Maybe you haven't heard of him because his crystal ball, like others, had flaws. A few years ago, the Hulbert Financial Digest [a service that tracks the performance of other investment newsletters] reported that The Granville Market Letter "is at the bottom of the rankings for performance over the past 25 years-having produced average losses of more than 20% per year on an annualized basis."
Losing an average of 20% per year over a 25 year period is just an astonishingly bad result that would be hard to replicate even if we were trying to.
In March of this year, which was the low point for the US markets and for many markets around the globe, I had conversations with several clients about how bleak the outlook was, and about the apparent improbability of any kind of an economic or market recovery. The consensus around the TV dial and around many kitchen tables was that the situation was bad and would only get worse, with no hope of recovery in sight . . . and then, seemingly out of nowhere, the news started getting less bad, and then gradually better, and with that little bit of improvement, global markets soared 50% to 70% in a period of five or six month, their best showing since 1938.
Summing it all up, I'll quote Niels Bohr, Danish physicist and eventual Nobel Prize Winner: "Prediction is very difficult - especially when it's about the future."
So, going forward, it's worth keeping in mind that events and outcomes are almost always much clearer retrospectively than they are prospectively.
For a very good look at what the stock-seers and subscription investment newsletter services were saying a year ago, just prior to the Lehman crash, I highly recommend Mark Hulbert's excellent article Let's Do the Time Warp Again, published on the MarketWatch website last Friday. The article concludes with Warren Buffett's accurate observation that the purpose of stock market forecasters is to make fortune tellers look good.
Where to From Here?
With any luck, we've seen the worst of what the markets have to offer. You'd have to reach back over 75 years to see anything as broad in scope and comparable in magnitude to what we've all witnessed and lived through over the last year or two. For investors who have had an equity portfolio that is similar in composition to the Dow Jones Global Total Stock Market Index[1,2] , and who have been invested over the last five years, the net effect has likely been a surprisingly positive one, even if values are off of the late 2007 highs.
However, it's entirely possible that through the market gyrations of the last two years, your appetite (or tolerance) for risk has been recalibrated. Additionally, for many clients - especially those in or nearing retirement - it might be comforting to revisit your retirement projections just to see where we stand. If you would find either of these helpful to look at, please let me know.
In the meantime, please let me know if you have any questions or if there is anything I can do for you.
2. While international investing may provide growth opportunities and diversification, it does involve special risks such as currency fluctuation and political instability and may not be suitable for all investors.
3. Data for US equities based on S&P 500 data provided by Dow Jones/Wall Street Journal; data for global equities based on Dow Jones Total Global Stock Market Index provided by Dow Jones/Wall Street Journal; data for real estate based on Case-Shiller Housing Price Index (A Look At Case-Shiller Numbers, April 28th, 2009, Wall Street Journal); data for oil from US Dept. of Energy website.
4. Federal Reserve Bank of Cleveland, August 10, 2009;
5. Whether or not the demise of Lehman worsened the crisis, or ultimately was the justification for the Fed to step in and implement its massive response is a hotly debated topic. Joe Nocera's Lehman Had to Die So Global Finance Could Live in September 11th's New York Times, argues the latter point and is worth the time to read.
6. Patterson, Scott, Joanna Slater and Craig Karmin, Right Forecast by Schiff, Wrong Plan, The Wall Street Journal, January 30, 2009.
7. Around the World, Stock Markets Fell and Rose, Together, New York Times, September 11, 2009