Giving Thanks for Good News. You're Just Not Hearing It.A SPECIAL REPORT
November 25, 2008
Events of the past few weeks have been nothing short of astonishing. After losing 9% in September, the S&P 500 Stock Index1 lost another 17% in October, placing that month into the history books as the third-worst performance ever (with 16 down days for the month).
And November might be even worse: The stock market indexes have fallen in 10 of the month’s 14 trading days, as of Nov. 21. That puts the S&P 500 down 46% year to date. As if that wasn’t bad enough, most investors have done even worse, because 76% of U.S. stock mutual funds have lost more than the S&P 500 — some of them with losses of 60% or more. (Not so for investors in our Edelman Managed Asset Program® — more on that later.)
Furthermore, investment losses haven’t been restricted to stocks. Virtually everything everywhere has declined this year, sometimes massively. The bond market is down 12% to date (with 80% of bond mutual funds having lost even more than that), oil is down 47%, gold funds are down 51%, real estate investment trusts are down 57% and foreign stocks are down 54%.2 Even interest rates are down sharply, with short-term CDs, U.S. Treasuries and money market funds paying less than 1%. If there’s ever been a perfect storm in the financial sector, this is it.
Fueling all this are current worries about the nation’s automakers, projected weak retail sales this holiday season, new corporate bankruptcies and bank failures, continuing mortgage foreclosures, and uncertainty over the incoming administration and President-elect Barack Obama’s policies.
Clearly, the economy is weak and is likely to remain so for many months to come — certainly well into 2009. However, as our most recent letter stressed, there is a big difference between the economy and the stock market. Although the former is expected to be officially declared a recession in January, with many economists predicting that it will last for months, it is not at all a foregone conclusion that the stock market will be relegated to the doldrums for such a long period. Indeed, it is likely that stock prices will recover well before the economy does.
Still, you might ask, if weakness is in our short-term future, why don’t we sell and move our assets to cash, where we can wait patiently for the storm to end instead of risking our life savings further? History provides the reason why we shouldn’t do that: As past recessions, panics and depressions have taught us, stock markets recover with astonishing suddenness and velocity. By the time you realize that the bottom has been reached, prices have already risen sharply — meaning you are forced to buy back in at prices that are higher than when you sold.
Perhaps that answer isn’t completely satisfactory. After all, if selling and moving to cash “until it’s over” doesn’t work, then why don’t we take advantage of the market’s daily volatility? With the Dow Jones Industrial Average falling hundreds of points one day and rising as much the next, can’t we jump in and out to miss the losses while securing the gains?
Well, no, we can’t. While that’s a fine idea theoretically, in real life it doesn’t work — for one simple reason: It’s impossible to know for certain what will happen from one day to the next. That means you might find yourself selling when you should be buying, or buying when you should be selling.
Indeed, making the wrong move at the wrong time could prove disastrous. Take the last 10 years, for example. If, as shown by data provided by Ibbotson Associates, you were invested in the Wilshire 5000 Stock Index every day from Oct. 1, 1998 through Oct. 31, 2008 except for the 20 days when stocks made their biggest gains, you would have ended the 10 years with a loss of 57%! But if you had stayed invested the entire time, without trying to figure out when to be in and when to be out, you would have ended the decade with a profit of 13%. Clearly, the stock market punishes those who try to invest only during “good” times. This is why we are willing (albeit reluctantly sometimes) to remain invested throughout the storm: We realize that, at some point, suddenly and without warning, the stock market will swiftly change direction. We don’t want to miss it, and we don’t want you to miss it, either.
Please don’t take these remarks to mean that the stock market’s recovery is necessarily upon us (although it could be). Some people are looking toward New Year’s Day with much anticipation, planning to bid “good riddance” to 2008. What they don’t realize is that 2009 could be just as bad.
Can you imagine having to endure another year that’s as bad as this one has been? Well, if you’re in your 60s, you don’t have to imagine. You can remember it. According to Ibbotson Associates, the S&P 500 fell 14.7% in 1973. As bad as that was, 1974 was even worse: The index fell another 26.5%. The same thing happened in the 1930s: The stock market fell 24.9% in 1930, 43.3% in 1931, and 8.2% in 1932. We saw that happen again earlier this decade: The S&P 500 dropped 9.1% in 2000, 11.9% in 2001, and 22.1% in 2002. Thus, such year-over-year occurrences are possible. I mention this merely so you’re not shocked if that occurs.
But don’t let that scare you, either — for two very reassuring reasons. First, those three periods (1930-32, 1973-74, and 2000-02) are the only times such back-to-back losses have occurred since 1926, according to Ibbotson Associates. Thus, they are highly unusual events and should not be expected to be the norm. Second, and more importantly, those snapshots don’t tell the whole story. Let’s look at what happened after those back-to-back losses.
In the 1930s, the stock market skyrocketed 54% in 1933, was flat in 1934 (-1.4%), then rose 47.7% in 1935 and 33.9% in 1936. In 1975 and 1976, it soared 37.2% and 23.8%, respectively, and from 2003-2006, it rose 28.7%, then 10.9%, 4.9% and 15.8%.
As you can see, the roller coaster in those years made for a wild ride, but by the time it was over, the end result wasn’t bad. In other words, what we’re experiencing at present is one heckuva wild ride, but as theme park visitors discover when they ride today’s most extreme roller coasters, the trip ends well.
And this trip is indeed beginning to show signs of a positive ending. Oil prices have crashed from their July highs, and you’ve seen the results at the gas pump. Based on our analysis of data provided by the American Automobile Association and the Census Bureau, the recent drop in gasoline prices is the equivalent of a $300 billion government stimulus package — twice as much as the package President Bush approved nearly a year ago! And there’s serious talk of a new, massive program to further stimulate the economy. It could have a huge impact that consumers have not yet begun to appreciate.
We remain quite confident that we will survive and thrive, despite today’s challenges. However, don’t assume that we refuse to question our position. Quite the contrary; we continually re-evaluate our investment strategy. This past Friday, for example, with all the advisors of my firm gathered, I asked if anyone felt that we should recommend moving to cash.
The response was instant and unanimous. To a person — and I’m referring to financial professionals who have many years and often several decades of experience each — we are individually convinced that the lower prices go, the more dramatic the turnaround will eventually be. Thus, we personally remain fully invested (other than our own cash reserves, of course), and we continue to encourage you to remain so as well, assuming a proper portfolio allocation.
Indeed, prices have fallen so low that we’re beginning to think that investors have gone batty. This is only the second time we’ve felt this way. The first occurred in 1999, when in a very short period investors bid the prices of dot-com stocks to astronomical — and, we were convinced — unsustainable levels. Remember Qualcomm? Its stock price ascended 216% in just eight weeks, according to Bloomberg. Verisign jumped 141% in three months. JDS Uniphase rose 116% in three months and Nortel skyrocketed 191% in nine months. One stock, e.Digital, soared an incredible 799% in just nine weeks! Investors had completely disregarded investment fundamentals, we warned you back then. So we stayed away from the technology sector, convinced that one day — we couldn’t predict when — those prices would come crashing down. Clients followed our advice, but many other consumers did not. After all, it was hard to stay out of tech stocks while hearing stories of people getting rich virtually overnight.
The point is that, at the time, nobody seemed to object to the market’s volatility. That’s because it was upside volatility. But volatility is volatility — and too much of one kind is as bad and unsustainable as the other. So, we were not surprised that the dot-com party came to an end, which it did in March 2000. Subsequently, Qualcomm fell 66% in the following six months (and is currently down 82% from its high of 10 years ago); Verisign fell 61% in six weeks (and today is down 92%); Nortel dropped 71% in seven months (and is currently facing bankruptcy, with its stock near worthless); e.Digital fell 61% in nine weeks (and is currently down 99%); and JDS Uniphase collapsed 83% in the following year (and is currently down 99.7%). Overall, the entire tech sector, represented by the NASDAQ Composite Index, crashed 77% over the next three years.
Today, we find ourselves again warning about absurd levels of volatility — only this time it’s downside volatility that is causing investors to take foolish actions. Consumers withdrew $40 billion from U.S. stock funds in October, and are on pace to withdraw $70 billion this month (they withdrew $32 billion in just one week ,the one ending November 12), according to TrimTabs Investment Research. There is now $3.6 trillion in money market funds, reports the Investment Company Institute — a record. Including bank accounts and CDs, there is now $9 trillion in cash — and most of that cash is money that had been invested in the stock market. All those people were happy to own stocks when the Dow was 14000, but they don’t want to own shares while the Dow is in the 7000s.
Their selling has caused stock prices to fall to incredible levels. The Price-to-Earnings ratio, which for the overall stock market is historically 16, is now under 8 — meaning stock prices are substantially lower than the values of their underlying companies. (It was the opposite during the dot-com craze, when the market’s P/E ratio was 28.) When the P/E is too high, stock prices eventually fall (read: 1999) and when it’s too low, prices eventually rise (read: now). At some point, consumers who are sitting on the sidelines waiting for prices to begin rising will begin to buy again, and with $9 trillion at their disposal, we believe the buying will turn into a frenzy, causing the stock market to rise in a remarkably short period. (But the consumers who bought when the Dow was high, sold when it was low and those who rebuy once it’s high again won’t be among the ones who get rich.)
In the late 1990s, we warned people not to buy during the upside volatility (because prices would eventually fall). This time we are warning people not to sell during the current downside volatility (because we are convinced that prices will eventually rise).
The key to succeeding with our advice, then, is patience. The $700 billion rescue package was not a light switch; its passage did not mean the nation’s economic woes would be over instantaneously. Nor was Obama’s election a light switch. Nor President Bush’s economic summit. The problems that our nation is experiencing are real and deep, and it will take time to work through them. But that doesn’t mean we should sell and go to cash.
It also means we shouldn’t pay any attention to the punditry of the so-called experts. Hysteria in the media has reached new levels. Newspapers and broadcasts are replete with frightening words and phrases such as “spectacular declines,” “gruesome selloff,” “financial system unraveling,” “anticipation of harder times,” and even “a 1929 scenario.” The headlines make it seem as though there’s actually no good news anywhere because, as is always the case, the media do not report on all the gas stations that weren’t robbed last night.
But there is good news — plenty of it. The media are simply choosing not to report on it, because good news doesn’t attract readers, listeners and viewers as much as bad news does. So, in an effort to make amends for the media’s omissions, consider:
- The United States remains the largest, most powerful economy in the world. According to the U.S. Chamber of Commerce, 95% of the consumers of American goods live outside the United States.
- In the first nine months of this year, U.S. exports of goods and services were 10% higher than the same period in 2007, according to the office of the U.S. Trade Representative, which says “the United States remains a global leader in manufacturing, services, and agriculture.”
- The United States is still the world’s largest manufacturer, producing nearly one-fourth of the world’s industrial output.
- At the same time, significant job growth is projected for many sectors of the economy. Employment in computer systems design and related services is projected to grow 40% by 2016, according to the Department of Labor’s Occupational Outlook Handbook. Education and health service employment will grow by almost 20%. Other sectors expecting sizeable job growth are energy, insurance, and professional services.
Furthermore, the economy will continue to benefit from astounding technological advancements that continue on a regular basis. A few random and recent examples:
- Nissan, BMW’s MINI, and Audi will be introducing electric cars in the next few years. They all have plants in the U.S. The electric MINI Cooper reaches showrooms in 2009.
- Homeowners can now protect windows from Category 4 hurricane winds with fabric shutters that are affordable yet stronger than plywood, while letting in 80% of sunlight.
- A new skyscraper in Bahrain features wind turbines that supply 15% of the building’s electricity needs (and look really cool, too!).
- Floating, moveable wind-turbines are being developed for ocean use, enabling the creation of large wind farms far out at sea.
- Eco-rock, a new alternative to drywall, uses 80% less energy to produce and is 85% made from recycled products, but costs no more than ordinary drywall.
That’s not all. Thanks to other innovations:
- Per 100 million miles driven, the fatality rate has dropped 16% and injuries 37% over the past 10 years, thanks to improved automotive design and highway engineering, according to the Department of Transportation.
- Scientists this week reported that they have cured Type 1 diabetes in lab mice. The breakthrough could lead to a cure within a couple of years for the more than 1 million U.S. children who suffer from juvenile diabetes.
- Physicians from four European universities in June completed the first successful transplant of a human windpipe, saving the life of the 30-year-old patient. The bioengineered trachea was developed using the patient’s own stem cells, avoiding the controversial use of embryonic stem cells.
- A teenager, whose transplanted heart failed, was kept alive by an artificial pumping device for 118 days until another donor heart was obtained for a second transplant. The 14-year-old girl was released from a Miami hospital last Wednesday, and she’s expected to resume a fairly normal, active life.
- Pharmaceutical research and biotechnology companies are testing a record 633 new biotech medicines. This next generation of medicines uses unprecedented technologies, such as nano-sized particles that seek out and kill viruses, ways to actually regenerate healthy muscle to replace damaged heart tissue and gene therapy. The medicines in the research pipeline include treatments for cancer; infectious, autoimmune and cardiovascular disease; and diabetes.
Thanks to these innovations, we’re living longer and healthier lives, according to the Centers for Disease Control. Cancer death rates are down, fewer people are smoking, childhood immunization rates are at or near record high levels and life expectancy rates in the United States have jumped from 63 years in 1940 to 75 years in 2005.
We truly live in amazing times, and it would be a shame to discount all the positives while considering our current economic setbacks. After all, the stock market’s malaise will prove temporary, but medical and technological innovations won’t be.
And what of the new administration? Some are worried that President-elect Barack Obama will reverse the Bush tax cuts. Will that further damage the economy? Perhaps — but don’t assume that higher taxes are a sure thing, at least not right away. By selecting Tim Geithner as the new Treasury Secretary, Obama is demonstrating a strong degree of pragmatism. And he has already indicated that he’s not going to implement for at least one year the tax increases he touted during his campaign. Even if he did, higher taxes don’t necessarily mean that the stock market will do poorly. Consider 1991 to 1996, when the capital gains tax rate was 28% and income taxes topped out at 39.6%. During that period, the Dow enjoyed an average annual return of 14.4%. And when tax rates ranged between 28% and 33% from 1988 to 1990, the Dow rose 11.9% annually. Although nobody likes to pay taxes, let’s not assume that higher taxes necessarily lead to a weak stock market.
The brutal stock market, coupled with economic recession and a sweeping change in government, make us all understandably anxious — and our angst is being exacerbated by the irresponsibly negative tone of the news media. But let’s keep everything in perspective and remember that history shows that our country not only meets these challenges, but goes on to thrive at higher levels than ever before.
And if you need assistance, we’re here to help. Thanks to the extensive diversification and daily rebalancing review provided by the Edelman Managed Asset Program®, our EMAP portfolios have fallen less than the S&P 500 in 2008. All our clients in EMAP are also enjoying lower risks and lower costs than the market averages. Although EMAP hasn’t been immune to the tribulations of these days, it’s reassuring to know that our clients are surviving it better than others. And most importantly, the EMAP portfolios are positioned so they have the potential to enjoy the broad-based economic recovery when it occurs.
Like you, we look forward to those days. Until then, we wish you and your family a healthy, happy and safe Thanksgiving. As always, feel free to contact us with any questions.
1An index is a portfolio of specific securities (common examples are the S&P, DJIA, and NASDAQ), the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios, and investors cannot invest directly in an index. Past performance does not guarantee future results.
2 Source: Ibbotson Associates for the Lehman Brothers Intermediate Bond Index and MSCI EAFE Index; Morningstar data on returns for all mutual funds in the gold and REIT categories. All data as of Nov. 21, 2008. Past performance does not guarantee future results.