Although returns for stocks and bonds in December were positive, this provided little relief in the final quarter of an awful year for investors. Fourth-quarter and full-year returns were dismal for most equity asset classes. The Vanguard 500 Index Fund, a proxy for large-cap U.S. stocks, lost about 22% and 37% for the fourth quarter and calendar year, respectively. Foreign stocks, as measured by the Vanguard Total International Stock Index Fund lost 21% in the fourth quarter and 44% for the full year. Outside of traditional asset classes, RIETs, emerging markets, corporate bonds, and hedge fund strategies were all down. In a grim year where almost nothing unfolded according to expectations, and there was no place to hide short of stuffing cash in a mattress, that is little surprise.
Investment Review and Outlook
Portfolios that we manage generally did better than the broader equity market but there is little conciliation in that fact, since 2008 was a once-in-a-lifetime train wreck. The year was arguably the most painful in modern investment history (it was the worst year for the stock market since 1931) and we are disappointed we didn’t do a better job of protecting our clients’ capital. In hindsight, we should have given more weight earlier in the year to the likelihood of an extremely negative scenario playing out, and made tactical adjustments to significantly reduce our portfolios’ risk exposure. While we did make some moves in that direction, they were not enough.
Now we are clearly in the midst of a severe recession. Beyond that we also now believe it is not just possible, but likely, that we will experience several years of economic growth that is below the historical trend as consumers adjust to a new reality in which they finally have to pay down debt and increase savings. A trend that has been building since the late 1980s – the growth in household debt – is finally reversing.
If the environment plays out as we believe it could, it may take a number of years after the recession ends for corporate earnings growth to return to its long-term trend, and the recession itself could last through 2009 or even into 2010. This has implications for stock market returns and investment decisions which in turn are being incorporated into how we are currently positioning client portfolios.
Despite all this pain, there are some encouraging signs:
I believe the crisis stage of events has past and now we are faced with the reality of a severe recession. And while we had no roadmap with which to navigate the “crisis,” we have experience navigating though recessions. Given time this recession, like all others, should end.
Stock market valuations, depending on which market and how they are measured, are somewhere between fair and very low. Below average current valuations set the stage for above average future returns.
U.S. equities have produced a negative return over the last ten years (at the end of November the annualized 10-year return was -1%). Believe it or not, this is good news. The Leuthold Group has researched subsequent 10-year returns after stocks had suffered through a 10-year period with annualized returns of 1% or less. The worst annual subsequent 10-year return was 7.2% and the average of 15 periods 10.7%. The takeaway is that based on history the next 10 years is likely to deliver at least satisfactory nominal equity returns.
We believe that much of the selling in the 4th quarter was the result of forced liquidations and margin calls, the majority of which is behind us.
All of this evidence as it relates to the long-term potential in stocks is encouraging, but the near term is much less clear.
Secular bear markets usually end at extreme levels of undervaluation. So while equity markets looks cheap now they could get cheaper.
Economic risk remains high. Policy makers have made it clear that they will do whatever it takes to support the economy, yet credit markets, though improving, remain dysfunctional and the housing market remains highly stressed. And while a financial system collapse has been avoided, a newly realistic consumer, attempting to reduce debt and increase savings, could mean an economic retrenchment that lasts longer than expected.
Weighing the Evidence
While it is quite possible, maybe even probable, that we have seen the bottom, we can’t be sure. This recession is likely to be with us for a while, probably at least through the first half of 2009 and very possibly into 2010. Forced selling by hedge funds and others may not finished and more individual investors could simply give up if the market heads back down towards its prior low. In the near term of 2009, it is critically important that the marginal improvement we’ve seen in the credit markets takes hold and gathers strength. That is a prerequisite to an improved economy. We believe that credit markets will improve over the course of 2009 and if we are right it will be a good year for bonds. We are less certain about the immediate future for equities although we think that investors are very unlikely to get hurt owning equities over the next five to 10 years and are likely to reap satisfactory returns.
Thus far this discussion has focused on equities, but they are not the only game in town. Many attractive opportunities have been created in the wake of this market decline. We are currently researching and considering positions in high-yield bonds, convertible bonds, corporate bonds, and master limited partnerships. All of which have very compelling risk/return profiles.
We believe that at some point in the future we will be able to look back and see that our commitment to doing what we believe is right for our clients during this time period led to good long-term decisions. The investment business is stimulating, fascinating, and humbling. It is also challenging in many ways. There are times (not often) when what we believe is right for our clients is at odds with what they believe. During times like these our discipline is an important part of our value added and what we are paid for. We are fortunate to have a great group of clients who have shown confidence in our abilities in a year in which the markets were uniquely challenging.