Market Update

 

 

The dust has settled on one of the most eventful and unsettling years in memory. After a rocky start, investors who stayed the course were rewarded with generous gains in stocks and certain segments of the bond market, which salved the wounds of a treacherous 2008.

 

Stocks finished the year strongly, continuing a powerful run that began in early March. Large-cap stocks, based on the iShares S&P 500 Index Fund finished 2009 with a 26.4% gain. International Stocks as measured by the iShares EAFA Index Fund were up 31.4% for the year. The best equity performance was found in emerging markets as represented by the iShares MSCI Emerging Markets Index which returned 71.8% for the year.

 

On the domestic fixed-income side the aggregate bond market (iShares Barclays Aggregate Bond) gained 5.1% for the year, while more credit sensitive sectors like investment grade corporate bonds and high-yield bonds delivered strong gains and recovered ground lost in 2008.

 

Lessons from the Past Year

 

The chart below illustrates the 2009 returns for various asset classes as well as their recovery from the market’s rebound, which began in March. One thing that is clear when examining the table (and our performance) is that maintaining exposure to assets that experienced steep declines proved to be the most effective way to recoup the losses of 2008. This of course was no easy feat and required steadfast determination at what looked like the economy’s darkest hour.2009 Performance

 

The pain of holding stocks through this (and any) bear market was compounded by the doom and gloom of what we read in the press -- the near collapse of the banking system, fraud, bankruptcies, and government bailouts. Of course, these issues are real and cast doubt on the foundations of investor’s beliefs.

 

This is the nature of the markets. They are driven by greed and fear and the extent to which those conflicting emotions feed on themselves is quite remarkable. The stock markets (and investments in general) are unique in that they are the only items people love to buy at higher and higher prices. This logic does not apply in the grocery store or the car dealership. We know the value of what we buy in these places and lower prices are what we all desire. But with investments, investors (or should I say speculators) don’t mind putting money into something as long as its price has gone up in the past (as if that is the only determinate factor in whether it will continue to go up in the future).

 

When the market trend is up, people are more willing to put money to work, the press validates the sensibility of this action, as does the market, which rises even further. There is enormous social proof that confirms this type of behavior. All the news is good, the economy is strong, everybody’s doing it and every investor is a bull market genius.

 

Just the opposite happens during a steep market decline. All decisions seem to lose money in the short term. All the news is bad and staying invested is the hardest thing you can do. It is precisely because it is the hardest thing to do that it will prove to be the most profitable. The profitable decisions are never easy.

 

Lessons from the Past Decade

 

Diversification is dead. Long live diversification. It is quite common to hear or read that diversification (constructing portfolios of different complementary assets in an effort to reduce risk) failed investors in this bear market, and to some extent, that is true. It is also quite common to hear or read about the lost decade – from 1999 to 2009 – when the annualized return from U.S. Equities was -1.03% (as measured by the Vanguard 500 Index VFINX). Negative performance over 10 years is a horrible and rare result experienced only one other time in the last 100 years – from the end of the roaring ‘20’s through the Great Depression. The technology bubble of 1999 and its bursting, and the housing and credit crisis have taken their toll on U.S. investors, no doubt.

 

While diversification as a tool may have disappointed in 2008, it was a welcome friend throughout the “lost” decade. Prudent investors and advisors who employed a globally diversified portfolio had a very different investment experience. Exposure to the technology collapse of the early 2000’s was muted, while exposure to assets classes like emerging markets, international equities, global real estate and others offset the negative returns experienced here in the U.S. Net-net, a globally diversified, equity tilted portfolio would likely have annualized at around 6.5%.

 

Lessons for the Future

 

The economy is in recovery but we are by no means out of the woods, and this recovery faces unique challenges. There are headwinds in unemployment, a weakened consumer, and continued weakness in commercial and residential real estate. None of these problems are insurmountable and they can all be overcome with time, but they will likely add to our collective anxiety for years to come.

 

Going forward, our biggest challenge will be the enormous expansion of government debt and budget deficits. This debt, while currently large in absolute terms, is sustainable, but we are running out of wriggle room. As a country, we’ll soon be forced to make hard choices regarding government spending, taxation, and entitlements. I welcome the challenge, as I think that a realignment of our national priorities and spending can set the stage for the prosperity of future generations.

 

Disclaimer

Posted by Jay Healy at 1:00 PM
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