2008 was an annus horribilis for Wall Street, with stocks on track for their worst performance since 1931. The broad based S&P 500 index plunged 40% by late December, shocking the pundits and Main Street alike with a downturn the likes of which most of today’s investors had never experienced.
No Place to Hide
2008 was marked by the complete failure of diversification strategies. Compare the Nasdaq led downturn of 2000, when value stocks like energy and financials offered a safe haven. Then, while the Nasdaq sank 39% a portfolio of small cap value stocks climbed 23%.
This time around, there was no place to hide. Diversifying overseas disappointed investors looking for shelter from the effects of plunging US residential real estate prices. Foreign equities were down on average 48% by late December.
Small stocks, thought to be particularly vulnerable because of less access to credit, sank 37% as measured by the Russell 2000, pretty much in lockstep with large cap stocks, as the Dow itself tumbled a similar 35%. Investors did not discriminate between value and growth stocks, as the Russell Value index declined 40.07% by late in 2008, almost identically with the Russell Growth’s swoon of 40.3%.
Even economic sectors with traditionally defensive characteristics could not advance, although losses were somewhat less than more economically sensitive sectors. For example, Fidelity’s Consumer Staples fund was down “only” 25% by late 2008, outperforming somewhat its Consumer Discretionary fund, down 35%.
Diversification into fixed income generally was a loser. High grade corporate bonds tanked, even after adding back the income, by 7%, while low quality junk bonds arguable suffered through their worst year on record, down 31%.
Muni bonds suffered from the same litany of concerns affecting the rest of the market: Suspicions over their credit quality, fears over how sinking real estate prices and weak employment trends would affect tax collections, and low liquidity exacerbated by an outright refusal of some Wall Street banks’ trading desks to continue making markets. An index of these bonds sank 14% in 2008.
Commodities proved to be a loser, too, as the great deleveraging process scuttled all assets other than those that could be used to repay debt, namely US Dollars. Oil had a tremendous rise in the first half of the year, but then plunged in record fashion, losing nearly Âľ of its value in some 5 months.
Despite the mother of all financial crises in the post war period, investors did not go for the gold in 2008; it eased 3% through late December. While it did temporarily top $1,000 an ounce in March in connection with the collapse of Bear Stearns, investors felt little need to hold the yellow metal as the US Dollar strengthened and investors demanded only assets that could be used to pay debts (cash) or had guaranteed convertibility into cash (US Treasury bonds).
The winner for 2008: US Government bonds. Inflation became a no show, interest rates declined, and the return of principal become more important that the return on principal. Long dated ones rose over 30% by late 2008.
The US Dollar advanced nearly 5% against a basket of other currencies, as investors fretted that the financial crisis’ effect on other countries would be worse than its effects here. The Japanese Yen also fared well, rising 28% versus the US Dollar. Many speculators had borrowed at very low rates in Japanese Yen and reinvested in higher yielding US junk bonds, leveraging their bets by up to a factor of 50 in the process. When those bets soured, and the value of the Yen started to soar, the massive rush to unwind those trades caused massive appreciation of the Japanese currency.
Advice for 2009
Amid the massive deleveraging and economic panic, many investors have become forced sellers. Hedge funds are selling as their bankers terminate credit lines, mutual funds are liquidating to meet redemption requests, individual investors are pulling the plug on even their IRAs to pay off bills, while small business owners sell to keep the family enterprise operating. Some charities are selling because their portfolios securing many of their annuity obligations have so declined that further deterioration cannot be tolerated. These are forced sales, without analysis as to their merits.
If you are not among the misfortunate forced sellers, do not get into the line to sell. Distressed sellers do not get good prices. If you’ve got the gumption, take advantage of those forced sellers. While the future is uncertain, as it always is, we do know prices are as much as 60% off from those prevailing in 2007. That puts the odds in your favor to make some serious money over the next 5 to 10 years. As Warren Buffett says: Be greedy when others are fearful.
What to buy? Usually, the investment experts advise extreme selectivity. While selectivity is always helpful, this is one of those rare moments when investing in anything other than cash or Treasury bonds will prove profitable. As everything else has declined severely, nearly all of it can be expected to turn profitable once confidence and liquidity returns.
Why the Weakness?
Following the horrific events of 9/11 and the popping of the internet bubble, monetary authorities worldwide injected massive amounts of liquidity into the system, pushing short term lending rates down as low as 1%. This liquidity shunned the public equity markets, being skeptical of prospects and valuations, but found a home in residential real estate markets.
Record low interest rates and lax lending standards helped stimulate robust and bubblelike real estate markets. The mantra that there’s never been a nationwide real estate downturn stimulated buying interest in US residential real estate mortgages worldwide, with the thinking that diversified portfolios of US mortgage backed securities was a prudent way to generate excess yield.
Subsequent monetary tightening to reduce an overheated economy soon put pressure on home prices, mortgages secured by them, and entities specializing in this area. The mortgage lending leader Countrywide narrowly averted collapse; Bank of America bought it at a distressed price.
By March 2008, Bear Stearns, heavily exposed to real estate, was bought by JP Morgan at a fire sale. However, the deal was only consummated by the Federal Reserve’s willingness to backstop some of Bear’s most toxic assets.
By late last summer Government sponsored entities Fannie Mae and Freddie Mac were effectively nationalized, as their core capital was essentially depleted by soured residential real estate loans. The world’s largest insurance company, AIG, met a similar fate as it could not meet requirements to post additional collateral to support its corporate debt guarantees.
Investors were shocked at the collapse of Lehman in September. Despite its being larger than Bear Stearns, this time the Federal Government offered no assistance, no buyer came forward, and both Lehman’s stock and bonds became virtually worthless.
Several money market funds owning short term Lehman paper either “broke the buck” or threatened to, meaning having to tell investors that they could not maintain a constant $1 per share value. Investors started yanking funds from money market accounts, insisting on holding only US Government paper, frightened that their short term cash holdings, needed for their day to day operations, were at risk.
This made private sector issuance of high quality short term paper nearly impossible, and corporations and individuals started hoarding cash and deferring all but the most critical expenditures. Markets plunged, economic activity weakened.
However, investors are now taking comfort in Governmental actions to restore liquidity and confidence. Critical developments include legislation for expenditures of up to $750 billion to shore up the financial system. Citigroup received a very generous relief package helping it avert failure. GM and Chrysler secured up to $17 billion in short term funding.
Bleak Economic Outlook
There’s no question, the economic outlook is challenging. Recession started last year at this time, and GDP could drop some 4% in 2008’s fourth quarter. While economists expect some relief by 2009’s second half, the current recession could still be the longest in post war history.
Unemployment could rise to 8%, the worst since the 1970s. While this is a lagging metric, consumer spending still constitutes some 70% of the economy. Job market weakness will put a major damper on spending.
Home prices, the epicenter of the current crisis, have yet to stabilize. Most non-Governmental debt is trading, if at all, at record spreads over Treasuries, bringing borrowing to a halt, crimping plans for capital expenditures.
Overseas economies are weakening fast, putting a damper on the source for 40% of the S&P 500’s revenues, amid recent trade reports show slowing US exports. While investors cheered the recent emergency financial assistance extended to GM and Chrysler, millions of jobs are tied to whether Detroit can restructure their businesses sufficiently to survive.
What Do the Financial Markets Now Discount?
Still, investors have to ask themselves what is now priced into stock prices? If “Armageddon” is now discounted, the downside risk of the continued drum beat of bad news may be less than the upside potential should economic collapse not occur.
The decline in stock prices rivals anything seen in the post war period, with the major market averages having declined over 50% from their October 2007 peaks. The proverbial mattress, US Treasuries, is now offering record lows yields, close to (or even below) 0% for very short maturities, the lowest since records started being kept in 1934.
Commodity prices, a barometer of economic health, have just suffered through one of their steepest declines on record. The dividend yields on the stock market now exceed by a wide margin the yield on the 10 year Treasury, reflecting great skepticism that the dividend payouts can be sustained, even though historically they’ve grown some 6% annually.
Sign Posts
Watch these clues on the stock market’s direction in 2009. The risk premium on (the spreads over) non Governmental debt relative to Government debt: Short term LIBOR rates have tightened up considerably since October, indicating less fear in the market, while 30 year home mortgage rates have declined, a boon for the real estate market.
The price of crude oil: Its recent fall, including the price of gas at the pump, translates into a massive tax reduction for the economy, but further falls may indicate economic weakness, spooking investors.
A continuation of the market’s recently rally: It has led to a technical end to the bear market as the S&P has climbed over 20% since its 11/20 lows. Also, the VIX, a gauge of fear and volatility, has retreated significantly from its November extremes.
Developments in Washington: The massive dose of fiscal stimulus being promised by President elect Obama may jump start spending and boost confidence, while the last minute reprieves in the form of financial assistance to the automakers may allow the economy to avoid the shock of a Detroit collapse.
Monetary developments: Look for continued rate cuts by the Federal Reserve, but with rates approaching zero, it must creatively find other ways to stimulate the credit markets, like expanding its recently announced programs to buy mortgage and consumer related debt.
In sum, 2008’s awful performance discounts a lot of the bad forecasts for 2009. Just slightly better than expected economic news, coupled with miserly returns on cash and Treasuries, could jump start 2009.
David G. Dietze, JD, CFA, CFP™
President and Chief Investment Strategist
Point View Financial Services, Inc.
Summit, NJ
www.ptview.com
December 22, 2008
No Place to Hide
2008 was marked by the complete failure of diversification strategies. Compare the Nasdaq led downturn of 2000, when value stocks like energy and financials offered a safe haven. Then, while the Nasdaq sank 39% a portfolio of small cap value stocks climbed 23%.
This time around, there was no place to hide. Diversifying overseas disappointed investors looking for shelter from the effects of plunging US residential real estate prices. Foreign equities were down on average 48% by late December.
Small stocks, thought to be particularly vulnerable because of less access to credit, sank 37% as measured by the Russell 2000, pretty much in lockstep with large cap stocks, as the Dow itself tumbled a similar 35%. Investors did not discriminate between value and growth stocks, as the Russell Value index declined 40.07% by late in 2008, almost identically with the Russell Growth’s swoon of 40.3%.
Even economic sectors with traditionally defensive characteristics could not advance, although losses were somewhat less than more economically sensitive sectors. For example, Fidelity’s Consumer Staples fund was down “only” 25% by late 2008, outperforming somewhat its Consumer Discretionary fund, down 35%.
Diversification into fixed income generally was a loser. High grade corporate bonds tanked, even after adding back the income, by 7%, while low quality junk bonds arguable suffered through their worst year on record, down 31%.
Muni bonds suffered from the same litany of concerns affecting the rest of the market: Suspicions over their credit quality, fears over how sinking real estate prices and weak employment trends would affect tax collections, and low liquidity exacerbated by an outright refusal of some Wall Street banks’ trading desks to continue making markets. An index of these bonds sank 14% in 2008.
Commodities proved to be a loser, too, as the great deleveraging process scuttled all assets other than those that could be used to repay debt, namely US Dollars. Oil had a tremendous rise in the first half of the year, but then plunged in record fashion, losing nearly Âľ of its value in some 5 months.
Despite the mother of all financial crises in the post war period, investors did not go for the gold in 2008; it eased 3% through late December. While it did temporarily top $1,000 an ounce in March in connection with the collapse of Bear Stearns, investors felt little need to hold the yellow metal as the US Dollar strengthened and investors demanded only assets that could be used to pay debts (cash) or had guaranteed convertibility into cash (US Treasury bonds).
The winner for 2008: US Government bonds. Inflation became a no show, interest rates declined, and the return of principal become more important that the return on principal. Long dated ones rose over 30% by late 2008.
The US Dollar advanced nearly 5% against a basket of other currencies, as investors fretted that the financial crisis’ effect on other countries would be worse than its effects here. The Japanese Yen also fared well, rising 28% versus the US Dollar. Many speculators had borrowed at very low rates in Japanese Yen and reinvested in higher yielding US junk bonds, leveraging their bets by up to a factor of 50 in the process. When those bets soured, and the value of the Yen started to soar, the massive rush to unwind those trades caused massive appreciation of the Japanese currency.
Advice for 2009
Amid the massive deleveraging and economic panic, many investors have become forced sellers. Hedge funds are selling as their bankers terminate credit lines, mutual funds are liquidating to meet redemption requests, individual investors are pulling the plug on even their IRAs to pay off bills, while small business owners sell to keep the family enterprise operating. Some charities are selling because their portfolios securing many of their annuity obligations have so declined that further deterioration cannot be tolerated. These are forced sales, without analysis as to their merits.
If you are not among the misfortunate forced sellers, do not get into the line to sell. Distressed sellers do not get good prices. If you’ve got the gumption, take advantage of those forced sellers. While the future is uncertain, as it always is, we do know prices are as much as 60% off from those prevailing in 2007. That puts the odds in your favor to make some serious money over the next 5 to 10 years. As Warren Buffett says: Be greedy when others are fearful.
What to buy? Usually, the investment experts advise extreme selectivity. While selectivity is always helpful, this is one of those rare moments when investing in anything other than cash or Treasury bonds will prove profitable. As everything else has declined severely, nearly all of it can be expected to turn profitable once confidence and liquidity returns.
Why the Weakness?
Following the horrific events of 9/11 and the popping of the internet bubble, monetary authorities worldwide injected massive amounts of liquidity into the system, pushing short term lending rates down as low as 1%. This liquidity shunned the public equity markets, being skeptical of prospects and valuations, but found a home in residential real estate markets.
Record low interest rates and lax lending standards helped stimulate robust and bubblelike real estate markets. The mantra that there’s never been a nationwide real estate downturn stimulated buying interest in US residential real estate mortgages worldwide, with the thinking that diversified portfolios of US mortgage backed securities was a prudent way to generate excess yield.
Subsequent monetary tightening to reduce an overheated economy soon put pressure on home prices, mortgages secured by them, and entities specializing in this area. The mortgage lending leader Countrywide narrowly averted collapse; Bank of America bought it at a distressed price.
By March 2008, Bear Stearns, heavily exposed to real estate, was bought by JP Morgan at a fire sale. However, the deal was only consummated by the Federal Reserve’s willingness to backstop some of Bear’s most toxic assets.
By late last summer Government sponsored entities Fannie Mae and Freddie Mac were effectively nationalized, as their core capital was essentially depleted by soured residential real estate loans. The world’s largest insurance company, AIG, met a similar fate as it could not meet requirements to post additional collateral to support its corporate debt guarantees.
Investors were shocked at the collapse of Lehman in September. Despite its being larger than Bear Stearns, this time the Federal Government offered no assistance, no buyer came forward, and both Lehman’s stock and bonds became virtually worthless.
Several money market funds owning short term Lehman paper either “broke the buck” or threatened to, meaning having to tell investors that they could not maintain a constant $1 per share value. Investors started yanking funds from money market accounts, insisting on holding only US Government paper, frightened that their short term cash holdings, needed for their day to day operations, were at risk.
This made private sector issuance of high quality short term paper nearly impossible, and corporations and individuals started hoarding cash and deferring all but the most critical expenditures. Markets plunged, economic activity weakened.
However, investors are now taking comfort in Governmental actions to restore liquidity and confidence. Critical developments include legislation for expenditures of up to $750 billion to shore up the financial system. Citigroup received a very generous relief package helping it avert failure. GM and Chrysler secured up to $17 billion in short term funding.
Bleak Economic Outlook
There’s no question, the economic outlook is challenging. Recession started last year at this time, and GDP could drop some 4% in 2008’s fourth quarter. While economists expect some relief by 2009’s second half, the current recession could still be the longest in post war history.
Unemployment could rise to 8%, the worst since the 1970s. While this is a lagging metric, consumer spending still constitutes some 70% of the economy. Job market weakness will put a major damper on spending.
Home prices, the epicenter of the current crisis, have yet to stabilize. Most non-Governmental debt is trading, if at all, at record spreads over Treasuries, bringing borrowing to a halt, crimping plans for capital expenditures.
Overseas economies are weakening fast, putting a damper on the source for 40% of the S&P 500’s revenues, amid recent trade reports show slowing US exports. While investors cheered the recent emergency financial assistance extended to GM and Chrysler, millions of jobs are tied to whether Detroit can restructure their businesses sufficiently to survive.
What Do the Financial Markets Now Discount?
Still, investors have to ask themselves what is now priced into stock prices? If “Armageddon” is now discounted, the downside risk of the continued drum beat of bad news may be less than the upside potential should economic collapse not occur.
The decline in stock prices rivals anything seen in the post war period, with the major market averages having declined over 50% from their October 2007 peaks. The proverbial mattress, US Treasuries, is now offering record lows yields, close to (or even below) 0% for very short maturities, the lowest since records started being kept in 1934.
Commodity prices, a barometer of economic health, have just suffered through one of their steepest declines on record. The dividend yields on the stock market now exceed by a wide margin the yield on the 10 year Treasury, reflecting great skepticism that the dividend payouts can be sustained, even though historically they’ve grown some 6% annually.
Sign Posts
Watch these clues on the stock market’s direction in 2009. The risk premium on (the spreads over) non Governmental debt relative to Government debt: Short term LIBOR rates have tightened up considerably since October, indicating less fear in the market, while 30 year home mortgage rates have declined, a boon for the real estate market.
The price of crude oil: Its recent fall, including the price of gas at the pump, translates into a massive tax reduction for the economy, but further falls may indicate economic weakness, spooking investors.
A continuation of the market’s recently rally: It has led to a technical end to the bear market as the S&P has climbed over 20% since its 11/20 lows. Also, the VIX, a gauge of fear and volatility, has retreated significantly from its November extremes.
Developments in Washington: The massive dose of fiscal stimulus being promised by President elect Obama may jump start spending and boost confidence, while the last minute reprieves in the form of financial assistance to the automakers may allow the economy to avoid the shock of a Detroit collapse.
Monetary developments: Look for continued rate cuts by the Federal Reserve, but with rates approaching zero, it must creatively find other ways to stimulate the credit markets, like expanding its recently announced programs to buy mortgage and consumer related debt.
In sum, 2008’s awful performance discounts a lot of the bad forecasts for 2009. Just slightly better than expected economic news, coupled with miserly returns on cash and Treasuries, could jump start 2009.
David G. Dietze, JD, CFA, CFP™
President and Chief Investment Strategist
Point View Financial Services, Inc.
Summit, NJ
www.ptview.com
December 22, 2008
