The Ultimate Stress Test
The recent stock market decline, largely resulting from the continued uncertainty and speculation regarding the Treasury’s Financial Stability Plan, has left the S&P 500 Index only marginally above the low breached on November 21st. In all, the index is down just over 50% from its record finish of October 2007. However, it’s worth noting that periods of similar declines also experienced the retesting of market lows: the October 2002 low was retested in March 2003 and the October 1974 low was retested in December 1974.
The current bear market is the fifth to experience a decline in excess of -40%. Excluding the market sell-off at the front-end of the Great Depression (1929-1932), the magnitude and duration of the other three occurrences (1937-1938, 1973-1974, 2000-2002) suggest that we are close to reaching, or may have reached, a bottom. Encouragingly, from the bottom, each of these three occurrences generated significantly positive returns over the ensuing 1, 3, and 5 years.
Historical comparisons such as these, particularly the exclusion of the 1929-1932 period, beg the question of how the current environment may differ. While there’s no doubt the global economy is under tremendous stress with still-indiscernible consequences, it is worth revisiting key distinctions between our current environment and that of the Great Depression.
Learning from the Great Depression
Federal Reserve chairman Ben Bernanke has focused much of his career on the study of the Great Depression. The fact that nearly half of all banks either closed or merged while more than 40% of mortgages were in default is largely attributed to a severe lack of government action. The takeaway lesson from the crisis, Bernanke has stated, was that “In the end, Fed officials decided not to intervene in the banking crisis.” Clearly, the coordinated and aggressive actions of both the Fed and the Treasury over the last year are borne of the lessons learned from that mistake.
Magnifying the crisis was the lack of since-installed safety nets such as Federal Deposit Insurance and unemployment compensation. “The experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns,” Bernanke has said.
In the Fed’s recently released projections, unemployment is forecasted to near 9% by the end of the year and the economy is expected to contract between 0.5% and 1.3% for 2009. However, Fed officials expect the fiscal stimulus, combined with central bank efforts to support the credit markets, to result in a return to economic growth in late 2009. In comparison, the Great Depression saw unemployment approach 25% and an economic contraction of almost 30%. Additionally, leading up to the 1929 market crash, stocks had risen over 500%; the bull market preceding the current bear market advanced stocks approximately 100%.
Testing Your Faith
No wonder it feels a bit like the world is ending. The conflict between head (rational judgment) and heart (emotional reaction) is always present, but it’s likely never been more apparent than in the current environment.
Given the extreme market volatility and the extraordinary declines in asset values that have occurred, it is natural for investors to question the validity of the portfolio strategy to which they comfortably adhered in less challenging times. And we certainly understand that maintaining discipline in an environment such as this is incredibly challenging. However, we choose to endure the pain of discipline now so as to avoid the longer-term pain of regret.
As brutal as the current environment is, it is critical that the immediate situation not derail long-term plans. The portfolio’s strategic asset allocation is meant to represent a long-horizon investment policy. Consequently, the effectiveness of any strategy must be judged on its impact over multiple market cycles, rather than over one part of one cycle (however dramatic that cycle may be). The biggest danger investors have in volatile markets is abandoning their long-term strategy.
Our chief role today is to help clients resist imprudent action in the face of panic. The point of sticking to sound, fundamental strategies, after all, is to avoid big mistakes in moments of crisis. Looking at the value of your portfolio today can be gut-wrenching, but it is critical to remember that investing remains a long-term proposition — a horizon of at least your lifetime and possibly that of your heirs.
The Rewards of Capitalism Will Return
While it remains uncertain if the market has bottomed, we are not abandoning our view that capitalism will continue past this crisis and long-term equity investors will be rewarded. The events of the past six months starkly illustrate why stocks have had higher average returns than safer assets: market risk is real. But if you can hang on during times like these, there is still every reason to expect you’ll be well-paid for it over time.
The current market environment has tested investors and financial advisors like no other period in modern history. Ultimately, the resolve of monetary and fiscal policy makers and the resiliency of the global economy will lead us to the conclusion of this very turbulent period. In time, the markets will recover and those investors who maintained the greatest discipline at the bottom will likely fare best in the rebound.
In Jeremy Siegel’s classic book, Stocks for the Long Run, he analyzed 200 years’ worth of U.S. market returns and concluded that patient, consistent investment in stocks over a long period is the most effective strategy for wealth creation. We’ll leave you with a recent quote from Professor Siegel:
“Look, it’s always painful near the bottom, but the outlook from here is extraordinary for investors,” he says. “I think the important thing is that the question of buy-and-hold comes up at the bottom of every bear market that I have gone through, and I get calls about it, and invariably that proves to be the time when you should own stocks.”
