It’s been a while since we have seen the devastating market action that we have experienced these past few months. As advisors who council our clients to do the right thing, its very upsetting to see the value of our homes and portfolios depreciate as much as they have this past year. With the exception of cash, everything is down substantially. It’s now to the point where it’s totally irrational behavior. Great companies with solid earnings, paying extraordinary dividends are trading at a fraction of their real intrinsic value.
Given the severe situation we have found ourselves in, several of you have asked “Have you ever seen anything like this before? That got me thinking and the answer is yes.
Market Crash of 1973 and 1974
In 1973 I was a young man in my twenties who had purchased my first home in 1971. I was working for New York Telephone after graduating from college. I began investing with Bache & Company and E. F. Hutton with what little discretionary money I had to save for the future. Here is what that environment looked like back then:
- Richard Nixon was President and under threat of impeachment
- The Vietnam war was concluding
- Our national self-esteem was at a low point
- Congress was in its usual disarray and had lost the public trust
- Detroit automakers were losing business to imports as petroleum prices had escalated, for the first time
- Business confidence was reaching new lows
- Interest rates were on the rise
- The Markets for ’73 and ’74 were disastrous
a. Common Stocks were down 14.66% in ’73 and down 26.47% in 74
b. Small Cap Stocks were down 30.99% in ’73 and down 19.95% in 74
- Inflation was going up:
a. CPI rose 8.08% in ’73 and 12.20% in 74
- And to add insult to injury, we had to wait on very long lines to buy gasoline that was outrageously priced. Gasoline went from 39 cents per gallon to 55 cents per gallon due to shortages.
At the time, most of my generation felt that our financial future might not rival the success of our parents. The investment mood of the nation was sour and the national deficit was deemed out of control, mostly due to the cost of the Vietnam War. Needless to say, this set the stage for markets to turn in excellent performances in 1975 and 1976 with positive returns of 37% and 23% in those years. This helped build the base for the 1980 through 1999 bull market.
Market Crash of October 19, 1987 (Black Monday)
On October 19, 1987 when R. W. Rogé & Company was just a little over a year old, I was working from my home office. I remember watching the market (Dow Industrials) dropping 23% in one day. I was literally sick to my stomach. I felt helpless. How could that be? I was trained in Modern Portfolio Theory (MPT) Statistics and Portfolio Construction. I was counseling clients that a moderate risk portfolio could be down about 15% in any one year time frame, 95% of the time. I quickly learned that it could be down much more in a shorter time frame and there was that remaining 5% where it could be down more than 15% in any one year. Today they refer to this as tail risk. The very end of the bell shaped curve, we learned in high school statistics, where there are low probability events that can occur with high degree of impact on the portfolio. This was one of those outlier events.
In any event, the Dow closed up positive by year-end 1987 and it took less than two years to surpass its previous high of 2722 reached on August 25, 1987.
Market Crash of 2000 to 2002 (The Three Year Bear Market)
The technology and telecom bubble created rapid growth from 1992 to 2000. From September 2000 to January 1, 2001 the NASDQ dropped 45.9%. It eventually dropped 78.4% from its all time high reached in March of 2000. As a result of this real estate became the next outlet for a speculative frenzy, which is the cause of the current market correction. The market as measured by the S&P 500 Index produced very good positive returns in 2003, 2004, 2005, 2006 and 2007 of 28.67%, 10.87%, 4.90%, 15.79% and 5.50% respectively.
Our Advice and Guidance
The markets have experienced about a 40% write-down in the last 12 months; an over correction to be sure, but not necessarily the bottom yet. At low points in stock market cycles, it is not unusual to look up and feel that years of returns have been lost in a single year and to feel an urge to leave the market altogether and go to cash. However, it is critically important to not leave the market for any length of time or you risk locking in your losses, and missing the opportunity to benefit from the inevitable recovery. Alternatively, you might wish to even consider increasing allocations to equities now (within your risk tolerance) even though emotionally, it may seem very counterintuitive.
Warren Buffett, the world’s best investor has said recently he has a simple rule that dictates his buying “You should be fearful when others are greedy and greedy when others are fearful. He has been buying equities lately and that should be a signal to all of us to follow his advice. His investment in those equities is now under water (trading lower than his purchase price). However, Mr. Buffett understands that you can’t time the market. He is still happy with those investments and is confident that they will provide very nice returns in the future, because he knows that he did not overpay for those companies.
A good example of how this may play out is in 1975 and 1976 the markets had successive returns of 37% and 23% which started building the base for the 1980 through 1999 Bull Market. Given that it is impossible to “time the markets,” most who left the ’73-’74 markets in disgust failed to return to the stock market until after the gains of ’75 and ’76. The moral of the story is a few poorly timed, emotionally-driven trades can destroy a lifetime of investment performance.
Please understand, while this year has been a big disappointment, it is also presenting us with great opportunities now and for the future. We are actively assessing each of your accounts individually to ensure your investments are properly aligned and prepared for the challenges and opportunities to come in the next two to three years (as it relates to each of your goals, objectives, and investment risk tolerances).
For the past 4 months we have been harvesting tax losses in our taxable portfolios. You will notice we are placing the proceeds from these trades into Exchange Traded Funds (ETF’s) such as the S&P 500 ETF to maintain proper market exposure and avoid taxable capital gain distributions that most mutual funds will have between now and the end of the year. The reason regular mutual funds will most likely have capital gain distributions this year, even though they have negative returns, is due to liquidity issues. As mutual fund shareholders sell their shares due to fear of the markets, the mutual funds have to sell positions that they have held for years at a profit to meet the share redemptions. This causes a taxable distribution to the remaining shareholders.
The ETF positions are temporary investments that allow us to maintain market exposure as we implement our tax strategy. We will most likely return to our regular mutual funds after the first of the year.
Based on the historical evidence, we are very confident that when we look back in 3 to 5 years at the actions we are employing today, that we will be extremely pleased with our portfolio’s performance. Most bear markets bottom at a 30% loss off their previous highs. We are now at 40% off the highs reached in October 2007. So we are in a bottoming process that could take a while. I believe we are in the early stages of a recession and the late stages of a bear market since markets look out to the future, they usually begin to turn at the early stages of a recession.
The government bailout package and guarantees is already showing signs of providing much needed liquidity to banks and financial institutions and will eventually restore public confidence in the financial system. The markets are now turning their attention to the recession, the election and new financial regulation. All of this will be worked out over the next 12 months. Yes the economy is in for some rough sledding but it too will recover as these issues are resolved. The key to a recovery is (1) stabilizing the financial system, which has already begun and (2) working off the excess inventory of homes for sale. Once the real estate market begins to show signs of recovery, the economy will begin to feel normal again.
Thank you for your patience and understanding of the environment we are experiencing. We are extremely grateful for our good fortune to work for you and are humbled and honored in the trust you have placed in us over the years. Yes, we have seen events like this before and rest assured that we will come through this market correction together as we have done several times before.