Commentary For March 2008

“Despite nine recessions, three wars, two presidents shot (one died and one survived), one president resigned, one impeached and the Cuban missile crisis, stocks have been a great place to be. The United States has had a perfect record when it comes to rebounding from the most difficult times.  With those nine recessions, we have had nine recoveries. Since World War II, corporate earnings are up 63 fold and the stock market is up 71 fold. Corporate profits have grown over 9% annually despite the down years.”

Peter Lynch, the former portfolio manager of the Fidelity Magellan Fund in the wake of the tragic events of 9/11.

Today we face oil at over $100/barrel, the dollar is at an all-time low against the Euro, gold has traded above $1,000/oz. and we are in the midst of an unprecedented credit crunch that in the end has a potential for creating over $450 billion in losses. One might say we have had the perfect storm with everything converging at the same time (Note emphasis).

Several clients have expressed concern about the aforementioned perfect storm and their perception that there doesn’t appear to be any relief on the horizon. This, when combined with the market decline, brings back Déjà Vu memories of the painful 2000-2002 bear market, so it is understandable for them to feel this anxiety. World-renowned psychologists Amos Tversky and Daniel Kahneman were early pioneers in the study of loss aversion, which refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.

Michael J. Mauboussin, Chief Investment Strategist at Legg Mason Capital Management, in his May 24, 2004 article, titled, “Decision-Making for Investors, Theory, Practice, and Pitfalls”, describes a test thateconomist, Paul Samuelson, offered his lunch colleagues: a bet where he would pay $200 for a correct call of coin toss and he would collect $100 for an incorrect call. But his partners didn’t bite. One distinguished scholar replied, “I won’t bet because I would feel the $100 loss more than the $200 gain. There are no casinos I am aware of that give you those odds with that type of payout.

The S&P 500 experienced its worst quarter in five years being down <9.45%>. The S&P 500 hit an all-time high (1,565.15) on 10/9/07, which coincided to the day with the five-year anniversary of the bear market bottom. Subsequently, it fell to 1,273.37 (3/10/08) resulting in a <17.98%> decline.  It almost met the definition of a bear market (>20%). 

It sure seems simple to just get out of stocks and get back in when there are confirmations that the market has stabilized and we are hitting on all cylinders. Unfortunately, the reality is that by the time we do see those signals, the easy money will have been made. To illustrate this point, for the period 1987-2007, there were 5,296 trading days and had you been invested in the S&P 500 for that entire period, you would have had an annual average return of 11.50%.  Missing just the 10 best days (.02% or 2/100th of a %) would have reduced your return to 7.96% and missing the 40 best days (.08% or 8/100ths of a %) would have reduced your annual return to 1.30%. If during the quarter ending March 2008, you had missed the best five days, your return would have fallen from <9.45%> to over <21%>. What is important to remember is that it’s time in the market that matters, not market timing.

It is natural for investors to think they can predict the direction of the market, whether it is a ‘gut’ instinct,  “holy grail” investment strategy or by what they read and hear from the media. There is a budding area of study called behavioral finance. It talks about the skeletons in our closet or baggage that hinders us from making good decisions. The study does this by incorporating mathematics, psychology, statistics and finance all rolled up into one ball. This commentator confesses in advance that I took only one psychology class and when it came time to take a test, I literally had to ask the professor what the questions meant in order  to attempt answering the questions. Thank goodness it was a true/false test. Many of you might have known or heard of Knoxville businessman Rod Townsend, or “Random” Rod, as he was known to many. He loved to talk about the chaos that randomness caused people. Wish he were here to explain this.

Many of us have a linear thought process where by we assign cause and effect in making decisions, which works well in a two-dimensional world. But when introduced to a multidimensional, multivariable scenario, “us” linear thinkers are heading to the bar to get our monkey drunk so he can throw darts to come up with our “informed” answers. The question is how do “us” linear thinkers overcome this limitation. Left to our own means, we probably look to the media for our information and filter information using our own “rule of thumb”, ignoring what we don’t understand or agree with. Unfortunately, because of the biases it will probably undermine the decision quality.

As John Naisbitt once said, “we are drowning in information and starved for knowledge. Rather than attempt to sip selectively from a fire hydrant, we inevitably defer to consolidators and aggregators – the financial media – in at least some of our consumption of supposedly relevant “news”. Handing over our editorial filter to others can lead to some awkward tensions between a complex world and somebody else’s interpretation of reality.” Hallelujah

What is our perspective of the perfect storm? We believe we have seen the worst and we are moving towards recovery and certainly aren’t pessimistic like the market. The Fed has responded almost too well. They have lowered the Fed Funds rate by 3.00% from 5.25% to 2.25%, which is the lowest since December 14, 2004. During the same period, the prime rate has fallen from 8.25 % to 5.25%. Since June of last year, the 5 and 10 year treasury yield has dropped from 4.92% and 5.03% to 2.58% and 3.52%, respectively.

Doug Kass, author of The Edge, wrote an article about a conversation he had with a seasoned money manager, who he has found to be very balanced in his view on the market. There are a couple of encouraging points that you should find interesting.  First, corporate debt as a percentage of capital has consistently dropped from two decades earlier. Peaking at about 49% in 1990, debt is now under 38% of capital. Cash as a percentage of assets bottomed back in 1990 at about 4.5% of assets but has more than doubled, and now the percentage stands at nearly 9%. Second, the prospects for stocks vs. other assets are very attractive. Since March 24, 2000, almost every asset class has outperformed stocks. During the eight-year period, the S&P has declined by 16.6%, gold has risen by 242%, copper by 372%, wheat by 360%, crude oil by 281%, home prices by 41.4% and the Euro by 57%. An interesting aside, Doug is a short seller and he actually became more constructive on the market after talking with the advisor.

As part of our proactive investment monitoring process, we terminated Neuberger Berman International. We originally engaged them to increase our exposure in the small and mid cap international space. Our other two managers covered the large value and growth area for us. Over the last couple of quarters, the size of the stocks Neuberger Berman has been buying has gotten larger, so much so that it some overlap with our large cap managers. Consequently, we terminated Neuberger Berman and have reallocated their monies pro-rata between the two remaining managers.

For the quarter just ended, returns for the S&P, NASDAQ, Russell 2000, MCSI EAFE and Lehman Brothers Aggregate Bond indexes were <9.45%>, <13.90%>, <9.90%>, <8.91%> and 2.20%, respectively.  For the same period, our Stock, Aggressive Stock, Balanced and Fixed account returns were   <10.11%>, <10.06%>, <3.84%>, and 2.52%, respectively.

We appreciate your business at The Trust Company. If we can provide any other information, please do not hesitate to contact us.