The market volatility, credit crunch, housing market collapse, and hedge fund debacles make it hard to believe the overall stock market was in the black during the third quarter. But it was, with the S&P 500 gaining 2%. Moreover, through September the index is up 9.1% on the year. While the numbers for the overall stock market were quite satisfactory over both periods, there was a wide degree of variation across asset classes. Value benchmarks were in the red for the quarter, with smaller-caps doing worse. Growth benchmarks did quite a bit better, with larger-cap growth stocks generally delivering strong returns during the quarter. For the year growth is ahead of value by a wide margin after seven consecutive years of underperformance. International stocks gained over 4% in the quarter, extending their run of impressive returns. With the exception of high-yield bonds most other fixed-income asset classes had a solid quarter, with investment-grade bonds climbing almost 3%, and emerging-market short-term bonds returning almost 5%. Commodity futures gained over 6%. REITs managed to post a positive quarter with a return of 2.4% though they are still in the red on the year.

“Prediction is Very Difficult,                  
                     Especially of the Future”  

The above quote is credited to physicist Neils Bohr, and it comes to mind in assessing the developments of the turbulent third quarter and what they may mean for investors.

The Economy — In the realm of economics and investing it is easy to find plenty of intelligent-sounding predictions about the future. Investors are drawn to forecasts about the economy and the markets because they make investment decisions much easier. Unfortunately, accurately predicting the future is another story. The real key is to accept that some things are inherently uncertain and instead focus on the knowable. The trick is then to balance the two in assessing a range of possible outcomes.

When it comes to assessing possible scenarios, it would be immensely helpful to accurately predict the health of the economy. One thing we know is that credit is the lifeblood of the economy and it has become less available than it was. The ability of homebuyers to easily access capital without having to prove their creditworthiness will go down as one of the defining characteristics of the last few years, as it contributed to an unprecedented surge in housing prices in many parts of the country. At the same time, in the leveraged buyout market, loans were written on remarkably generous terms, which spurred acquisitions at ever increasing cash-flow multiples and boosted stock prices.

Unfortunately, when excesses end, things don’t just return to “normal.” Often they go to excess in the other direction. This type of snapback triggered much of the volatility during the third quarter as there was an extreme lack of interest in holding consumer-backed debt, and an inclination on the part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who had played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks. With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points things have settled down but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This we can count on and it’s not a bad thing, because excess liquidity was leading many investors to make imprudent investment decisions. What is bad is a seizing up of the credit markets in a credit-dependent economy. It seems highly probable that the economy will, at the very least, experience slower growth.

The question now is how long it will take to fully return to a normal credit environment, which is necessary to mitigate recession risk. If there are other events that shock the markets and cause another retrenching, recession risk will rise further. Because there is a lot of credit extended through hedge funds (which lend their capital) and structured products (e.g., collateralized debt obligations which slice and dice loan portfolios to create different risk tranches that are then repackaged and sold to investors) it is difficult to know the magnitude of some of the more questionable debts, who holds them, and whether they are in strong or weak hands. This in turn makes it hard to know if there may be blow-ups yet to come.

While the credit markets are better than they were but still not back to normal, the other problem—also making daily headlines—is the housing market. The housing market is loaded down by months of excess inventory, while at the same time the downfall of the subprime lending market and the tightening up of the rest of the mortgage market has led to a sort of negative feedback loop. The problems result in fewer and more-cautious buyers, which makes for softening prices, which keeps lenders cautious, which makes for fewer buyers, which softens prices, and so on.

With the housing ATM machine largely shut down and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending—the primary driver of economic growth. Consumers have less cash available, there are fewer homebuyers buying things for their new home, and the homebuilding and mortgage industries are retrenching. All this has a negative multiplier effect on the economy. A key going forward will be the labor market, which, while still pretty healthy, has begun to exhibit a few signs of weakness over the past few months, starting even before the summer meltdown.

As always there are additional factors to consider.

• The global economy has been quite strong and is less dependent on the U.S. than it used to be. For example, according to Goldman Sachs, the four largest emerging market economies—Brazil, Russia, India, and China—are responsible for a sizable portion of the growth in global demand and significantly more than the U.S. In general, due to much-improved economic fundamentals, the emerging markets are playing a much more important role in the global economy. On the other hand, the credit crunch is being felt around the world, not just in the U.S. Europe, in particular, is sharing the U.S.’s experience and in several countries there are similar problems in the housing market.
• The weakness in the dollar, as long as it doesn’t turn into a rout, is like an interest rate cut. It will help U.S. export growth, which has already been very healthy, and contribute to the bottom line of U.S. firms that do business globally. Meanwhile, a dollar collapse is unlikely because this outcome would be very harmful to the global economy. For this reason central banks around the world would take extreme measures to avoid it.
• The Fed does have influence and room to maneuver. If the economy continues to weaken, the Fed can be expected to continue to lower short-term interest rates to make more capital more available at a lower cost, which should spur the economy. But the financial markets are expecting additional rate cuts, so if the Fed doesn’t lower rates this year, market participants are likely to react negatively. Also, additional Fed rate cuts (along with a declining dollar) may spur increasing inflation expectations, which would not be a positive for the economy or longer-duration interest rates.

The bottom line is that the economic outlook is murky. Due to the credit crunch and continued deterioration in the housing market, recession is more likely than it was earlier in the year. But it is not a foregone conclusion. The few firms whose economic forecasting we respect (which doesn’t mean they are always right or that we make decisions based on their forecasts) continue to believe that a recession is not the most likely outcome, but most are less confident than they were a few months ago.

Looking beyond the recession question, longer term we are cognizant of possible inflation risk and perhaps the worst case—stagflation. This would result in higher interest rates that would hurt valuations, without a fully compensating offset from earnings growth. It is early to worry about this now because the impact of the housing and credit markets on the consumer is likely to keep inflation under control. But longer-term, some inflation risks are building and a big driver is the rapid growth in the developing world—though it also provides a major structural inflation benefit because of the abundance of labor in these countries. Over time we will be considering whether it is prudent to build more of an inflation hedge into our portfolios.

Reminders, Observations and Lessons

There are lessons to be learned and observations to be made from every market event. The events of this summer were significant, and bring to mind several valuable reminders.

Market declines are common and don’t always lead to bear markets: According to Ned Davis Research, Inc., there have been 262 instances since 1928 in which the S&P 500 dropped at least 5% but did not drop as much as 10%. When the market has dropped at least 5%, only 33% of the time has it ultimately dropped more than 10%. There have been 87 other instances when the market dropped 10% but not as much as 15%. When the market has dropped 10%, 44% of the time the loss reached at least 15%. Regardless of how far any market decline goes, investors are always nervous during the decline and headlines are usually disturbing as the risks become the central focus. But more often than not, when the market declines are in the single-digits, it doesn’t turn into a double-digit decline.

Excesses always end badly: We’ve seen this many times before … betting on things that don’t make sense does not pay in the long run. Investing in real estate during the 1980s based only on tax benefits turned out to be very costly. Buying Internet stocks that had no earnings and not much of a business plan was a disaster. And investing in loans that had virtually no underwriting standards—no money down or income verification—was an accident waiting to happen. Investment discipline based on common sense can sometimes test an investor’s patience when common sense is temporarily ignored (e.g. the Internet stock bubble in the late 1990s), but it always pays off in the end.

There are certain return relationships between asset classes that generally hold, but basing a portfolio strategy on the assumption that they will always hold can lead to mistakes: We all like to have general rules we can apply. But the world is not this simple. For example, in stock market declines, REITs tend to outperform equities and value stocks tend to outperform growth but the context of each period can lead to different results. In the recent market decline REITs, which were already in a bear market, following a huge multi-year bull market—fell more than the overall stock market. Value stocks fell more than growth stocks after a similarly long stretch of value outperformance as investors worried about earnings. By factoring in the prior market performance, valuations, and the market cycle, it was possible to add value beyond just relying on rules of thumb.

Final Thoughts

With three-quarters of the year in the books, returns have been pretty good—not fantastic but not bad either. But somehow it doesn’t feel that way. Looking ahead, there are a number of positives for the financial markets, including relatively low interest rates and a surplus of global liquidity looking for a good return. However, the driving factor for returns over the next year will likely be the U.S. economy and its impact on the rest of the world. However, we’ve been through many difficult times over the years including market crashes, recessions, Fed tightenings, terrorist events, oil price spikes, geopolitical drama, and the worst bear market in 35 years (and arguably the worst since the 1930s). We also have a deep respect for the financial markets’ ability to surprise investors. We have lived through many troubling times, when investor sentiment was in the dumps, but they were somehow followed by good returns. And when the opposite occurred—nasty market corrections or bear markets—we were able to take advantage of compelling return opportunities that were created. So while every cycle is different, what is the same is our philosophy of structuring portfolios to capture the best long-term return we believe possible while seeking not to violate the portfolio’s one-year risk tolerance. (We don’t focus on risk over shorter time periods because it results in excessive conservatism and opportunity cost.) This approach has stood up well over time, and is what you can expect from us going forward.

As always, we appreciate your confidence and trust.