Third Quarter 2008 Letter to Clients
“I guess it comes down to whether I believe in capitalism itself. And I do.”
Those were the musings of one of our clients we spoke with late in the week of October 6, a period of time in which the world’s major stock markets all saw declines of between 20% and 25% in just five trading sessions. He was reaffirming that, while it is unsettling and extremely painful to experience a sudden plunge of such magnitude, he still had faith in the ability of the free-enterprise system to mend itself over time and resume what has essentially been a three-century success story.
Simultaneous with this, millions of people around the world were reaching a different conclusion. Despite the assurances of political and economic leaders that steps were being taken to address the global financial crisis, investors panicked en masse and began leaping from the market like so many lemmings into the sea.
It is undeniable that all is not currently well with the global financial system, of course; when a credit bubble of historic proportions pops, the ship doesn’t just get righted over night. And when the bursting of that bubble follows closely on the heels of the bursting of another (the technology stock bubble that unwound from 2000-02), it makes for a decade’s worth of stock returns that are, suffice it to say, well below their long-term historical averages.
But the real questions for long-term investors are these: Are things really irretrievably broken? Is it really “different” this time, as far as the stock market is concerned? Is the stalwart worldview that the stock market, while prone to periodic upheavals, is a good long-term investment still valid? Or is the current turmoil, and the past decade of marginal returns, proof that such assumptions are folly?
There is plenty of fodder around right now for anyone who wants to make the latter case, and the media is serving it to us on a silver platter every day. We are bombarded with an endless supply of factoids about failing banks, non-existent credit and investor anxiety levels beyond any ever measured. Several well-known (not to be confused with well-respected) talking heads in the media actually encouraged investors to flee the market during the height of the turmoil, reminding us that the most dangerous market-timers are those who actually believe themselves.
When it comes to successful investing, the easiest thing to do in the moment is nearly always the wrong thing to do. This is why so few people succeed in the stock market, because it is so much easier to point to whatever current events are occurring in the world at any given time and say: “See, there’s your evidence. Things are just different now. And we need to make our investment decisions accordingly.” It is much more difficult to say: “I know that things seem different now, but history has shown that, however illogical the stock market might seem presently, logic and reason eventually win the day.” The former mentality is rooted, it seems, in hard fact. The latter is a sort of expression of faith, and that can be scant comfort in times of market extremes.
In such times of extremes – whether they be good markets or bad markets – clinging to that faith becomes extraordinarily difficult because “group think” begins to take hold and a herd mentality sets in. As the esteemed Princeton economist Burton Malkiel (author of “A Random Walk Down Wall Street”) noted in the October 13, 2008 issue of The Wall Street Journal:
The herd instinct is extraordinarily powerful. When the economy and the stock market were booming in early 2000, investors could easily convince themselves that prosperity would continue without interruption and that stocks catering to the "New Economy" were surefire tickets to wealth. Individuals poured more money into equity mutual-funds during the last quarter of 1999 and the first quarter of 2000 than ever before. And not only was the timing wrong but so was the selection of funds. The money flow was directed to the hot Internet funds. Investors liquidated "value" funds that owned less exciting businesses, whose stocks sold at only modest multiples of their earnings and book values.
The herd instinct works exactly the same way in bear markets. Nervous investors convince themselves that every "light at the end of the tunnel" is a train coming in the opposite direction. Panic is just as infectious as blind optimism.
The herd mentality becomes nearly unstoppable just when events reach a critical mass
and all signs seem to point to an obvious, inescapable conclusion; one that cannot be factually refuted in the short-term and that leaves advisors like us offering what sound like hopelessly naïve bromides such as “stay the course” or “don’t chase returns”. Recall, for example, how the masses so flippantly dismissed the “cynics” of the New Economy in late 1999 (we remember the sting well) for inconveniently pointing out that a bunch of stocks trading at $300 a share with no earnings might be considered a sign that things were “risky”.
Just, then, as the herd could make a very compelling case in 1999 that you were a fool if you weren’t margining your portfolio of dot.com stocks to buy more dot.com stocks (yes, people really did that), the herd can now make a case that the financial system is a hopeless wreck and the ship is going down.
The herd mentality was wrong in 1999, and we believe it is just as wrong now. When crises occur in the world – whether they are economic, political, military or some combination thereof – by their nature they violate the established order of things. The world as we thought we knew it no longer seems the same (think 9/11). Everything seems to be in chaos. And yet, without fail, out of that chaos rises the next great period of opportunity.
Sometimes, then – very often the most important times – successful investing requires moving forward on nothing more than principle. When panic grips the market and investors are selling everything from Morgan Stanley to McDonalds to municipal bonds with the same disregard, you can’t know in real time when that mindset will abate. You can only know that such events represent a complete break with the way markets work, and that historically it will not be those who stay in the market that lose their shirt – it will be those who blink.
It is our mission at Capital Directions to make sure our clients are in a well constructed, prudently diversified investment portfolio suitable to their risk and return needs, so that they can stay invested and receive all the long-term benefits that the capital markets have to offer. We know that there will be times, such as the present one, in which that mission may seem out of touch, and we accept that as a necessary part of our refusal to succumb to the herd mentality in times of market turmoil. We strongly believe that our clients will benefit from this resolve over time.
As Professor Malkiel noted in the closing of his aforementioned column:
Don't forget that the U.S. economy is still the most flexible in the world and our "innovation machine" is alive and well. No one has consistently made money by selling America short, and I am confident the same lesson is true today.
At Capital Directions, that is about as well as we could sum up our investment philosophy.