Third Quarter 2010 Letter to Clients

Just a little over two years ago, on September 15, 2008, the investment bank Lehman Bros. announced that it would file for Chapter 11 bankruptcy. It was a stunning end for the 164-year-old Wall Street icon, a victim of its own greed and profligacy, as the massive amounts of leveraged bets on subprime mortgages the firm had made finally brought down the house.

The Dow Jones Industrial Average on that day stood at 10,917.

The days and weeks that followed the fall of Lehman were times of historic, unprecedented turmoil. Lehman’s collapse set in motion a chain of events that would rattle the global capital markets to its core as a series of financial dominoes began to fall that threatened the very fabric of free-market enterprise. Many of this country’s largest, most iconic institutions – from GE to GM to AIG to BoA – teetered at the edge of the abyss. Some, like GM and AIG, fell in and had to turn to the government to save them.

In an effort to stave off financial Armageddon, Congress and the U.S. Treasury wrestled with the TARP bailout package for days, while the market waited breathlessly to see what would emerge from the political wrangling. Every utterance from Capitol Hill instantly sent the Dow up or down by hundreds of points. Once the TARP package was signed into law by President Bush on October 3, pundits thought the markets would be calmed. Instead, the opposite transpired. The first true panic since 1929 swept the world’s capital markets, taking the Dow from 11,000 on October 3 to an intraday low of 7,700 on October 10 – a 30% decline in five trading sessions.

From that point in mid October, things really got interesting. The Libor/OIS spread, which indicates banks’ willingness to lend to one another, soared from its historical average of 11 basis points to 364 basis points. The VIX index, which measures stock market volatility, hit a record high of 89. (For comparison, a reading above thirty is considered an indication of high anxiety in the market.) Credit markets froze completely shut. The yield spread between government bonds and corporate bonds blew out to levels never before seen. Every asset not named “U.S. Treasury” was sold off without regard to risk or expected return, including stocks, bonds, real estate and commodities.

Daily market gains and losses of 5% or more became more the norm than the exception, with several days in October and November seeing intraday swings of nearly 1,000 points in the Dow. Though the market stabilized temporarily in December, it resumed its relentless selloff in January and continued unabated until March 9, 2009, when the Dow closed at 6,547 – down nearly 55% from its October ’07 high.

All in all, the volatility the market experienced during the sixth-month period from October 2008 to March 2009 compared only to the stock market crash of 1929. Of the forty largest percentage gains and losses in stock market history, seven of them came during the 2008-09 bear market.

There was no shortage of advice from the talking heads in the media about what to do during all the hysteria. CNBC’s Jim Cramer appeared on the Today Show on October 3 and modestly told America, “I can’t have you risk your money in the stock market.” Get out of the market, he said. Panic. Now. And millions did.

Others encouraged investors to be more aggressive and take advantage of a market that was stuck in a downward spiral by implementing all manner of shorting strategies, timing strategies and hedging strategies. Take advantage of all the rubes who aren’t selling out, they said. Easy money. And for six months, it was.

The only given – the only absolute – we were told time and again, was that “buy-and-hold was dead.” Just building a diversified portfolio and staying the course wouldn’t work in the post-Lehman world, they said, as evidenced by the fact that bonds had not held up their end of the bargain when the panic set in. Things are different this time, they told us. Things are broken. Don’t just watch your nest egg go down the drain. Do something. And millions did, jumping in and out of the market on a daily, sometimes hourly, basis.

Flash forward to the present: October 2010. A mere two years later.

The Dow, as of this writing, stands at 10,944. Twenty-five points above its level the day Lehman failed.

Whether it treads water at that level, moves higher or moves lower is really beside the point. The undeniable reality is this: All a well-diversified investor had to do to survive the worst financial crisis in a century was to do exactly nothing. Not blink. Not panic. Not do something, but do…nothing.

It is one of the great ironies of successful investing; as Warren Buffet once famously observed, “Much success (in investing) can be attributed to inactivity.” And never has there been a better example than this: Investors in a well-diversified portfolio who did nothing may, in fact, be the only ones who survived the worst financial crisis in a century without doing major damage to their net worth.

Those who tried to play the market by implementing shorting strategies and timing strategies destroyed themselves once the market bottomed on March 9, 2009 and began its meteoric recovery. Those who bailed out and went to cash remain there today, earning less than 1% on what money they have left, having missed a once-in-a-lifetime market recovery of 65%.

The only ones left standing amidst the rubble are the very ones who were told they were fools for staying the course in the face of total pandemonium – those who built a properly diversified portfolio and kept the faith. It didn’t require any secret trading strategy or divine vision. But it did require an incredible amount of emotional discipline and intestinal fortitude.

We said in our client letter in this space exactly two years ago that “sometimes you have to go forward on faith alone.” In the fall of 2008, that was all we had to lean on.

Now, two years later, we are gratified to know that our clients were rewarded for keeping their faith during a time when nearly all others around them were losing theirs.

* * * * *

Economic and political uncertainty dominated financial markets during the third quarter, fueling a continued exodus of small investors from U.S. stocks and a buying binge of bonds and gold.

Still the Dow Jones Industrial Average rallied a solid 10.4% for the quarter…

“Blue Chips Surge 10.4% Even as Small Investors Pull Back,”
Tom Lauricella, Wall Street Journal, October 1, 2010, p. C1


Do you recall the 1993 movie “Groundhog Day” with Bill Murray and Andie MacDowell? It recounts the story of a long suffering TV weatherman who keeps waking up to find that the calendar is stuck on February 2. No matter what Murray’s character does to try to change things around, he is forced to relive the same day, with the same exact scenarios, over and over again. The more violently he reacts to events, the more frustrated he becomes, because nothing changes his outcome. Every day he starts over at square one.

We would like to hereby nominate “Groundhog Day” as The Official Movie of the Small Investor. It seems that no matter how many times investors panic out of the market during a downturn and miss the inevitable recovery that follows, they never seem to learn their lesson. They always revert back to the same behavior when the next crisis comes around.

If ever there was a microcosm of the small investor’s typical investment experience, it was in the spring and summer of this year. After experiencing the first sharp pullback in the market in more than a year in May, individual investors threw in the towel and bailed out of the stock market en masse, locking in a steep decline and missing out on an even steeper recovery in the process.

The chart below illustrates this exodus; it shows the net fund flows for U.S. stock funds and bond funds year-to-date. Note the massive flows out of stock funds that began in May and continued throughout the summer:
Thus did small investors – yet again – experience all of the downside and none of the upside of stock investing.

We say “yet again” because we have been here many times before. Just in the past ten years, we have seen the investing public flee the market like a house on fire in 2008 and 2009, only to miss the biggest rebound in the market in 80 years. They did likewise in 2002 and 2003, just when stocks soared 50% coming out of the 2000-03 bear market. It is a sad pattern to observe.

And there is an even sadder part to this particular chapter of the story that will be unfolding down the road. All of those small investors have piled into bond funds believing them to be safer than stock funds. They are finding, however, that the price of lower volatility in this ultra-low interest rate environment is ultra-low yields on short-term bond funds. So many of these investors are naively loading up on funds that invest in longer-term, lower quality bonds in an effort to increase their yields.

It is a mistake, and one they will learn the hard way. When interest rates rise – and when they are hovering near 0% there is nowhere to go but up – bond prices fall. And bond prices fall exponentially the farther out you go on the yield curve, and the lower down you go in quality. Many investors in long-term bond funds and junk-bond funds could see those funds plunge in value between 20% and 30% if interest rates rise just 2% in the years ahead.

Ultimately in Groundhog Day, Bill Murray learns his way out of his Promethean nightmare. He finally realizes that he must change, not the external events, but his behavior, before fate allows him to exit his endless loop.

Perhaps we can hope that one day small investors will awaken to learn that it is not events, but their behavior, that is causing them to lose money in the stock market time after time after time.

Alas, that’s not the way we would bet it.