Third Quarter 2012 Letter to Clients

“Stocks climb a wall of worry.”

Of all the pithy sayings that have evolved about investing over the years, perhaps none are truer than that one. Stocks historically trudge along on their inexorable upward climb despite the occasional setbacks and incessant negativity of the media. It is easy enough to see in retrospect, of course. The challenging part is believing it going forward.

At Capital Directions, we believe this is the greatest challenge that investors face – finding the fortitude to keep the faith despite all the potential landmines that are always lying in the road ahead. In fact, so strongly do we believe this that we created our own “Wall of Worry” in the lobby of our offices in Atlanta using old Time Magazine covers to illustrate the point for our clients.


The covers span a forty-year range and feature everything from the U.S. dollar crisis of 1970 to the U.S. credit downgrade of 2011. Inside of this ring of covers we have a chart that shows the steady, upward climb of stocks over the long term. The juxtaposition is hard to miss: No matter how distressing current events may be, keeping the faith has always paid off.

As we move into October and contemplate the months ahead, Americans of all political persuasions are staring at a Wall of Worry of momentous proportions. From the outcome of the U.S. election to the pending “fiscal cliff” set to take effect in January to rising tensions in the Middle East, there is indeed much for investors to fret about.

In searching for perspective about these events, perhaps it is better to look backward than forward and contemplate the 25th anniversary this month of what is known today as “Black Monday” – October 19, 1987. It was the day the stock market inexplicably dropped 23% in a single trading session.

Much like the “Flash Crash” of May 2010, Black Monday came seemingly out of nowhere and was largely attributed to the role of program traders in the market. But Black Monday’s decline was more than double the decline of the Flash Crash – the equivalent today of a 3,000 point, single-session drop in the Dow. The result was a much bigger emotional scar on the psyche of the investing public.

To understand the extent of the fear that pervaded the market that day, consider this: The VIX index, which measures volatility in the market, is considered to be in “anxiety territory” when it reaches a level of 30. During the peak of the market panic in October 2008, the VIX topped out at a reading of 80. Though the VIX didn’t exist in 1987, statisticians have reverse-engineered it and found that it would have reached a level of 170 on Black Monday – more than twice the peak of the 2008 Financial Crisis!

Black Monday wasn’t just a bad day for the market, the media told us then. It was a “game changer,” the end of the stock market as we knew it. Investing in stocks was no longer a smart bet, we were told. The cover of Time Magazine that week, which hangs on our Wall of Worry, reflected the ominous tone of the day:

So concerning was the event that a group of 33 of the world’s pre-eminent economists met in New York that December to consider how best to avoid a repeat of the crash. Their conclusions were not encouraging: ''Unless more decisive action is taken to correct existing imbalances at their roots,'' they said, “the next few years could be the most troubled since the 1930's.'' (“Group of Seven, Meet the Group of 33,” New York Times, December 27, 1987).

Black Monday left the Dow at a level of 1738. And while the Dow eventually regained its lost ground two years later, the 1991 recession knocked the index down again and it would be a full five years before the market was able to retake and hold its pre-crash high of 2246.

And that, by the way, is the perspective.

Did you miss it? Here it is again:

“…it’s pre-crash high of 2246.”

Despite all the anxiety, speculating, hand wringing and stomach churning wrought by Black Monday, the Dow today, a quarter-century later, stands at a level of about 13,500 – more than 600% above the pre-crash levels of 1987.

Just like the bursting of the dot.com bubble, 9/11, the Great Recession, and the myriad other challenges we have faced in the past 25 years, all an investor had to do to survive Black Monday was to be well diversified, stay invested, and keep the faith. For all the complicated trading strategies that Wall Street has ginned up since 1987, this is the only investment strategy that, given time, has always been successful.

There is much to worry about in the months ahead. There always is. That’s why stocks deliver the returns they do – if it was always placid, stocks wouldn’t need to compensate investors for the risk they take. So accept the worry and embrace it as a necessary evil in the long-running success story that is the stock market. And if you need some perspective along the way, feel free to visit our offices and have a good, long look at The Wall of Worry. It is guaranteed to make you feel better!

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While we are on the subject…

It’s never hard to find the bricks to build the Wall of Worry; the media gives them to us every day. But what about the case for stocks? What reasons do we have to believe that the environment in the years ahead will be a positive one for equities?

Keeping with the counter-intuitive nature of successful investing, one of the strongest cases to be made for stocks is the fact that so few people believe in them these days. This isn’t just the old adage about being “greedy when others are fearful and fearful when others are greedy” (although there’s a lot to be said for that). There is a real cause-and-effect relationship between economic anxiety (cause) and the market realities that follow (effect).

Consider first the amount of cash that currently sits piled up in the world’s financial system. According to the Federal Reserve, U.S. corporations are sitting on a stock pile of cash that is approaching $2 trillion. (That’s two trillion dollars!) But even that estimate may be far lower than what is actually available; according to IRS figures from 2009 (the most recent estimates available), non-financial U.S. companies are sitting on more than $5 trillion in liquid assets!

Note in the above chart that the historical average prior to the 2008 Financial Crisis was consistently in the $3.5 trillion range, but corporate cash holdings shot up nearly $2 trillion from 2008 to 2009; given that those numbers are nearly three years old, the likelihood is that the cash hoard is even higher. Those are assets that are earning nearly nothing in cash-equivalent investments and need to either be put to work, distributed to shareholders in the form of dividends, or invested in higher-yielding investments. All of these are positive factors for stocks going forward.

The same scenario exists with individual investors. Since the financial crisis of 2008, investors have fled equities for cash and bond funds, putting the majority of their assets into low-yield investments.

It almost defies the imagination that in a zero-interest rate environment investors are fleeing the one asset class – stocks – that has produced significant gains in recent years for the absolute certainty of earning no return in cash and very low returns in bonds. Yet that is what is happening. Sooner or later those assets will have to be reinvested in stocks if those investors are to earn any return on their money.