First Quarter 2017 Letter to Clients

“The buying opportunity of a lifetime.”

That was how the esteemed financial writer Nick Murray described the stock market environment in early 2009. Hindsight shows he was, of course, spot on. But it certainly didn’t feel that way to many investors at the time.

After plunging from 11,000 to 8,500 in just a few weeks in the fall of 2008, the Dow Jones Industrial Average renewed its freefall in early 2009, hitting a low of 6,594 on March 5. At its low point, the Dow was 53% below its October 2007 high of 14,047 – and that was the best of the major indexes! In comparison, the Russell 2000 small stock index was down 59%, and the MSCI EAFE international index was down 61%.

The global economy was in a recession the likes of which hadn’t been seen since the 1930s, and credit markets around the world were completely frozen. The talking heads on TV repeatedly warned us not to expect a “v-shaped” recovery once the market hit bottom, meaning investors should not look for a sudden rebound in stock prices. Instead, they told us to expect a “u-shaped” recovery, with stocks bouncing around their new low point for months or even years before recovering. On March 9, The Wall Street Journal ran a story with the ominous title, “Dow 5000? There’s a Case for It.”

Stories abounded in the financial press about the “death of asset allocation,” which, they noted, had failed to dampen the effects of the stock market crash. Instead, they urged investors to trust only skilled stock pickers who could navigate the market minefield. Many investors instead gave up on stocks entirely, turning paper losses into real losses as they succumbed to the panic sweeping the capital markets and fled to bonds and cash.

And then, despite all the predictions to the contrary, stocks bounced off their March 5 low and began a decidedly v-shaped recovery. Just three months later the Dow had gained 30%. One year later, the Dow was up 50%; small stocks gained even more, with the Russell 2000 up 93%.

Despite a number of hiccups along the way, stocks haven’t looked back since their lows in 2009, soaring to record levels in 2017. As we passed the eighth anniversary of the bottom of the market downturn a few weeks ago, it is astounding to see the gains that stocks have enjoyed over that span.


Let us pause, then, to appreciate the reality that stocks were indeed “the buying opportunity of a lifetime” in early 2009. Few dared to suggest such a notion back then because investors were psychologically scarred by the sudden downturn that stocks had just experienced. To assert that stocks were a smart place to put one’s money at that time was viewed as insanity. But those who understood the historical behavior of the stock market knew it to be true.

At Capital Directions, we steadfastly rebalanced our clients’ portfolios throughout the 2008-09 bear market, selling fixed-income positions that had become overweighted in the portfolios and investing the proceeds in equities to bring the portfolios back in line with their long-term allocations. Our clients benefitted greatly from this disciplined process by having their portfolios properly allocated when the smoke cleared and stocks began their dramatic recovery. In contrast, investors who fled to the perceived “safety” of bonds and cash missed out on the once-in-a-lifetime returns that stocks generated in the years that followed. This is the sort of disciplined approach that must be maintained during times of market extremes - both bad and good - to keep emotions from overwhelming investment decisions.

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Blackrock, the world’s largest money manager with more than $5.1 trillion in assets, made a surprising announcement in early March.

In an article in the March 28 edition of The Wall Street Journal, Blackrock announced that it was dramatically shifting away from human money managers and will henceforth rely mostly on computers to make stock-picking recommendations. According to the article:

The company has taken the view that it is difficult for human beings to beat the market with traditional bets on large U.S. stocks. So the firm on Tuesday announced an overhaul of its actively-managed equities business that will include job losses, pricing changes and a greater emphasis on computer models that inform investments.

This admission from a giant in the active management industry is hard to over-emphasize. Blackrock’s mystique as a money manager lay in its supposed ability to provide outsized returns with deft stock picking. But in recent years its returns have lagged the market significantly, and the company began to shift more of its efforts to indexed-type investments. Blackrock’s tacit acknowledgment that its human fund managers were not delivering enough value to justify their existence is a blow to the active management industry, which continues to assert that market-beating performance can overcome the exorbitantly high fees and trading costs associated with active management. Blackrock has all but admitted that such efforts aren’t worthwhile.

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As the stock market grows more efficient, the only way for managers to beat the market is to take large, risky bets that can deliver outsized returns if they pay off. But when those bets go wrong, the results are often disastrous. This has been especially apparent in the hedge-fund industry, where managers are allowed to take riskier bets than their counterparts who run conventional mutual funds.

A March 29 article on CBS Marketwatch’s web site titled “Hedge Funds Buyers Are Getting Soaked” highlighted some of the more notable recent examples:

• High-flying hedge fund manager Bill Ackman finally threw in the towel and sold his fund’s stake in Valeant Pharmaceuticals, a bet that cost the fund’s investors more than $3 billion according to Forbes Magazine.

• Viking Global Investors, a $30-billion hedge fund, suffered its biggest annual loss ever due to large positions in Valeant, Teva Pharmaceutical Industries and Allergan.

• A nearly $6-billion hedge fund overseen by Carl Icahn suffered its second consecutive double-digit annual loss in 2016.

• John Paulson, whose claim to fame was a hugely successful bet against subprime mortgage debt in 2007, has seen assets under management in his fund decline by $26 billion in the past five years as his funds lost more than two-thirds of their value.

• A decade ago, Warren Buffett made a $500,000 bet with a hedge fund company that an S&P 500 index fund would outperform the hedge fund’s best picks. In the nine years since, the Vanguard S&P 500 index fund has gained 7.1% annually while the five funds-of-hedge-funds selected by the hedge fund returned 2.2% annualized.

Hedge funds often draw the attention of investors during times of market turmoil, when their ability to take large short positions in stocks can sometimes pay off handsomely. But extreme volatility is the exception, not the rule, in the stock market. In the long run, the apparent magic that hedge fund managers seem to possess seems to disappears entirely, and investors in those funds are left holding the bag.