Fourth Quarter 2008 Letter to Clients

If ever there was a vivid example of the notion that time is relative, it was the last four months of 2008.

Was it really in only 120 days’ time – less, actually – that Lehman Brothers collapsed, Merrill Lynch was forced to merge with Bank of America, Wachovia was forced to merge with Well Fargo, Citibank nearly failed before being bailed out, as did the entire U.S. auto industry, scores of financial services firms – including Goldman Sachs, Morgan Stanley and American Express – changed their stripes to become bank holding companies so they could belly up to the government bailout trough, and Ben Bernanke and Hank Paulson morphed from government officials into a two-headed monster that got to decide who lives and who dies in American Enterprise? Oh, and the stock market dropped 20% in six trading sessions and posted its worst year since 1931.

It seems like a spate of such momentous events should have taken place over the course of decades, not days. Not surprising, then, that the six weeks from October 1 to November 13 saw 20 trading sessions in which the Dow Jones Industrial Average experienced an intraday swing of 5% or more – including four sessions that saw 10% intraday swings. The VIX index, a measure of investor fear, moved above 50 for the first time in its history and twice reached a peak of 80 (keep in mind that a level of 30 in the VIX is the threshold most market pros say reflects “extreme fear” in the market.)

When historic economic crises are afoot it is hard for everyone to keep perspective, because we have no way of knowing how events are going to play out. Anxiety about the future becomes acute, and the stock market becomes seemingly electrified with fear.

Once that fear recedes and volatility returns to near-normal levels – as it has the past few weeks – investors are left to contemplate the diminished asset totals in their monthly brokerage statements. It is easy to become discouraged and believe that it may take many years to regain the ground that has been lost.

Now for the good news: While there are certainly no guarantees about the near-term direction of the stock market, history shows that deep market declines have typically been followed by extended market rallies that often last many years.

The following chart, produced by Dimensional Fund Advisors, depicts the bear and bull market runs that have occurred since 1926:

It is worth examining some of these market recoveries in more detail. For instance, coming out of the 1930s, the stock market gained 210% from 1939 to 1943; then, following a brief, six-month bear market, stocks soared another 491% over the next ten years. Likewise, coming out of the 1982 recession, stocks soared 282% over the next five years. After the 1991 recession stocks gained 355% over the next eight years.

It is no coincidence that deep declines in the stock market are usually followed by extended rallies. Such downturns usually accompany economic upheaval just like we are experiencing presently. While these crises are painful for everyone in the short term, they are essentially economic forest fires that clear the excess from the system and allow for healthy, sustained growth to resume once the conflagration is over.

As Warren Buffett once observed, “When the tide goes out, you find out who’s been swimming naked.” Clearly there were a lot of skinny dippers in the corporate pool who were exposed when the credit bubble burst in 2008. Our system is in the throes of weeding out those firms, and it isn’t pretty to watch. But the reality is that our economy will be much healthier for it when it’s all said and done.

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“The worst year for the stock market since 1931.”

When we hear such statements in the media about 2008, it is hard for anyone not to be jarred by the magnitude of it. The reality is that almost no one who has investable assets in the market today has ever seen a worse year than what we’ve just experienced. Investors who held assets in 2008 other than Treasury Bills – including stocks, bonds, commodities and real estate – saw significant declines in their portfolio value. Clearly even well-diversified portfolios could not escape the carnage.

As we look in the review mirror at the last nine years, we see the bursting of two of the biggest investment bubbles in economic history – the dot-com bubble in 2000, and now the credit/housing bubble in 2008. It is hard to imagine a worse scenario for stock investors than that. The decade of the 2000s will likely be second only to the 1930s for worst stock performance.

And yet there is an interesting point to be made here, because for all the historical significance of the events of this decade, a well-diversified investor – even one who was invested in an all-stock portfolio – could have emerged from this period of time with his or her assets completely intact.

Consider this hypothetical portfolio* of market indexes:

• 40% Large Cap Stocks (S&P 500 index)
• 20% Midcap Stocks (Russell Midcap index)
• 20% Small Cap Stocks (Russell 2000 Small Cap index)
• 10% International Stocks (MSCI EAFE index)
• 10% REIT (Wilshire REIT index)

Despite the worst 10-year run for the stock market since the Great Depression, such a portfolio (and remember, this is an all-stock portfolio) would have ended 2008 with an annualized gain of 1.86%. While such gains may seem paltry compared to our expectations for stock returns, the point is that well-diversified investors can survive the worst of downturns – even extended ones – with their assets intact, so that they can make sure they are in the market when the extended bull markets commence.

There is a further point to consider about the above example. For the 30-year period ending in 2008, that sample portfolio would have earned a return of 11.44% a year, despite the 1981-82 recession, 1987 market crash, 1990 S&L crisis, 1992 recession, 1998 foreign currency crisis, 9/11, bursting of the dot-com bubble, Iraq War, and now the 40% decline that the market experienced in 2008.

Stock investing is like that. While the long-term return for stocks has averaged around 11%, the reality is that the dramatic losses and gains are often clustered close together. There is both risk and reward to being a stock investor. In 2008, all such investors experienced the risk side of the coin; let’s be sure we are there to reap the rewards that will inevitably follow.

* This is a hypothetical portfolio containing performance numbers for market indexes; these are not actual investment vehicles, and the performance numbers do not reflect costs such as fund fees, transactions costs and other associated costs that would be incurred in the management of an actual investment portfolio.