I sense a gradual capitulation in the market that could be completed by year-end. Many investors have given up on equities.  Mutual fund redemptions are at an all time high.   Its no wonder why investors have given up. Besides the worst "waterfall" decline in stocks since 1920's, the last ten years were a subpar decade for stocks. Interesting to note that a poor performing decade in stocks is usually followed by good performing decade. Moreover, the risk premium for equities and corporate bonds is at its highest level in decades. Investors are actually getting paid to take risk this time around.   Investors are notoriously bad market-timers usually selling around a market low and getting back in after a major rally.  Morningstar studied investor returns--which consider the timing of investors' purchases and sales-and found that investors buy high and sell low to their own disadvantage.

Holding too much cash becomes risky when the economy is half way through its recession. The duration and depth of this recession is really unknown. Many economists have altered their forecast to the downside, and some are not counting on policy action and lower energy prices being of any help. The less bearish view is that the half way point might occur sometime early first quarter 2009.   The market produces the highest returns from a Bear market low to early Bull phase. In order to make up Bear market losses investors must own more equities and less cash. Investors that were fully invested at the bottom of a Bear market saw a typical twelve months return of 47% according to Ned Davis Research Inc.  Of course past performance is no guarantee of future performance, but there is significant upside in the market when it bottoms.

If you try to time the market, by waiting just three months from a market bottom to invest, the twelve months return figure drops to 18%. Conservative investors may want to wait a bit to be on the safe side.   Instead of trying to time when to get back in, which is nearly impossible to do, take advantage of the attractive valuations that exist now by investing a small amount of money each month during the recession. The money you invest must have an investment horizon of at least three years. Invest in areas that are not defensive but instead are recovery type investments. Investors should be rewarded as the economy bottoms out.

Most money managers agree, along with Warren Buffett and Jeremy Grantham, known as a bear investor, that valuations are attractive enough to commit cash for the long term.
 
Be well and enjoy the rest of the fall season!

Market & Economic Commentary 

 
Subprime losses and associated excessive use of leverage by financial institutions, and investors has created a credit crisis not seen since the Great Depression.   In response, investors have been thrown into a sea of chaos not seen since 1920's. The October 2008 "waterfall" decline in stock prices is unlike any market in the past. No sector has been speared panic selling. It seems everyone is struggling to sell assets to raise cash.   The de-leveraging by investors is in large part due to the BIGGEST MARGIN call ever forcing wholesale indiscriminate liquidations of even the most credit worthy high quality stocks.

Everything has been more extreme this time around. The volatility has been off the charts. Over the last decade ending last year, the DOW had only fourteen days where it went up or down by five percent. This year alone that's happened twenty times according to the Wall Street Journal!  Investment Grade/Non-investment Grade yield spreads are at 1930 levels, oil shot up a record $25 in one afternoon session only to subsequently drop by more than $25, and a few weeks ago investors bought  T-bills yielding almost zero.    The fourty percent market decline this year is the largest market sell-off in the past sixty years. The average is around fifteen percent. The 2008 Year-to-date returns rank among the worst annual returns of all time. They get thrown in the same bucket as the 1931, 1937, and 1974 annual returns.

The market over the short term goes where it wants to go. If there are more sellers than buyers it goes lower even though stocks are fundamentally worth more. Eventually all investors that have to sell will have sold. At large, I think this should be the case by year-end. November 15th was the last day in the quarter for Hedge Fund redemption requests, and mutual fund investors already sold in record numbers over the past two months. The market volatility is likely to abate as time marches on into the New Year especially as the banking system continues to move away from the abyss and back to the business of lending.

There has been no place to hide in this bear market. In the last Bear market only five sectors were in negative territory at the low according to Standard & Poors.  Even Healthcare is down twenty one percent and consumer staple stocks have fallen thirty two percent. Not even high quality corporate bonds are immune to the indiscriminate selling.  The only good thing about the sell-off is that risk premiums are at multi-decade highs in many investment sectors. That bodes well for future returns. The years following 1931, 1937, and 1974, were positive years and 1938 and 1975 were up thirty percent plus!

I believe the BIGGEST MARGIN CALL in history explains the recent death spiral down. Following a "waterfall decline" (precipitous drop in prices), there has been a base building period in which the lows are tested over minimum of two months. Hopefully a bottom could be put in place by year-end. Recessions tend to bottom four months after a market bottom. Therefore, the recession may bottom sometime in the next quarter. My research tells me the worst economic quarter will be the one we are in now. The consumer recession has been with us all year thanks to record high energy prices taking a giant bite out of consumption. Consumers just stopped spending last quarter. Earnings trough occurs three months after a recession bottom so by late Spring earnings declines may hit a bottom.     The market tends to rally four to six months before an economic recovery. It is possible that the market can begin a rally any time from this point on. The rally becomes even more likely as we get deeper into the first quarter of 2009. Just about every investor I know is waiting to invests in this rally which could make it explosive on the upside.  

Timing the market bottom is a risky tactic. It's much easier to buy investments at attractive prices. Thanks to the credit crisis, many markets have become Illiquid thereby creating a once in a lifetime buying opportunity from Blue Chip Dow stocks to Mortgage-backed securities backed by the full faith and credit of the US Government. These are temporary conditions that should last less than six months.
Although Treasuries and other defensive moves might work out better over the short term, going into next year, the "recovery" type investments is likely to begin outperforming as the market and economy hits bottom. Investors don't want to miss out on that opportunity. A few Monday's ago the market went up 10% in one day!

What's will help us turn things around?

• Global Coordinated Central Bank Rate cuts - give them up to nine months to help Main Steet. Wall Street will lead by six months. Monetary policy has injected more than $2 trillion into the economic system.
  
• Fiscal policy - a massive Government's response - TARP $700 billion. In the past, fiscal stimulus package of this size tends to make a recession shorter and shallower. A second economic stimulus package is going to be at the top of the agenda for the new administration. The package includes $100 billion-$150 billion in aid for the economy-increased unemployment benefits and food stamps, probably combined with a major spending program for infrastructure. The key thing here is to get money in the hands of consumers so they can spend.
  
• Typically historically low interest rates stimulate borrowing which must occur for an expansion to happen. Low rates also reduce the cost of borrowing freeing up money to spend on other household items. Now that the banking system is more stable, over the coming months  they should increase their lending.
  
• Businesses and consumers are de-leveraging at a fast rate. Household debt outstanding peaked in 2006 and has seen a steep decline in just two years.  Debt service payments peaked in the fourth quarter of 2006 at 14.85% and are falling towards 13%. Consumers are paying down debt, borrowing less, and saving more than in the past few years. They are keeping their powder dry and as conditions bottom out they should boost discretionary spending.
• In order for consumption to pick up in 2009 unemployment must level off around 7.5%. Consumption tracks personal income growth which depends on employment levels. Oil is trading at below $60 should put about $30 billion in the hands of consumers this holiday season alone. For most of this year high energy prices took a big bite of consumption. Now that's gone away!
• Every $10 drop in oil adds 0.2% to GDP. Lower prices may add $100 billion to consumption each quarter of 2009.
  
• Finally, we are beginning to see early signs of a recovery in the credit markets which could be the catalyst to boost virtually all asset classes other than Treasuries.
  

Portfolio Management   

WHAT TO DO NOW

Investors want to sell at the top and buy at the bottom. Well if you missed selling at the top here is your chance to buy at the bottom. It may be volatile for the next two -three months and the low is likely to be re-tested and even breached but that's what bottom investing is all about.   I would follow Warren Buffet's advice. Here is what he recently said in a New York Times Op Ad article.

"The financial market worldwide is a mess, and both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.  So ... I've been buying American stocks. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.  In the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor's best friend. It lets you buy a slice of America's future at a marked-down price. Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: "I skate to where the puck is going to be, not to where it has been."

The best US stock returns have been born out of troubled times. Below are five year returns from subsequent year:

•  Great Depression (May 1932) subsequent five year total return of 367%. Some of you believe that 2008-2009 will be a depression years. If so look at the return that followed the depression in 1932. 
• 1980-82 Recession (worst in 25 years) subsequent five year total return of 267% - I believe we are experiencing a recession that's as worse as the 1980-82 recession. I also believe the recession will end by the second half of 2009. I estimate that the economy will experience a very mild recovery in the second half of 2009.  
  

(c) Aspetuck Financial

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