This has been a week to remember.  Markets are clearly trading on emotion rather than fundamentals.  Good news is being ignored, while bad news has triggered another round of indiscriminate selling.  Investors are frustrated and confused.  We at Beacon Pointe fully understand our clients’ doubts and concerns.

Friday’s open (October 10, 2008) brought in high volume and another triple-digit drop in the Dow to cap off two weeks of unrelenting selling.  We maintain that it would not be prudent to sell out today.  Data shows that “cash on the sidelines” has reached significant levels; it may rush back in at the first signs, however tentative, of a positive turn in the markets, which could cause a swift rally in the early stages of a recovery.

The following table shows that the performance of small cap stocks over the past few days ranks among the worst weeks since 1987.  The table also confirms that in most cases, big sell-offs are followed by positive market moves that average 7% over the following one month, 11% over the following three months, and 19% over the following twelve months.

Any scenarios other than a "Great Depression II" imply huge returns over time.  Remember that monetary and fiscal policy during the Great Depression was to tighten; this is not the case in the current cycle.  Many fundamentals are being put into place to stabilize the system.  General Electric said in their earnings statement that short term credit markets are working for them, while IBM pre-announced better-than-expected earnings earlier in the week, all of which have been offset by negative momentum.

During periods of panic and fear, all investors can do is fall back on their investment philosophy and process.  Without that discipline and process, investors fall prey to human emotions, which we know result in poor investment decisions.

There is danger in dropping your discipline during periods of extreme, irrational markets.  That is just as true for the “greedy” periods – when investors ignore their valuation discipline to chase momentum – as it is for “fearful” periods – when investors keep selling because they cannot bear losing, despite knowing the stock market is undervalued.

With the unprecedented volatility, investors have the opportunity to own high quality businesses at great valuations.  To wit, Warren Buffet recently purchased stakes in General Electric, Goldman Sachs, and Constellation Energy.  According to investment management firm Dodge & Cox “…though investors face unprecedented near-term uncertainty, the backdrop for long-term investing is more encouraging given the substantial drop in equity valuations.  While the current financial crisis has led to a slowdown in economic growth, we believe the U.S. economy is resilient; it has rebounded from significant strains in the past, and will undoubtedly recover from the challenges it faces today.  Given this outlook and significantly lower starting prices, we believe the return outlook for equities for the next five years has improved.”

The following study from Leuthold Group confirms that future returns are highly correlated with the currently prevailing market valuation – the lower the valuation at present, the higher the expected return for investors going forward. 

Moreover, stocks still offer investors the best shot at long-term capital growth, despite the fact that stock returns have actually lagged those of bonds over the past 10 years.  According to Money Magazine, of the 73 rolling 10-year periods since 1926 (1926-1935, 1927-1936, etc.), stocks have outperformed bonds 85% of the time.  And if the period is extended to 20 years, stocks do better than bonds 98% of the time.

Bear markets, although painful, are normal and necessary in order to clean up excesses and set the stage for the next part of the cycle.  As we have said many times, although the timing is unknown, this bear market, too, shall end.  As the following Putnam Investments chart illustrates, bull markets last longer and account for roughly 75% of the past 60 years of market history.

Please feel free to call Beacon Pointe at 949-718-1600 should you need additional information or have any questions.

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