Beacon Pointe Advisors

The first weeks of the New Year proved to be extremely testing for investors.  With the barrage of negative headlines in the media and increasing recession fears, it appears that market psychology has crossed the line into the land of bears.  Here is a look at the year-to-date performance (through January 16th, 2008) for key stock market indices, their returns since the respective October highs, and their 2007 annual returns:

All equity asset classes posted negative returns over the past few weeks and are off significantly from their October highs.  This market behavior certainly qualifies as a correction.  So, what are the implications for Beacon Pointe clients?

Most of Beacon Pointe’s senior professionals have been in the business long enough to remember several previous recessions and market corrections.  Despite taxing investors, consumers, and the economy, these difficult times eventually passed and were followed by strong economic growth and market gains in the years that followed.  With perfect hindsight, avoiding the periods of correction and redeploying proceeds at the beginning of an expansion would be optimal.  Since timing these inflection points however, has been proven near impossible, we believe that the prudent decision for our clients is to remain invested and let your strategic asset allocation and investment managers work for you.

A Look Back at History

If we are heading for (or already in) a recession, it is important to look back at previous recessions for clues about how the markets perform in such trying periods.  Stock market corrections and economic recessions don’t always coincide, as seen by the following chart:

The Wall Street Journal examined the issue in its recent article “History Lessons: Past Recessions Yield a Few Clues”, dated January 14, 2008.  Using the S&P 500 Index as a proxy for equities, the following table compares stock returns before, during, and after the last six U.S. recessions.

Investors’ memories are typically short.  The recession we remember most vividly is the last one.  The recession of 2001 was relatively short, lasting nine months, but it was exacerbated by 9/11.  The bear market persisted for a year after the end of the recession and cut the S&P 500 almost in half.  Barring another “black swan” event, markets should withstand a recession better in 2008, supported by relatively reasonable valuations.  The forward-looking P/E ratio of the S&P 500 Index stands at 14, implying limited downside risk from a valuation perspective.  Of course, the key metric to watch in the coming months is corporate earnings guidance.  If downward profit revisions are significant and prevalent among U.S. corporations, downside risk will be magnified.

Although no two downturns are alike, Beacon Pointe believes that the current situation is most similar to the recession of 1990-1991.  Then and now, the major headwinds were a housing bust and ailing banks.  The Fed, in both instances, started cutting rates before the onset of recession.  This may have helped stocks avoid a bear market in 1990-1991, as the S&P was up 2.5% during the recession (July 1990-March 1991) and advanced another 7.7% for the next six months (April 2001-September 1991).  This gives us hope that the current recession (if we are indeed in one) would not be brutal for equity investors.

The recessions of the 1980s were similarly benign for stocks and were followed by strong gains of 19% and 23%, respectively, over the 6-month post-recession period.  The recessions of the 1970s coincided with (or were the cause of) bear markets in stocks, but equities rebounded nicely after the end of both recessions. 

The problem with drawing conclusions from this data is that we don’t know exactly where in the cycle we are today.  As we have discussed in the past, the National Bureau of Economic Research has the ultimate say in determining when recessions begin and end.  However, their pronouncements come with a significant (12-18 month) lag.  By then, hopefully, the economy is well on the road to recovery.  On the other hand, capital markets tend to be leading indicators of future economic conditions.

A study by Northern Trust Global Economic Research examined the success of the S&P 500 Index as a leading indicator for economic recessions.  Its findings support our belief that the market tends to decline or "price in" during economic slowdowns and recessions prior to their occurrence.

Source: Northern Trust Global Economic Research

Based on the data presented above, the median decline of the S&P from peak to trough is 17%.  The Market Update section at the beginning of this report shows that the S&P 500 Index has already retreated 12% (with other indices posting even larger declines) from its October high.  Without the benefit of a crystal ball, our best guess is that equity markets may decline by an additional 5% over the coming months before they settle down and then resume their upward trajectory. 

The Election Factor

The 2008 elections make things even more interesting.  From a historical perspective, election years are typically positive for both the stock market and GDP growth, as shown on the following charts:

Source: DRI, UBS                                                                   Source: DRI, UBS

Both the Democratic and the Republican primaries are close races and the two political parties have widely divergent agendas.  Both the economy and stock market have historically performed better under a Democratic president.  According to the Stock Trader’s Almanac, since 1900 the Dow Industrials have climbed 13.3% annually under Democrats versus 7.1% under Republicans.

Conclusion and Recommendations

Howard Marks of Oaktree Capital recently wrote: “…for each period there’s a mistake waiting to be made.  Sometimes it’s buying too much, and sometimes it’s buying too little.  Sometimes it’s being too aggressive, and sometimes it’s not being aggressive enough.  Which it is depends on the combination of the going-in opportunities and the environment that unfolds.”  While he recommends caution, Mr. Marks went on to say that “Yes, it can be dangerous to jump in after the first price decline.  But it’s unprofessional to hang back and refuse to buy when asset prices have fallen greatly, just because it’s less scary to wait for the dust to settle.  It’s not easy to tell the difference…” and this is where professional investment managers step in.  The good ones will make more right decisions than wrong calls and, ultimately, will help their clients preserve and grow their capital.

Over the years, Beacon Pointe has devoted significant time and resources to manager research.  We typically recommend bottom-up, fundamental managers that build portfolios of high-quality businesses likely to perform well regardless of the market environment.  These managers conduct rigorous due diligence on potential investments and carefully evaluate downside risk.  The quality of management is a crucial determinant of business success, especially during tough times.  In much the same spirit, Beacon Pointe looks for proven investment managers with experienced and motivated decision-makers, compelling investment philosophies, consistent and sustainable long-term track records, lower risk profiles, and commitment to downside protection.  Such deliberate selection of superior investment managers, in addition to efficient portfolio diversification, should serve our clients well in 2008 and beyond, as it has done in the past.

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

(c) Beacon Pointe Advisors

500 Newport Center Drive, Suite 125 | Newport Beach, CA 92660
PHONE (949) 718-1600 | FAX: (949) 718-0601
www.bpadvisors.com

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