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Below is a summary of Cambridge Advisors’ thoughts and strategy going forward.

2008 Overview

As more data emerges, we begin to see a clearer picture of 2008 and how markets were impacted by the credit crisis.  The S&P 500 stock index was down 37% for the year.   It was not a surprise to learn that the financial stocks suffered the steepest decline at 55%, as the media has been more than happy to relay their troubles.  However, all stocks suffered.  The Consumer Staples sector which includes food, tobacco and personal products has historically been resilient because consumers tend to purchase these items regardless of how the economy is doing.  Not in 2008.  Even though Consumer Staples was the best performing sector, it was still down more than 15%.  Healthcare and Utilities are also normally thought to be more defensive sectors of the economy but they, too, lost 22% and 29% respectively.

Aside from Treasuries and Mortgage Backed Securities, bonds were down, as well.  Corporate bonds, high yield bonds, and municipal bonds, (not to mention foreign debt) all had negative returns.  Normally, being diversified (using a “balanced” approach) is a winning strategy.  In 2008, a “balanced” portfolio resulted in a 23.6% loss.  The “balanced portfolio assumes the following weights: 15% in the Russell 1000 Value (Large Cap Value), 15% in the Russell 1000 Growth (Large Cap Growth), 10% in the Russell 2000 (small cap), 20% in the MSCI EAFE (international stocks), 30% in the Barclays Capital Aggregate (bonds), 5% in the CS/Tremont Equity Market Neutral Index (Long/Short fund), and 5% in the NAREIT Equity REIT Index (real estate).

Outlook

The media has been full of bad news:  Foreclosures are up, home prices are down, GDP growth is the worst since 1982, unemployment is rising, consumers aren’t spending, entire industries need bailouts.   The continued debate over the stimulus plan focuses on the negatives and in this environment it is easy to feel like the economy will never recover.  When the stock market is selling off it’s difficult to believe that we will ever make money in stocks again – at least not for a very long time. Because Treasury bonds and money market accounts were the better investments last year, it is tempting to protect against further erosion by switching to these types of investments.  Unfortunately, doing this now could hurt rather than help you.  The 10-year Treasury bond is yielding 2.98% today and a 5-year Treasury bond is yielding 1.0%.  Money markets are yielding around 0.5%, some are as low as 0%.  With the Fed targeting 2% inflation, real returns could actually be negative.  You may not lose money by buying Treasury bonds and holding them to maturity, but it will be difficult for most people to reach their financial goals and maintain their current standard of living using this strategy.

To gain some perspective, it is helpful to look back through history and try and learn from other difficult times in US history (please refer to the American Funds piece included with this email).  Every recession has had its own set of circumstances that made it unlike any other.  Over the long term, the stock market has always recovered.  Even looking shorter term, we normally see a strong rebound 12 months after the low of a bear market.  In the last 10 bear markets, the average return has been 32% one year after the market reaches a low.  Even in the Great Depression, the market fell 50% quickly but then had a rebound of 50% (recouping half its losses) before it eventually fell 89%.

To be sure, there are some similarities when you look at what we are going through today compared to what happened during the Great Depression.  The government was unable to spend its way out of the Great Depression.   Some of the social programs implemented as well as the “protectionism” measures enacted are blamed for making the recession last longer.  The current stimulus package that was passed is expensive, increases government programs, and contains a “buy American” clause all which could result in higher taxes, higher inflation and retaliation from foreign trade partners.  These are valid concerns and could hinder the stabilization intended by the Stimulus Bill.  In addition these similarities have caused many investors to fear the potential of stock prices falling further like they did in the 1930s. 

A closer look at the Great Depression shows that even though there are similarities, there are also key differences.  The money supply contracted by 30% while interest rates and taxes increased dramatically.  This time, our money supply has been increasing, our interest rates are low, and tax rates are relatively low even when accounting for expected increases.  While unemployment is higher than recent history and is forecast to potentially reach 11% or 12%, the Great Depression saw unemployment of 25%.  Our government is taking action quickly, significantly and in coordination with the rest of the world. Another key difference that does not get much attention is the Dust Bowl that happened at a time when the economy was already in disarray.  Three significant government programs that did not exist to help soften the Great Depression are in place today: 1) FDIC Insurance (the government acted swiftly in 2008 to guarantee bank deposits up to $250,000), 2) Social Security and 3) Unemployment Benefits.

I separated this paragraph on purpose because it is a key difference when comparing this crisis to the Great Depression.  Leading up to the stock market crash of 1929 and its subsequent 89% decline over the rest of the decade, the stock market had run up 500% over the preceding 6 years.  Compare that to the peak in 2007, stocks had only increased 100% over the preceding five years.  Stocks appeared to be reasonably valued.  The P/E was at the peak in 2007 was 19. This is very close to what it was in 1997 before we entered the period of “irrational exuberance”.  At the peak in 2000 and the peak in 1929, the P/E was more than 30.  Currently, trailing P/Es are very low compared to history because prices have contracted sharply.   It’s unclear whether the decline in forward P/Es is too severe or whether forward P/Es are accurately reflecting expectations of lower future earnings.  Many companies aren’t giving guidance for next year, and analysts are erring on the side of caution by focusing more on downside risk than upside potential.   

We’re at a time where to sound optimistic is to sound foolish.  Anybody who voices any hint of optimism immediately gets mocked by those who are pessimistic.  The abundance of negative news makes it easy to ridicule those who point out the positives.  While contrarian investing has proved profitable, contrarian arguments are seldom accepted by the general population.  Individual investors tend to take the recent past and project it into the foreseeable future.

People have increased their savings rate dramatically and cut their spending significantly because of the fear of an uncertain future.  However, people cannot continue to save at the current rates and put off purchases indefinitely.  If people continue spending on new cars at the current depressed rate, people will be driving their cars for an average of 25 years instead of the historical rate of about 13 years.  In addition, if the rate of new homebuilding were to stay where it is currently, the average replacement age for homes would be 279 years compared to the normal life expectancy for homes of 70 years.  At this pace of home construction, homes would need to be about 40 years older than Thomas Jefferson’s Monticello before they were replaced.  New home construction at the current pace can’t be sustained indefinitely.  Once prices correct to a point that people are confident that they can sustain the payments and once fear of losing jobs starts to subside, people will begin spending again.  Maybe not as extravagantly as the recent past, but the economy does not need consumers to go back to their extravagant spending habits the economy simply needs to see that the contraction in spending is not getting more severe each reporting period.  In other words if consumers revert to their early 1990’s spending habits, before credit was pervasive, the economy will start to grow again and the stock market will begin to reflect this reality even before the data confirms it. The stock market tends to anticipate what is happening in the economy by six to nine months.  That means that even when the stock market bottoms and starts to recover, we’ll continue to hear reports of unemployment increasing, banks failing, homes being foreclosed and GDP languishing.  Things will still “feel bad” and if investors wait until “things feel better”, they may miss out on much of the rebound. 

A rebound could happen quickly.  There is now 8 trillion dollars in cash and cash equivalents – that’s more than the combined value of the companies of the S&P 500 Index!   Let me say that again.  With the money that is sitting in low interest, short term accounts, if the individuals and corporations holding that money were to coordinate their efforts, they could purchase every company in the S&P 500, make them private companies, and have a few trillion left over.  Much of this money was a result of panic selling in the fourth quarter as hedge fund, and mutual fund liquidations and outflows were 10 times higher than they were in 2002.  This money is earning close to 0% and once the stock market shows signs of improvement, it can flow quickly back into stocks and stock mutual funds providing momentum to support and drive stock prices higher.  People are not likely to settle for earning 0% for too long once opportunities for gains become apparent. 

It is difficult to imagine and even more difficult to believe, but if history is our guide we could be entering a period where future stock returns are above average.  Past results are not predictive of future returns but looking back over the past 200 years in the stock market, (that’s back to 1800 so we are encompassing the Civil War, a couple of World Wars, and the Great Depression), rolling 10-year average annual total returns in the stock market have averaged 8.4% per year.  Historically, when the market returned less than 2.5% for 10 years, the next 10 years averaged 13.3% (with a range of 7.1% to 18.6%).  That’s almost 5% higher than average.  The 10-year return as of October 2008 was 0.4%, one of the lowest in history.  For the last two centuries, the 10-year return never went lower than -1.3%, not even in the periods encompassing the Great Depression.

Strategy

We do recognize that there is a lot of bad news, people are pessimistic, and stocks are not currently trading on fundamentals, but rather on fear and emotion.  Even though stock valuations seem low, a prolonged recession could mean that current stock values are appropriately pricing in high risk.  The uncertainty surrounding the new administration and its policies is also pressuring stock prices.  We expect more volatility in stocks.  Individual stock selection will be even more important as overall stock market movement may not equally benefit all companies and not all companies will survive. 

Good companies will survive.  We expect that an environment of more regulation and stricter lending requirements may lead to large company stocks outperforming smaller company stocks.  Large companies have more resources and are viewed by banks as more stable.  Companies with low debt and higher cash balances should also perform better than debt laden companies.  Many technology companies are cash rich, and analysts have cited that the Technology sector may help lead us out of the bear market.  In contrast, Financials and Consumer Discretionary stocks have often led out of recessions.  With consumers saving more and not having as much access to credit, the Consumer Discretionary stocks such as cars and travel may not do as well.  Financial stocks also have issues to resolve which may continue to suppress their stock prices. 

In the past, it has been prudent to make decisions based on sound investment principles and not emotion.  We believe that tenet continues to be true today.  Selling out of the stock market is a two part trade and it only works if you also know when to get back into the market.  Missing out on the best days or the best month, could mean your returns are lower than they would have been if you had stayed invested or invested more through the dips. 

One issue that has been brought front and center for some investors by this crisis is the importance of understanding one’s own risk tolerance.  Some investors have expressed an interest in adjusting their risk tolerance after reflecting on the events of the last year.  This leads to the conversation on rebalancing to a more conservative allocation.  If we see the typical 30% bounce 12 months after the market bottoms, and assuming we are near the bottom now, we believe there may be a better opportunity to reallocate in the next year.  Year-end and mid-year estimates from Goldman Sachs, DeMarche Associates, and other prominent analysts are in line with a 30% or more bounce in the stock market by year-end.  In the meantime, we continue to make the changes outlined above and to evaluate the evolving data and market movements.  As the news and outlook changes daily, we gain a clearer view of the new administration’s policies and attempts at stabilizing the credit and housing markets. 

There are definitely reasons to be concerned, but there are also positives that are not being acknowledged.  I hope this email is helpful and the attached articles show you some of the positives.  If you would like to discuss your account specifically and our strategy, please email me or call me so we can arrange a convenient time to talk either on the phone or in person.

Justin S. Anderson, MBA, AAMS Portfolio Manager Cambridge Advisors Inc. 17330 Wright Street, Suite 205 Omaha, NE 68130 402-697-1166 janderson@cambridgeadvisors.net  

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