GOOD NEWS ON A RELATIVE BASIS

Although the 4th quarter of 2008 was one of the worst ever for the stock market, we were again able to minimize the downside for our clients while outperforming the overall market. According to Standard and Poor’s, for the 4th quarter, the Standard & Poor’s 500index had a loss of 22.56 percent, including -16.94% in October, -7.49% in November and +0.78% in December. The Oxford Core performed better, with -2.92 percent for the quarter, including -2.98 percent in October, -0.56 percent in November and +0.63 percent in December. For the year, the S&P 500 was down 38.5 percent and Oxford Core down just 3.54%.

For the year, the standard deviation of the S&P 500 shot to 20.99 while Oxford Core stabilized at 6.11, less than a third of the market rate. (Remember, the lower the number the better, since standard deviation is the quantitative measurement of volatility).

RIGHTS AND WRONGS

After the quarter and the year we just experienced, there is little to be said in terms of any errors we might have made, particularly since our returns were a full 35 percent better than the S&P 500. Granted, since we did call the bear well in advance, perhaps we could have created greater efficiencies in net return that would have resulted in a positive number as opposed to a slight negative number. But we believe our 4th quarter and annual numbers were solid on a relative basis. I will admit that our eagerness to witness the recovery of the financial sector did take its toll a little, but one of the largest disappointments was the small allocation to the Reserve Fund (the oldest money market fund in the country) dropping below $1 NAV and ended up with a loss of 3%. We were poised to absorb the downward pressure and were comfortable with our sector weightings per se, as those sectors in which we did have exposure lost less than the overall market.  But ultimately, it was our call on the proper asset allocation that led to the above market performance.

TRACKING THE MARKET CYCLES

If you have read any of my reviews in the past, you are probably familiar with my belief in the natural flow of markets in a capitalistic structure and the significance of market cycle location. We have witnessed this natural progression of the market—the transition from a bull (1999) to a bear (2000-2002) back to a bull (2003-2007) and into another bear in 2008.

Natural progression of market cycles suggest that in the first phase of a bull market, small capitalized (cap) companies lead, followed by mid-cap leadership and end the bull cycle with large cap. As the market begins to enter the next phase from the top of a bull—which is the first cycle of a bear—large cap typically demonstrates greater buoyancy, and eventually all styles fall off to some degree or another.

That was the case in recent market cycles, according to Russell, 2003 was led by micro/small caps, and 2004-2005 was lead by mid-caps. In 2006, mid-cap became the worst performer, and in 2007 large caps led the way. In 2008, small caps led through

September and eventually reversed in the 4th quarter to large cap leadership. Also according to Russell, the year ended with the Russell 2000 (a small cap index) as number one, followed closely by the Top 200 (the biggest of the big). Hmmm… a place in the market cycle where the small and the very biggest lead the market? This seems to be contradictory to natural market progression.

Considering this development and therefore to test this performance leadership, I went back to January 2008 and randomly picked days through to Dec. 31, 2008 (as my start date) and compared the Russell 2000 to the S&P 500. Sure enough there was compelling evidence to support a leadership tendency by the small cap style. This is the result typically observed and reported by the industry and it begs the question, if this is supposed to be a bear, why are small caps outperforming large?

There is one minor flaw in this observation (and therefore its conclusion, as if this were the case it would be compelling to deduce we have entered into the next phase of the market cycle—the bull). The flaw—market cycles don’t occur on a calendar basis.

There is a matrix we use for various applications, which goes back to 1950, that allows us to track the three-month trailing average for bear period identification. The matrix simply suggests that when the three-month trailing average goes negative, we have experienced a -1.8% per month average or worse during the previous three months.

This matrix measures the disparity of today’s market activity compared to the three month trail. This disparity stayed negative for the majority of 2008 until December 24 when it went slightly positive. This indicates a break in the cycle. If you then go back and look at the lowest point during that period, you can determine a suggested bottom. That would have been November 20 when the S&P 500 hit 752. (Understand that the November low had no significant meaning until December 24.)

Therefore, if we go to the beginning of the bear cycle (not the calendar), October 9, 2007 (the peak) and track style leadership through to November 20, 2008 (the low), we see that large actually did lead small.

Did that mean that November 20 was the bottom of the bear and we have started to head into the next phase? Not so fast. Let’s back up a little.

SMALL LOSS LEADS, BIG LOSS FOLLOWS

There is another rule referred to as the one-third, two-thirds rule. History has shown that in the last one-third of the bear cycle, typically two-thirds of the value is lost. This rule was in form for the majority of the second half of 2008 until November20, 2008. As of November 2008, the bear had lasted 252 trading days. The first two-thirds accounted for approximately 26 percent of the loss and the last third 74 percent. What happened next was a correction in the market to get it back to its natural location in the cycle.

Over the next 11 trading days, the S&P 500 rebounded 21 percent to reach 910 by December 8. This extended the bear to 293 trading days and brought the last third to 62 percent of the drop—back to the one-third, two-thirds parameter.

Now, at the point since December 24, what we monitor is the daily change of the market (as a percentage) compared to the daily change three months prior. What we want to see is some consistency in order to declare a bottom and, therefore, look forward to a bull. As an example, on December 31, the market went from 891 to 903, providing a 1.35 percent gain for the day. However, if we compare that to three months prior—October 15, it moved the matrix from a -5.62 to a whopping positive of 5.13—a 10.75% swing. This leads to an analysis that probabilities suggest that we have not found a hard bottom. As a result, the lows could be tested again or at least there is much volatility ahead of us, and it is not straight up from here. As such, January will most likely be volatile and negative.

A WORLD OF CHOICES

The downward pressure felt by the world in 2008 made the three-year global returns negative and adjusted the 10-year average return for the U.S. to -3.31%. Capitalism is not failing us, it is doing what it is suppose to do. These are unprecedented times, but if you are going to own stocks globally, now is the time to consider it for the long term. During transition periods, you can enhance efficiencies by investing in other developed countries. If you must own stocks, non-domestic investment could play a part in your portfolio.

FAILED FORECASTS OF 2008

2008 will be recorded in history as one of the biggest losing years in history—both on paper and emotionally. We woke up to the realities of the “new America” and the impact caused when certain aspects go awry.

While the purpose of this review is to discuss the performance of 2008 and the prospects for 2009, there are certain political-economic issues not commonly associated with portfolio management that I believe I would be remiss not to address.

2008 tallied more inaccurate forecasts in history. Most firms lost not only their clients’ money but their balance sheets, as well. Names like Merrill Lynch, Bear Stearns and Lehman Brothers took on new meaning in the scope of the financial markets, and their cousins, Freddie and Fannie, lost the farm. Chinese consumption was recognized and then forgotten.

This year, no different than others, is filled with a wide array of forecasts for the market of 2009 with an average landing in the 17 percent range. Most articles written start with something like this: Despite their incorrect call of 2008, in 2009 their forecast is….and so on. I have been witness to news releases that actually give credit to prognosticators who ran two methodologies in 2008, one long and one short, and sang praise for their short (of the market) performance with returns in the 2-3 percent range.

My forecast for 2009? Honestly, it doesn’t matter. Not mine, not anyone’s. In a transition period, in this case, from a bear to a bull, the aggregate market should not be the focus, rather the sectors that comprise the market. It becomes the charge of the manager to constantly maintain the focus on cycle location and building for the future. The foundation is to be set by slowly building sector by sector.

To state that the equity markets, domestically and abroad, were poor in 2008 would obviously be an understatement. It is more than just the mere fact that markets declined, but the manner in which they declined.

The SP 500 reported its third worst year ever and the month of October ranked right up there with the worst months in history. The funny thing is, many investors by now seem to be, for the lack of a better term, numb.

I am familiar with “a deer in the headlights” analogy to the extent that investors will resort to doing nothing during certain periods, but in my usage of numb, I mean something more, something deeper, an element of concession.

At times of need, the mass will follow the first one to stand up and demonstrate leadership, often regardless of the ultimate direction they are being led. They are so concerned about the here and now that tomorrow seems far off and a moment ago seems years ago.

WHERE’S THEACCOUNTABILITY

I spoke at great lengths beginning in 2007 cautioning investors about the market cycle I believed we were in and stated flatly that investors should get out of the markets (or at least reduce their equity exposure). I spoke to the impact that intent plays on advice, particularly in the media. The large wire houses said nothing to the extent of the demise of the 2008 markets, and their client’s portfolios prove this to be the case. Yet, as we enter 2009, the press is setting the marquees with names of analysts at big firms and clinging to any correct calls that they made over the previous decade. 

Advertising shifted from “look at our performance” to “we are here to work side by side with you during this difficult time.”  If behavioral aspects, which I have addressed numerous times as well, and how they affect our decision-making process, did not show themselves enough to the investment world during this period, then I do not know a scenario that would. Every major aspect of the market environment declined—commodity prices, the dollar, every sector, interest rates, and even hope.  

Capitalism is one of many “isms” but make no mistake, when allowed to follow its natural course it is the best system the world has to offer. However, questioning whether

or not various aspects such as Keynesian economics (and models of this sort) are the right models for today’s ever changing global economy is a question worth asking, and rightfully so.

Capitalism did not let us down; we let ourselves down. Our sense of who we are was put back into check by the realities of the world. Instead of accepting the natural course, we decided that if we didn’t like how something was going, we would change it.  That simple. If we don’t like it, we change it. This type of behavior, in my opinion, is something an adolescent does when they are not getting their way.

I would rather avoid making comments that may be construed as not relating directly to the portfolio management process. However, despite my tendency to focus on the fundamentals of the natural progression of market cycles, I do believe that underlying economic and investor sentiment should also be considered, particularly now.

During bull periods, investors seem to be constantly seeking to maximize return, or at least their personal psychologies suggest it to them. As such, the SP 500 hit north of 1500 in October of 2007 and at that point you couldn’t pull investors out of the market.  At the close of 2008 with the SP 500 hovering south of 900 you couldn’t push them in. This behavioral aspect, despite its commonality, goes against basic economic and market principles.

Basic economics has taught us that price is the outcome of the functions of supply and demand. If supply is constant, for example, and demand drops, so should price.  Conversely, if supply remains constant but demand increases, shouldn’t the price increase, as well? So what happened in 2008 economically?

STOCK MARKET SUPPLY AND DEMAND?

We have been told that demand dropped dramatically (explained as being revealed in the billions of dollars of redemptions from hedge funds) and with a constant supply, prices therefore dropped. In other words, there were many more sellers than buyers. Hmmm. I agree with the basic principles of economics and have been witness to the graphs pertaining to supply and demand, but when was the last time you saw a supply and demand curve for the stock market? At first one may giggle, but if you think about it, how is it that a multiple trillion dollar market that affects the livelihood of so many and so much isn’t as common as things like the strength of the dollar or interest rates?

Simple—it would make it too basic. If the markets were so basic there would be little need for all of the sources of information that are retained for the purpose of guidance in such a complex market. The market isn’t complex; it is basic. The information we receive from the industry to assist us in understanding why something is occurring (and in an effort to preserve their interest) is the minutia that makes it seem and feel so complex.

This “complexity” can be broken down: at any given time the market can do one of only five things, go up a lot, down a lot, up a little, down a little or go sideways. That is it. Also, there are only three primary asset classes associated with our industry and they are stocks, bonds and cash. Also, there are only 10 sectors that comprise the market and only a handful of developed countries. 

The fact that there are thousands of companies and thousands of firms attempting to market the stocks of these companies is what creates the complexity, the confusion. If one actually stops and thinks about it (I am aware that hindsight is 20/20) the bear of 2008 should not have been that big of a surprise.

2003 through 2007 lulled investors back into their positive return sleep and they stopped paying attention, stopped caring. More can be learned from personal experience than anything you could read or watch on TV.  Ever notice how much you miss something once it is gone? Behaviorally we demonstrate this propensity to take things for granted. We focus on accumulating pride and shunning regret and think about the here and now.

I will not reiterate all of the reasons I provided (actually starting in 2006) for why the bear period was a likely possibility of the five courses, but rather let me inquire: did investors even ask themselves, “where are we in this market cycle (in 2007)?”

The answer to the proverbial puzzle, which came first, the chicken or the egg, is that they occurred simultaneously. We just didn’t know it. The efficient market theory suggests that all known information is discounted in the market, therefore reflecting accurate pricing. I agree with this assessment but I have to wonder exactly how one would define “known.”

We were told in 2006 that the Chinese were going to start consuming the energy (oil) at a rate faster than we could produce it with our outdated refineries. As such, the price of oil shot from around the $50 range to over $140 a barrel. Then, overnight, the prices started to drop and tanked back to under $50.  I do not recall hearing or reading about the Chinese announcing that they were wrong and they actually were not going to consume as much as they had anticipated. Nor did I hear that we had built more refineries overnight. If the reason it went up was to bring the economy of energy back into balance and price it more appropriately based upon this known information, why did it drop with no explanation. (So maybe it is more about who knows than what is known?)

WHERE DID ALL THE MONEY GO?

In the Midwest, million dollar homes are not as common as other parts of the country. But to see the day that a million dollars could not pay for someone’s idea of a “dream home” was and is flat out ridiculous. In addition, for a consumer to rationalize or accept that earning $50,000 a year could support a $500,000 mortgage is equally ridiculous. For the industry to allow this to occur (as I believe all industry should have a professional obligation to protect their clients from harm) and to create products that allowed for great latitude in the marketing, placement and selling of them is absolutely wrong.

Regarding the housing/mortgage market, are we to assume that all of this just vanished? Where did it go? If I buy a house today, the money that I borrow from a bank goes to the seller. The money they (the seller) received goes where? To their bank.  If I default on that loan, the bank I received my money from is out the money to the other bank. Now this is happening all over at all the banks. Leverage this problem at least 10-fold due to what the investment bankers did with these pools and yes it would appear there is a problem. I used the word appear as that is all it is. In reality, it is accounting.  If there are 10 banks, and they each lose $1, who made it? In every transaction there is a buyer and a seller and when one wins the other loses and vice versa. All we need to do is put all of them in a room and see who owes who what and settle it.

Also, how is it that all we hear about are the losers? Why don’t we hear about the winners? (Again, assuming that money doesn’t just vanish). It is these winners who will prohibit the markets from absolute collapse. Why? The spirit of capitalism.

This is not about judging the ethics, but evaluating the simple economics. Economics has not stated that in a capitalistic structure the competitive environment equates (allows) to the marketing and manufacturing of products that imply one thing but actually mean (and do) something else.  We lost the meaning of capitalism some time ago and it eventually caught up with us.

Each faction will attempt to point the finger at the other, but at the end of the day we are all to blame, each of us individually. Have we grown so large that our individual thoughts or ideas are not being heard, or heaven forbid, they have been heard and this is what we have come to as a society?

I have often said that just because something exists doesn’t make it right and, in fact, it doesn’t even make it real. Capitalism has shown its depth of power and its unwavering commitment to its definition. That’s what brought down the big financial institutions last year—Bear Stearns, Merrill Lynch, Lehman Brothers, Fannie Mae, and Freddie Mac. All were icons in the industry that were suddenly shattered to dust. The same power capitalism provided our country to grow from its infancy to a world power is the same force that could cripple it if not respected. 

By definition, there will be periods of slow growth and bear markets. This is natural.  When certain aspects accelerate in growth beyond the aggregate in multiples, there will be a reversion to the means. 

This is all our market has done. As such, I would not be losing faith in capitalism, rather I would have a heightened awareness that it is working and it did what it was suppose to do, which was to remove those who attempted to manipulate it or take advantage of it.

BLURRING THE LINE BETWEEN BANKS AND BROKERS

In the late 1980s, Merrill Lynch came out with an account called the CMA. This account allowed investors to put money in an account with check writing capabilities and an interest that was much higher than the rate paid by banks. The securities industry continued to move across the border between banking and investing and so did banks from the opposite direction. You could acquire home loans from a brokerage firm and you could buy a stock at a bank.  The contest for market share accelerated, and each side attempted to capture more and more market share. What is ironic is that it was a banking product that brought down the wire houses, and the banks were allowed to buy their competitors (the wire houses) at a discount. Now, apparently we, as taxpayers, are even going to lend a hand. I guess today we could say the bankers won?

But at what cost? They themselves have lost…themselves. They missed the forest for the trees. Citigroup, not being able to meet even one-third of its capital requirements to qualify as a bank in the U.S., will need to get rid of something or change their structure or both. The old global banks that have been around since dirt, such as

Royal Bank of Scotland, Lloyds and Barclays, are threatening to become a memory.

However, it seems that there is a possibility that this will not come to fruition as capitalism suggests it should, since governments may now get into the banking business, the airline business, the automobile business, the housing business, the brokerage business (and on and on). The problem is the government jumped in too soon. The first deal, the Bear Stearns buyout, was done over a weekend. Over a weekend?

If this continues to happen, I shudder at the “ism” this represents. If this is the role government is going to play in this “new economy” and replace the natural progression of a capitalistic market, I would suggest that investors never buy another stock again. I want to emphasize the “IF” that seems to be diminishing daily. 

Question: what if all of these entities were allowed to take their natural course? Some would have gone away and others would have been acquired or rolled up into fewer entities. What would this have meant to us, to the markets? By definition of capitalism, nothing to us (unless we owned stock directly in them) and little to the overall markets. Why? Because it is the natural progression.

The floor of a market based in capitalism is ever-present (unless the Universe stops believing in capitalism). We just don’t know where it is. That’s what creates the dynamics that make capitalism what it is—the risk and the reward.

I would like to reiterate a comment from my 3rd quarter 2007 Review, if we cannot rely on capitalism and its natural progressions, and instead rely on the various attempts to redefine our structure, there would be no point to evaluate risk. Without risk there is no reward. The return comes from others who bet against you. Extend this exercise to a point where there is all reward and no risk and you eventually hit a point were the price point is infinity, but limited to our own resources. If we violate capitalism to provide the basis for the hypothesis, we could equally deduce that economics would not maintain its definition. The more you pull on the fabric the more frayed it becomes. The more we attempt to remove all risk from an equity market, the more we violate its nature.

SUMMARY

The consensus of the pundits suggests that the market will provide a double-digit positive return in 2009, somewhere in the +17 percent range. However, according to them, this will not begin to happen until the second half of the year because things are going to be weak in the first half. Hmmm…So if I have this right, the first half of the year is going to be worse than it is now and then the market will find a bottom and start to recover. Just assuming that the markets do not fall from their current position this would lead to a rather strong rally to get to the 17% range. Then again, if things “get worse” than they are, this would merely lead to an even more impressive rally, an unprecedented one in fact.

I have a problem with the hypothesis. It’s the “if things do get worse” (which I agree they will) part. If things get worse from here, I find it hard to believe that this will boost investor sentiment. Let’s see, so far, the market has lost 39 percent (many investors have lost more), four of the top five investment banking firms have collapsed, Fannie Mae and Freddie Mac are gone, our dollar is shaky, commodity prices have tanked, and unemployment is as high as it has been in 25 years (just to name a few). And things are going to get worse? If things get much worse, I believe that will make the second half worse, not better. I realize that the market is ahead of the economy, but can you imagine attempting to rationalize putting money into the equity markets in conditions that are worse than they are now? It won’t happen—behaviorisms won’t allow it, period. Say what they may, spin what they will, but it is perverse logic at best, and I would not build my portfolio based on this hypothesis. Things need to get better…. before they get better. My forecast? We will experience continued volatility and if the government doesn’t do another thing to interfere with capitalism I suggest the market may end in the -3% to 3% range.

If they do, the first half of the year will be painful and there will not be enough of anything to provide a catalyst to get back to positive territory. As such I might put a – in front of the pundits 17%.

As I mentioned, the aggregate market need not be the focus, but rather the sectors that comprise the markets. I would recognize that the only way we get back to the next phase is when three key pieces are in place: a strengthening dollar, competitive commodity prices (for the right reasons) and credit windows that are open (this, by the way, is one reason for the big push to fund the banking system). If things get worse, that does not correlate to credit windows opening.

So what is an investor to do? Simple, rebuild while prices are cheap.

If ever, oh ever, a wiz there was, the wizard of oz is one because, because, because… comes to my mind. The more wizards the more problems because, after all, Dorothy was only dreaming—it wasn’t real. The sooner we as investors and citizens realize this and start believing in ourselves again, rely on our common sense and start asking the right questions and remember what has made the country strong, the sooner capitalism and freedom shall ring again.

See you next quarter-

Bo Beckman