I was in New Orleans late last week at a client's annual convention to make a presentation to the board on investment performance, strategy and outlook. During the downtime, I did a good bit of work from my room, which looked out over the city and the Mississippi River, and there was a striking contrast between what was going on in the markets and what was happening in the city below.
Stock markets around the world dropped sharply in value, and here in the U.S. volatility reached historic levels. It was as if the markets were indicating that the world had stopped, that companies of all sorts were now worth much less than they had been only a week or two before. And yet in the streets and on the river below, life went on. Tourists thronged the French Quarter, businesswomen and men continued working and massive ships slowly floated around the bend in the Mississippi.
It was an interesting perspective on what we will look back at as an historic time. What happens in the markets can diverge from what happens in the physical world, but inevitably the two will at some point converge. Just as the market can only sustain for so long the fiction that mortgage bonds are worth more than the properties of which they are composed, so too is there a limit to the amount of time the market can ignore the value and earnings that solid, well-run companies generate in the real world.
Your portfolio is comprised of solid companies, and as the economy recovers, earnings and stock prices will follow. Bonds will likely make a comeback a bit sooner, as the fundamental question in valuing bonds is simpler - will the company be able to pay the coupon and return the principal?
Although there are numerous indicators that the market is due for a rally, there are also significant risks that may lead to further declines. Foremost among these is the improvisational approach the Fed and Treasury continue to take. Although they seem to be working their way to the right answers, in many instances they are doing so too slowly and only after reversing course and at this point the credit markets remain essentially frozen. Each day this continues, corporate earnings will come under further pressure, and this will only serve to delay or dampen a rally.
How much longer this will continue is difficult to answer, but one interesting point to consider is a study completed by the IMF on banking crises. A number of countries have undergone banking crises over the last several decades, and as the chart below shows, in all instances in developing countries, the stock markets bottomed roughly a year after the crisis began, which is where we are now. There is no guarantee that the U.S. will follow the same path, but the convergence among other countries is encouraging.
In each of the above countries, the stock market recovered to its initial value at the time the crisis began within 1 to 2 years from the onset of the problems. That may be somewhat aggressive for the U.S. market given the high valuations of stocks at the time the crisis began here, but regardless it is likely that the initial recovery will be quick and sharp. The recovery in non-government bonds will probably be similarly dramatic given that they have been pushed to record lows, and in both instances market timers who miss out on these rallies will find their long-term returns negatively impacted.
For the time being, we plan on leaving excess cash in portfolios on the sidelines, but we may well move to invest that cash in the coming days and weeks. Medium term bond returns should be quite attractive, and given the markets' current levels, history tells us that long-term stock returns should be strong as well. However, until governments are successful in thawing the credit markets, market volatility is likely to be high - perhaps not as high as last week, but it is impossible to know.
Lastly, Dimensional Fund Advisors, the fund family we use for index funds, has pulled together an excellent presentation on market downturns that focuses on the question "What if this time is different?" Several clients have found it useful, and if you're interested in viewing it, you can find it here.
These are extraordinary times, the likes of which we have not seen in decades and which hopefully we won't see again for decades to come. We understand how stressful they have been. Nevertheless, if experience has taught us anything, it is that the market will recover and portfolios will recover with it. We will keep monitoring conditions closely and make recommendations as warranted to continue to build long-term value. In the meantime, if any you have any questions or concerns, don't hesitate to contact us.
Sincerely,
