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Was it my imagination or was the market really that volatile during the month?
The market was really that volatile. In fact, October 2008 was the most volatile in the 80-year history of the S&P 500. Here are just a few statistics from a recent New York Times article that make that point clear:
- October was the worst month for the S&P 500 since 1987, but the final week was the best week since 1974. For the month, the S&P ended down 16.9%.
- Market moves of more than 4% up or down are highly unusual. There were no such days from 2003 through 2007, and only 3 such days in the 1950s and two in the 1960s. In October, there were 9 days in which the market was up or down by 4% or more.
- During the last 80 years, the S&P 500 has had 11 days in which the index increased by more than 9% - two of those days occurred last month.
What drove the market volatility?
October began with worries about the credit crisis at a fever pitch. Investors were concerned that government actions would be too little and too late to get the credit markets moving again, and that this would lead to a severe recession or worse. Fortunately, governments around the world began acting in a concerted fashion around the 10th of the month, and in many instances they took actions that were unprecedented. As the month progressed signs began to appear that the credit markets were beginning to move again, which was very good news.
Unfortunately, at nearly the same time, data was released showing that the economy contracted in the third quarter, and many companies were reluctant to issue concrete earnings guidance, as they simply weren't sure of the depth and severity of the downturn. Thus the markets were on a roller coaster for the first three weeks of the month. As for the sharp recovery at month's end, many market watchers attribute that to the fact that the data released on the economy was not good, but it was not as bad as many investors feared it might be. In short, the data pointed to a recession, and perhaps a sharp one, but not a depression that so many had discussed in the preceding weeks.
Has the market hit bottom?
It's an interesting question, as the last week's market bounce looks an awful lot like the sharp reversals we saw off market lows during the bear markets in 1974 and 1982, when the economy was in the midst of recessions. This isn't unusual, as the market tends to act as a leading indicator for the economy, with bear markets beginning in expansions and bull markets starting in recessions.
Still, there are a number of reasons the market could trend down further, not the least of which is the fact that it is going to take consumers some time to retrench. If the holidays turn out to be very weak from the standpoint of consumer spending, the market might have trouble shaking that off and we would not be surprised to see another market downturn. Lastly, just as markets overshoot fair value in bull markets, they often do just the opposite in bear markets -- and we've seen some dire predictions that the market could fall another 40% if it mirrors other post-bubble markets.
The truth is we have no idea if the market has reached bottom. Having said that, we were awfully glad to see the market string together a few strong days to close out the month. Further, as long-term investors, it's nice to be in a market in which a number of very successful investors - Warren Buffet among them - profess to see so many long-term bargains.
How do I benefit from bargains if I'm fully invested?
A significant percentage of portfolios are invested using actively managed funds. Fund managers typically maintain lists of stocks they'd like to have if the stock prices became cheap enough. In some instances, the managers will have set aside some of the funds in cash to be invested, and in other instances the managers may sell a stock to purchase another that they deem to be more attractive. Further, most clients have excess cash that was set aside by design in their portfolio, and we will invest this in the coming months.
The declines are greater than I would have expected with a diversified portfolio. What happened?
In a word, correlation. Correlation in investing refers to the degree to which asset class returns move together. Diversification allows an investor to put together a portfolio consisting of asset classes that don't all move together, and that helps smooth out returns. Unfortunately, during this downturn, nearly all asset classes lost value, including most types of bonds (the primary exception here was U.S. Treasuries). If you pair a sharp market downturn with bond performance that doesn't offset stock declines, you encounter losses higher than would normally be expected.
The good news is that a very small portion - less than 1% - of the decline in the bond funds' prices represent a permanent loss of capital. The vast majority of the decline is simply due to the fact that prices are depressed and as the market recovers and panic abates, we expect these funds to recover. In fact, we're already seeing the Yieldquest family of funds begin to perform well as the closed end fund market finds its footing.
What is your plan moving forward?
If there is one refrain we hear from some of the best investors out there, it is that times like these offer outstanding bargains. Still, we are aware that losses have been higher than anticipated and furthermore, we're not convinced that the market has truly found bottom. Thus, we're moving slowly in investing excess cash, and when we do we'll likely look to bond funds first and then to stock funds. The reason is that we believe we may be able to get equity-like returns from non-Treasury bonds in the next few years without as much downside risk as we find in equities. As for equities, most of our actively managed funds have performed quite well relative to their peers, but we continue to research other funds that have held up well.
For those of you with excess cash to invest, we will send recommendations over the coming weeks. Additionally, we'll examine taxable accounts for potential sales to generate losses and reduce taxes prior to year end. Finally, we do plan on beginning portfolio rebalancing shortly after the beginning of the year.
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