2008 will likely be the worst investment year that any of us will experience in our lifetime. Stocks had their worst calendar year since 1931. Almost every asset class was in the red for the year, with many deeply underwater, giving investors almost no place to hide. Clearly we are now in the midst of a severe recession with higher unemployment and other discouraging economic news over the next few quarters. Consumers are being forced to adjust to a new reality in which they finally have to pay down debt, increase savings and thus spend less than before.While it may be that we have seen the market bottom, we can’t be sure. We are prepared for volatile markets and expect that the stock market will continue to experience strong rallies and subsequent sell-offs. These rallies could last for months with sizable returns, followed by sharp pullbacks. We have already seen a stock market rally of 18%, followed by a 25% decline, and a 21% rebound within the last few months. We don’t know if this is what the next few months will look like, but we believe this to be a likely scenario – this is how other severe bear markets have petered out over time. Unfortunately, this grinding process is what keeps most investors’ fear level up and their money on the sidelines and they miss the final real rally when it comes.
However, with a great deal of negativity already priced in the markets, the longer-term return outlook is decent. We believe we will continue to see numerous opportunities created in this highly dislocated environment. There is a mountain of cash sitting on the sidelines. In fact, since the advent of money market funds more than 30 years ago, money market assets relative to total stock market capitalization has never been higher. Some of that cash will find its way back into stocks and bonds soon, especially with returns on CDs and cash so low. Thus, despite the near-term caution, we think the weight of the evidence overwhelmingly suggests that investors, over the next few years, are likely to reap at least satisfactory returns much higher than the 0% to 3% currently offered on money market funds and CDs. Moreover, periods of extreme dislocation usually create opportunities for significant value-added from active management. While the entire stock market does not have to do well, there will be sectors that will do very well. Based on our read of history, as well as data that indicates extensive valuation discrepancies in current stock and bond markets, we believe that the next few years are likely to be good ones for active managers relative to the indexes, such as the S&P 500 or Dow, and certainly superior to CDs or money market funds.
As we look forward from here, starting with beaten-down financial markets and an economy on the ropes, we ask the question we always ask: What expectations are currently reflected in asset class prices? Historical comparisons are sometimes helpful. There have been two extreme economic and investment environments in the last 80 years—the 1930s, and the 1970s/early 1980s. In both periods investor confidence was crushed after lengthy periods during which returns were dismal and because of a continuation of negative headlines. But as it turned out, both periods presented a great opportunity. This may be a similar time. These experiences reflect the tension that investors face—when risk seems greatest it is usually a good time to invest.
