Oh Ye Of Little Faith
Unless you’re the sort of investor who lets your mail pile up for a year at a time, you’ve faced the grim task of reviewing statements from your brokerage and 401(k) accounts during the past several quarters. You’ve seen firsthand the wreckage left in the wake of arguably one of the worst stock market sell-offs in at least a generation. What now? It’s a common question asked at a time like this and usually with a few small beads of sweat present on the brow.
Should conservative investors be selling their holdings into rallies like we had in April and May and simply park the proceeds in cash? Should investors ride out the storm and stick with their favorite stocks even though they’ve been beaten down in value? Given the unprecedented sell-off in the equity markets during the last year, it seems appropriate to take a walk down memory lane in an effort to understand the anatomy of a bear market.
First, investors need to remind themselves that there is a difference between a decline in value (a temporary condition) and losing money (a permanent condition). If there is no compelling need to generate cash flow, those willing to stay the course will benefit from the inevitable recovery in the market. In other words, the value in our portfolios will be restored in time if we give the market a chance to do its work.
Second, not all holdings are impacted equally during a bear market decline. Although some technology investors in late 1999 and early 2000 mistakenly condemned diversification as the product of a weak mind, the reason for holding stocks of more than a single company, as well as cash and bonds, is to diversify risk. Therefore, some holdings have done better than others during the severe market downturn. Energy and drug company stocks, for example, held up very well during 2000. If a need for liquidity does arise, chances are good that one can identify a fairly good place to get it that will not result in a loss.
Third, you should ask yourself this simple question. If you owned a business that had excellent prospects for growing profits in the future, would you think of selling it for half of its long-term value just because the next few quarters looked a bit rocky? The answer is probably, “only at gun point!” That is precisely the environment we are in now. Scores of America’s best-run and most-profitable companies are selling at 50% of year-ago values solely due to short-term considerations. Why should an investor let someone steal his shares for fifty cents on the dollar?
Recently, lots of folks have been talking about the fact it may take five years for the market to recover. Is that really relevant? Were you planning to be invested in something other than the market during the next five years? Rare coins or museum quality paintings perhaps?.
If you’d invested in the NASDAQ composite at the top in 1973 just before the bear market ensued and held until the recent April low, you would have started the period with a 60% decline and ended the period with a 60% decline. Even with that bad timing you would have averaged 10% on your money. It’s also worth pointing out that while it did take until 1979 for the NASDAQ to recover from the low in 1974, the index regained 60% of the decline within a scant 16 months. Worth the wait, I think. What’s more, supposing it does, in fact, take a full five years for NASDAQ to reach 5,000 again, an investor who rides out the recovery will earn more than 20% per year on the way! Where else will you find that kind of result? One important detail not mentioned by market experts when they refer to the 1973-74 NASDAQ decline, is the composition of the index. Back in the 1970’s, the NASDAQ was a fledgling market of small companies not worthy of listing on the New York Stock Exchange. Today, many of the largest companies on the planet trade on the NASDAQ market.
April was a strong month for the domestic equity markets. Stocks across myriad industry sectors made impressive gains. Importantly, this renewed strength continued into May with confident follow-though buying in some of the more damaged sectors such as technology.
But, just as it looked like this rally had legs, Senator Jim Jeffords of Vermont announced his defection from the Republican Party, effectively killing any hope of further gains. This political bombshell sent investors scurrying for the exits. Selling was heavy in policy sensitive stocks such as drugs, energy, and defense contractors. The second half of May looked like a mirror image of the first half, and so, the month finished virtually unchanged.
Can you imagine? Several thousand voters in Florida ultimately decided who would be President, now 60,000 voters in Vermont ultimately determined the balance of power in the Congress. President Bush can now look forward to the same gridlock that faced another Bush administration. Any meaningful reform will be difficult at best, so the stock market should actually react well to this shift in power once the initial shock is behind us. Then traders can get back to ignoring Congress instead of trying to predict where reform will take us. Gridlock will ensure everything is business as usual.
Data coming out of the economy is creating a real sense of confusion. The Federal Reserve is lowering interest rates and GDP appears to be improving, but auto sales are down and unemployment is rising. Mixed signals abound. However, one thing should be clear. Greater profit opportunity exists in being an owner (shareholder) than exists in being a lender (bondholder). Remain committed to a strategy of proper asset allocation between stocks, bonds, and cash, and be vigilant about adequate diversification. By doing nothing more than observing these two investing axioms, investors can truly weather any market correction, no matter how severe. Questions? Give us a call. After all, we’re here to help.