Now What?

October 6, 2008

Dear Investor:

The Bailout Bill was signed into law, but will be no panacea. The economy took a big hit, especially in the two weeks government bickered. Unemployment is likely to go to 9%. Credit is still stuck.

As we mentioned in our last letter, the question becomes binary at this point: is this the Great Depression or a severe recession?

There are really no times in history (except the Great Depression) where-at this point in the cycle-it wouldn’t pay to hold equities over the next five years. In other words, if you: 1) look at nearly every postwar rolling five year period on the S&P 500, 2) find an instance where the index was already down 30% peak to trough, and 3) calculate aggregate equity returns for the next five years, you always have a return that beats cash, usually by a vast amount.

So it leads to the question: is this another depression or not? If so, selling equities is the right call. If not, it would be a big mistake. There have been countless wrong predictions of another great depression over the past eight decades, in 1938, 1949, 1955, 1968, 1971, 1973, 1974, 1977, 1978, 1982, 1990, 1994, 2002, 2003 to name just a few-so it bears much thought to arrive at a conclusion. My view is that though the history of the 1930′s now rhymes, it won’t repeat. Things certainly seem scary enough, but the only cause of the Great Depression now in play is the credit crunch. We don’t have Smoot-Hawley style tariffs, deposits leaving the banking system, a lack of safety nets or a restrictive Fed. Most important, we don’t have a gold standard, the main cause of the Great Depression (along with protectionism) according to most economic historians. So while we may have a Fed that looks impotent, the reality is that the Fed is pumping liquidity at a ferocious rate, something that didn’t happen in the early thirties. This may not jumpstart lending right away, but it will prevent the complete collapse of all banking institutions that occurred in the 1930′s. In fact, bank consolidation is progressing, with J.P. Morgan Chase, Bank of America, Wells Fargo, and Citigroup acquiring the weaker ones. Cash is fleeing WaMu for J.P. Morgan Chase, not for the mattress. The evolutionary process of the strong swallowing the weak is underway. The financial index etf, the XLF, is at 18.89, up 13% from the July low of 16.77. In fact, the financials are performing best on a relative basis since then, which would be unlikely if markets were signaling a complete banking collapse. We were six months too early investing in the financials. But every day that passes with the XLF (as consolidation reaches its late stages) staying well above its July low makes us confident we got good prices.

Not a single asset class is up year-to-date except Treasury bonds. Commodities, tech, transports and industrials have collapsed. Even investment-grade corporates and munis have sold off. The flight to quality flows only to the government. Treasury bonds yield close-to-nothing, are overpriced and are becoming extremely dangerous, now that all risk is being transferred from the private sector to the government.

In such an environment, risk-reward favors equities for long-term money and low duration munis/corporates for short-term money.

Returning to the binary question: the only point in the past eight decades where it would have heavily paid to sell equities now, at this particular point in the cycle (after one year of market declines of 30%), was the Great Depression, and even then, only in the seven month window from November, 1930 to May, 1931. An obscure fact is that from 1932 to 1937, the Dow actually quintupled, from 41 to 194, against the backdrop of bread lines and apple carts. This is the equivalent of the Dow going from 10,000 to almost 50,000. If you’d sold in June, 1932, when things appeared most terrifying, you’d have missed the biggest rally in history. Markets move well ahead of real economic trends. Given that history is the only guide, logic dictates holding equities. Emotion says to sell everything, but logic disagrees.

However, logic also dictates having the right amount in cash and bonds to meet any need within the next three to five years. We are engaged in a special review of every asset allocation of every client to make sure that time horizons are appropriately addressed. If there’s been a major life change at your end, please inform us so we can incorporate it.

We know this is a difficult time. All investors are weary and frightened. The bad news is unrelenting. But things will turn around, often when least expected. Equity holders will be richly rewarded eventually, as they always have been. Please contact us with any questions or concerns.