November 20, 2008

Dear Investor:

The Dow has made a new low of 7,997, 2% below the 8,175 closing low of October 27. It held above the intraday October low of approximately 7,900, but not by much. The Dow is now down 44% from its peak. There’s not much I can say at this point without sounding repetitive.

For investors, it remains a binary question. Is it another “Great Depression” or not? If so, it would still pay to sell stocks here and now. If not, it would be a tragic mistake, given that five-year stock market returns following collapses of this magnitude nearly always beat cash, and usually by extraordinary amounts. Even in the Great Depression, the Dow went from its low of 41 up to 194-a quintupling-against a backdrop of bread lines. This would be the equivalent of the Dow going to 40,000 over the next five years. I’m not saying we’ll have a recovery of anything of that magnitude, only that stocks always eventually recover, even in the darkest of times.

It’s obviously difficult to conceive of the market ever going up against a backdrop of economic misery, but history shows that it does. The recovery is not caused by optimism, but by bottom fishing-buyers coming off the sidelines to acquire assets on the cheap. Here are the examples of bear markets of the current magnitude and their subsequent recovery. All the recoveries occurred against a backdrop of continued bleak economic news:

1907:  49% decline, by 1909 recovered 90%

1917:  40% decline, by 1919 recovered 81%

1938:  49% decline, by six months recovered 60%

1974:  45% decline, by 1976 recovered 76%

To repeat, the only time in the past century when U.S. stocks had to go past the 49% decline mark before recovery was in the Great Depression, when stocks didn’t recover until three years of collapse.

The terrifying events of the day-ranging from the impending bankruptcy of the major auto manufacturers to the looming default of sovereign debt to the spiking unemployment rate-are not alone the types of things that cause a depression. It may surprise many that a depression (as opposed to a recession) is shown by history to be the result of a lack of government intervention and stimulus in the face of awful economic conditions.

In the thirties, the Smoot-Hawley tariffs and the gold standard conspired to stifle the economy, not stimulate it. Today, the Fed is providing a wave of liquidity which is starting to show signs (as evinced by lower interbank lending rates) of working. It will not be perfect and it did not come soon enough. The global stimulus, however, is an unprecedented initiative and the right medicine for the current ailment. The Obama administration is expected to compliment this global monetary package with a fiscal one. Though fiscal stimulus is not likely to be as powerful or as targeted, it will help. I expect a severe recession, not a depression. I also expect negative effects of this intervention in the form of higher inflation and higher interest rates, but that’s a preferable problem and one for another day.

Even Jim Grant, the renowned economic historian and stock market bear, does not foresee another Great Depression. As he said recently to Vanessa Drucker of Fund Strategy: “Those glib comparisons ignore the reality of the economic backdrops. In the thirties, nominal GDP was sawed in half, while today it’s down less than a percentage point.”

Many investors will give up on stocks now, if they didn’t already do so in October. History shows they are likely to be making the wrong decision at the wrong time. They certainly appear correct now and definitely feel safer, but they’re selling assets at panicked prices and locking in their losses. They’re not different from the home seller who accepts $100,000 for the $1,000,000 home to just “get out.” The home may easily go down to $80,000 before recovering. But if the intrinsic value is $1,000,000, they’re selling a valuable asset for less than its worth. Stocks are the equity interests in businesses. To that extent they possess real value-value that the market’s not recognizing in its panicked state.

It might be right for some to sell stocks: Those who need the money within three years cannot keep money in stocks. Those who believe it will be the Great Depression again should sell. Those who are leveraged and margined have already been forced to sell. But those who can wait this out should.