In the credit markets a flight to quality caused sharp declines in corporate bonds of all types both investment grade and high yield, Reflecting the extreme nervousness in the market treasury bonds were the sole asset class to show gains. The ishares etf for long term treasury bonds gained 33.7% for the year while the etf for investment grade bonds rose only 1%.
There is no doubt that economic conditions deteriorated significantly throughout the year and the market declines were in response to those economic fundamentals. However, it is also important to recognize other factors that determined market movements during 2008. Rather presenting another review of those economic developments this analysis will focus on factors internal to the financial markets which contributed to the extremely high volatity and the massive declines across asset classes.
First and foremost is the massive deleveraging which occurred across the markets. Easy access to credit had allowed participants to leverage themselves (borrow heavily) in every sector of the economy : individual borrowers, financial institutions, hedge funds, commodity funds, private equity, real estate investors and others. This led them to take on large scale investments and purchases which in turn fuelled the massive increase in assets across the board and a consequent buildup of risky positions on balance sheets. As the credit crisis hit, this massive borrowing machine shifted sharply into reverse in massive deleveraging as access to credit was severely rationed.
In order to pay back borrowed funds investors had to engage in large scale liquidation of positions. Financial institutions, hedge funds and others had to meet what was in effect a global margin call, they were obligated to sell assets and reduce their level of leverage to meet the demands of their financiers. These were often forced liquidations.
In order to reduce their leverage investors would often engage in sales of assets on an often indiscriminate basis, thus correlations among asset classes increased considerably even if the fundamentals may not have fully justified the move. “The only thing that goes up in a down market is correlation” is an old market maxim and it was certainly true this year as investors simply raised cash selling off assets. As we looked across the financial markets there was carnage across the board: domestic large cap, small cap, growth and value, international developed and emerging, commodities, and corporate bonds. In fact due to the severely depressed prices and lack of liquidity in the markets for the riskiest assets, it was often the less risky assets with the highest potential long term value which were sold first.
The credit markets saw a flight to quality in which investors were interested in owning little else other than US treasury obligations. As a consequence the differential in yields (“the spread”) between investment grade corporate and municipal bonds and US treasuries increased reached levels seldom seen in the market.
In the process of this selling many institutions and hedge funds encountered severe lack of liquidity in many markets. The markets for the more esoteric financial instruments favored by these professional traders such as mortgage backed securities, credit default swaps, and other derivatives simply dried up as there were no counterparties willing to buy these assets in any significant volume. Faced with these conditions and a need to raise capital, these investors sold their positions in the more liquid markets of listed equities, commodities and investment grade bonds.. This fuelled further selling in those markets and in turn unprecedented levels of volatility.
Finally, one must always take into the account the all important impact of investor psychology on the financial markets. All of the above factors worked together into a negative feedback loop which was intensified as investor psychology turned massively negative. In 2008 individual investors took more money out of equity mutual funds than at any time in history and hedge funds experienced net outflows for the first time in well over a decade. since Of course the fund managers had to make forced sales to meet the investor redemptions further fuelling the negative cycle.
Advocates of actively managed funds have often argued that their funds would outperform index funds in down years, since the index funds are obligated to be fully invested in the stocks composing their index at all times. Yet once again actively managed funds failed to outperform. John Bogle of Vanguard noted in the Wall Street Journal
Indexing won in 2008 by an especially wide margin. Low-cost, low-turnover, no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and (admittedly a fairer comparison) more than 60% of all funds focused on large-cap U.S. stocks. This continues the pattern -- with some variations -- that goes back to the start of the first index fund 33 years ago. The bond index fund did even better. Its return of 5% for 2008 outpaced more than 80% of all taxable bond funds.
Looking at stock prices at year end, it is impossible to clearly determine whether the declines in stock prices represent an “overshoot” beyond some objective “fair value,” In the credit markets however, it is a bit easier to point to price relationships that are best explained as anomalous or even irrational: long term investment grade bonds carry yields close to 6% above those of similar maturity treasuries
2009 Outlook
Bearing in mind the warnings of John Bogle of Vanguard: that one should“beware of market forecasts “ here are some of my thoughts:
Looking at the factors that caused the market decimation in 2008 and the conditions they have now created leaves me cautiously optimistic for 2009.
Valuations: In the indiscriminate liquidations in 2008 left many company’s stocks were pushed down to values that are unjustified by their underlying business or even their cash or other assets on hand. Furthermore a large portion of the decline in the major market indices came from the massive losses in the financial sector.. While the financial sector will be constrained from ever achieving the growth rates of the past, the lower weighting in the major indices and the evidence that the government considers the largest players “too big to fall” places some limits on the potential impact of further negatives in the financial sector. Many other sectors of the market have potential to gain significantly from economic rebound when it occurs in both developed and emerging markets and from the fiscal stimulus in the US.
Government Policy After numerous false starts during 2008, it does seem that authorities have a more cohesive approach to both fiscal stimulus and monetary policy in place, one which has the potential for stimulating the economy towards recovery in 2010. Equity markets always turn up in advance of an economic recovery.
Money Flows: In my view much of the forced liquidation by hedge funds of listed equities has already occurred as has the panic selling of equity mutual funds by individual investors. There are also high levels of cash in the hands of equity fund managers. As the market stabilizes and begins to rise and investors are faced with the alternative of 2% rates on Cds and below 1% on their money market fund there is potential for a large flow of money back into the stock market.
The large scale deleveraging and sales that have occurred already makes similar volatility and indiscriminate selling less likely in 2009. There are simply fewer large leveraged positions left to be liquidated and little credit available to build new leveraged positions.
Emerging Markets Although these countries, particularlyChina are heavily dependent on exports to the United States, they are far better positioned than the US in many ways. There is significant potential to benefit from the growth of the middle class both domestically and in the rest of the developing world. And the large surpluses accumulated through exports could be increasingly invested domestically to stimulate their economy. Also the current depressed commodity prices are a boon to the developing world. Emerging markets will be well positioned when the recovery comes to the developed world.
Negatives:
I see little reason to expect a recovery in housing prices. At best one could hope for a stabilization 10 -20% below current levels aided by government policies to limit future foreclosures and push rates on mortgages lower. The stabilization in prices after that drop would likely be followed by an extended period of up to ten years with minimal or no price appreciation. Such a scenario would put prices back in line with their long term hisroy of home price appreciation which Professor Robert Schiller of Yale and others have found to be equal to the rate of inflation,
Consumer spendg; the inhigh levels of unemployment, the end of the home equity piggy bank, and even a modest increase in household savings will put a limit on consumer spending which traditionally had been the key driver of US economic growth. This is unlikely to improve before 2010 at the earliest.
“Known Unknowns”: The list of things that could go wrong and derail any positive performance in the equity markets is, unfortunately, a long one. It would include: failure of US government policy to revive the economy, political instability abroad, major bankruptcies, international conflicts, major economic crises abroad, and a sharp rise in inflation (or widespreade deflation).
Investing themes
While we maintain broadly diversified portfolios across the markets, we are positioning within that strategy to take advantage of the following:
Financials remain vulnerable and therefore we are investing in broad indices which underweight financials.
Developing economies have potential to benefit from growth within their own markets and do not carry the burdens of credit overextension, budget deficits or current account deficits. We maintain a significant weighting in this sector with a slight overweighting towards Asian emerging markets.
Small cap value stocks tend to be the first beneficiaries of recoveries in the stock market therefore we have an overweighting in this area.
We have small positions in etfs concentrated in clean energy and consumer staples.
The high yields on investment grade corporate and municipal bonds offer an attractive investment opportunity . Many have noted that high grade corporate bonds have potential with long term equity returns in the area of 8% based on current yields over 6% and the potential for capital appreciation should yields fall and/or spreads to treasuries narrow. Some of that narrowing has begun late late in 2008.
Finally I would like to remind you of some basic investment principles that were presented by John Bogle (generally regarded as the inventor of the index fund) in a recent Wall Street Journal article entitled : 6 Lessons for Investors
1. Beware of Market Forecasts
2. Never underrate the importance of diversification
3. Mutual funds with superior performance records often fail to repeat.
4. Owning the market remains the strategy of choice.f asset allocation
5. Look before you leap into alternative asset classes
6. 6) Beware of financial innovation. Why? Because most of it is designed to enrich the innovators, not investors.
Best Wishes for the New Year
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