Insights

2008 is now behind us. To say that it has been a challenging year for all of us would be a dramatic understatement. I would like to apologize in advance for the length of this communication but these are unusual times, and I would rather over communicate, than err on the side of brevity.

Many of our clients have asked for an explanation of “what is going on!” It all starts with mortgages. Over 250,000 homeowners in the United States received foreclosure notices in November. Some of these are unfortunate individuals who, due to a change of circumstances, can no longer afford the home they purchased. These people are not the problem. 

The majority of the foreclosures are speculators that were anticipating a quick flip or people who were not truthful in completing the mortgage applications. Ridiculous “no documentation” or “negative amortization” loans were encouraged by our elected officials in Washington to provide everyone with the American dream of home ownership. The mortgage companies who provided these loans were happy to place them because of the lucrative fees they earned in putting the loans together.  Then the government agencies (Freddie Mac and Fannie Mae) packaged these loans, putting the government wrapper on them and sold them. The Wall Street brokerage firms sliced and diced this mortgage paper into new securities called derivatives that no one seemed to understand. Since some insurance companies were happy to insure the safety of these derivatives they were subsequently purchased all over the world. Many aggressive financial institutions underestimated the real risk and borrowed money to buy these “safe” derivatives. This leverage multiplies the result of an investment. So when a company like Lehman Brothers (who was leveraged 40 to 1) started experiencing losses, those losses were multiplied by 40, it didn’t take long for Lehman to go down.

So where are we now? The government is frantically trying to make sure that the underpinnings of our financial system are secure. They are pushing the banking institutions to resume lending to credit worthy borrowers. This whole problem is similar to the Savings and Loan melt down 20 years ago, except this time it is world wide, and it is magnified by the corporate leveraging discussed above.

Needless to say, this has had a large impact on the economy and correspondingly the Stock Market. It is now believed that we entered into this recession in the beginning of 2008. The Stock Market as measured by S&P 500 lost 37% during 2008, its worst calendar year performance since the 43.3% decline in 1931. The loss in just the last 3 months of 2008 was 21.9%. That’s the worst quarter in 21 years going back to a loss of 22.5% in 1987. I am sure you have received your December 31^st investment statements by now reflecting the impact to your portfolio, especially the stock component. 

As you try to assess your reaction to current events and the seemingly endless torrent of bad news please keep the following five things in mind as you evaluate changes or investment alternatives. 

1. Short-term swings in the stock market are totally unpredictable.
2. Control the things you can control, for example spending, because you cannot control the market.
3. The stock market has never gone to zero.
4. When companies take care of their customers, or build better widgets, over time, the owners (shareholders) of a company will be rewarded through the growth and value of stock.
5. Over the last 75 years, the stock market has provided returns of over 3 times the return of risk-less savings accounts or CD type investments. (Source: Morningstar- Ibbotson) 

So what do we do now? If you move to cash, you are accepting a minimal rate of return that we know is not enough to sustain you for your long-term objectives. To move only “temporarily” would imply that one can predict the short-term movement in the various investment markets. We know we cannot, nor do we pretend too. If you move totally to government bonds now, you are setting yourself up for the next correction. The first stage of the correction will occur when investors sell out of Treasury bonds in search of better returns. The second part will occur when the Federal Reserve starts raising interest rates. The other alternative is to review your overall long term asset allocation strategy and make sure that it still makes sense. This is the course that we are recommending.

We believe that one of the greatest risks now is the risk of doing something impulsive that would have a long-term negative impact on the portfolio. One of the greatest investors of the last 70 years is Warren Buffet. Warren once said, “Be fearful when others are greedy and greedy when others are fearful.” Now is the time when this fear of the unknown is causing some investors to panic and make impulsive decisions that will irreparably affect their value forever. It is sometimes helpful to look at what has happened historically in similar situations. You will find below all 8-market declines that exceeded a 20% drop since 1950. Included are the dates, the total amount of the decline, and the total rate of return one year and two years hence. As you can see, once the bottom has been hit the return has historically been substantial. 

*Sources: Bloomberg. Returns reflect the performance of the S&P 500 Index (a registered trademark of the McGraw Hill Companies), an unmanaged basket of 500 stocks that are considered to be widely held and thus believed to be an indicator of overall market performance. This index of common stocks is weighted by market value. Returns for the S&P 500 Index are calculated on a price-only basis without dividends and capital gains distributions, reinvested. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

The average rate of return for the S&P 500 Index 1-year after a correction has been 36.47%. The average 2-year increase has been 53.86%. No one knows when the market will bottom or if it will turn back up as quickly this time. But the people who are on the sidelines waiting for a “sign” generally wait too long. Case in point, the stock market actually went up (based on the S&P 500) by over 20% during the last 45 days of 2008! 

Does that mean we have hit the bottom? We don’t know, but I think most of us would consider a 20%+ rate of return an excellent one-year rate of return. This rapid increase in the stock market value in only 45-days has been unnoticed by most of the public especially due to the retrenchment in January. While an overall economic recovery still does not appear to be imminent, we continue to believe we are in the classic “bouncing along the bottom" phase of an aging bear market. We realize these are both trying and confusing times, but our nation has successfully dealt with adversity before. This time will eventually be no different. 

If you should have questions regarding any of the details discussed in this letter please feel free to contact us. 

Schneider Downs provides accounting, tax and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh and Columbus.

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