October 17, 2008
“The point of maximum pessimism is the same point of maximum opportunity.” – Unknown. As I have mentioned in previous letters, the stock markets hate uncertainty. As you know, we have experienced our fair share of uncertainty over the past few weeks. I have read numerous articles, blogs and newsletters that have attempted to explain what has taken place with the credit, real estate and stock markets over the past 15 months. It is safe to say that these times will be studied and reviewed over the next 100 years. In the mean time, I believe it is prudent to adhere to the asset allocation previously agreed upon in our meetings and reviews. At these levels, we do not want to make “knee-jerk” reactions where we sell everything and move to cash. In fact, I believe there are some wonderful opportunities out there that many of our mutual fund managers will be taking advantage of. I will discuss these opportunities later in this letter.
I have always felt that one of my chief duties as an advisor is to keep clients informed and to provide educational materials for those who request them. I have always figured that the more informed clients were about their current circumstances, the more likely they would agree with my opinion and, thus, the happier they would be with our services. With all of this in mind, I have enclosed several articles that I have read over the past few weeks that I thought might interest you. Of course, I have many other video clips and articles that I could send along to you as well, so feel free to let me know if you are interested in learning more about what is going on with our economy and markets at the present time. Also, let me know if you have a particular area of interest (e.g. credit default swaps, etc.).
I know what many of you are thinking during these uncertain times: We do not have a lifetime to make up these losses in our portfolios. My response: I do not think it will take a lifetime. There is a reason advisors suggest that long-term investing should be three to five years – they want to provide enough time for a bear market to play itself out with a recovery afterwards. Please refer to the enclosed chart entitled: S&P 500 Total Return Index – 1 Year Rate of Return. Note at one of the lows on 09/30/74 that the S&P 500 is down 38.92% (we are in a similar situation as of this writing). Look at how quickly the stock market bounced back from this low point. It does not take long – and I do not want you missing that ride back up.
You might be asking yourself, “What is preventing us from going into a depression similar to what took place in the late 1920’s and early 1930’s?” During the late 1920’s the U.S. government believed in a “hands-off” policy when it came to private industry. They basically said, “You got yourself into this mess, you figure a way out.” The Great Depression was the result. Many argue that President Franklin D. Roosevelt’s New Deal or World War II was what pulled us from those depths. What we have learned is that the Great Depression may have been avoidable had the government acted sooner – much as it has right now. As you have read in the headlines lately, the U.S. government and leaders throughout the world have taken drastic and extreme measures to fight off another Great Depression. Just like there are limits to free speech (e.g. you can’t yell “fire” in a crowded theatre), there is no such thing as pure capitalism (the government will need to temporarily step in once in a great while to restore confidence in the free market system and/or enforce rules and regulations). Capitalism is not perfect, but it is still number one in my book.
We are focusing on the types of companies we always have – a combination of “cigar butts” (as Warren Buffett called Benjamin Graham-type stocks) and some truly exceptional businesses trading at fire sale prices. Sometimes when investing seems most scary it’s the best time to invest. This may be one of those times.” – Jean-Marie Eveillard, Matt McLennan and Abhay Deshpande, First Eagle funds, October 14, 2008
“This is the opportunity of a lifetime. The most important securities are being given away.” Marty Whitman, fund manager for Third Avenue Value fund, October 12, 2008 New York Times.
I cannot conclude this quarter-end letter without pointing out some of the opportunities taking place in the markets today. There are many deeply discounted stocks with 4-6% dividend yields that are selling near their 52 week low with single digit P/Es. For comparison’s sake, a five year treasury note is yielding 2.83%. In other words, as I write this letter, there are valuations out there that have not been seen in a very long time! With the U.S. government purchasing toxic mortgages from banks, temporarily increasing the FDIC maximum insurance on bank deposits to $250,000 and, more recently, buying actual ownership in some banks, Uncle Sam has provided a backstop for the finance industry. This backstop will serve as the stock market foundation as we look to the future. Our value fund managers are like a bunch of kids in the candy store right now. They are buying stocks at “fire sale” prices and we should be amply rewarded for hanging on to these mutual funds.
As many of you know, a P/E ratio is the price of a share of stock divided by the earnings. A P/E ratio tells you how many years it will take to pay for the current price of the stock based on earnings (either forward estimates or trailing). Just like in golf, the lower the number – the better. In the late 1990’s the P/E ratio for the S&P 500 (the largest 500 stocks in the United States) was in the low 30’s. In other words, it would take 30+ years to pay for the S&P 500 at that price. Currently, the P/E for the S&P 500 is between 12 and 13 – lower than the S&P 500’s historical average. There is value to be found out there. We just need to have patience.
This does NOT mean that we are going to sit and wait for things to happen with each of your portfolios. For those with taxable accounts, I will be going through and “harvesting” tax losses to use on your future tax returns. After the 2000- 2002 bear market, many of you found the value of having these losses on your return. For those that are not matched against applicable capital gains, $3,000 can be used as a deduction against your ordinary income. Any losses after that can be carried forward and used in future years. Of course, I will make sure that we are not out of the market while making these changes. We would hate to miss a 900+ increase in the Dow Industrials – like we had a few days ago.
It is a very difficult and challenging time. I can assure you that I will do my very best to make sure you have competent and experienced managers investing your hard earned money. While we cannot control the direction of the stock and bond markets, we can control the mutual fund expense ratios. We will do our best to keep these fees to a minimum. Until the markets turn around, I encourage you to use us as a resource. Let us know what is on your mind – we would be happy to hear from you.
Best regards,
Bill