Quarterly Market Updates

MARKET UPDATE AND OUTLOOK : OCTOBER 2008

Looking Back: Q3 2008 and Trailing 12 months

By now, everyone is aware of the economic situation here and abroad that has resulted in substantial declines in the values of almost all asset categories during Q3 2008, which accelerated during the first ten days of October. While we have been through worse recessions and even more dramatic stock and bond market drops during my nearly 30 years in my profession, the past six weeks have been as dramatic as any period I’ve experienced. Certain aspects of the current situation are unique: specifically, the breakdown of interbank lending, loss of confidence in the banking system and credit markets, and the failure of major non-bank financial institutions. Other aspects are reminiscent of prior periods: widening interest rate spreads between U.S. Treasuries and corporate bonds, dramatic declines in both U.S. and foreign stock prices, highly volatile commodity prices, and falling real estate home values. This last item has probably had the broadest, most debilitating effect on consumer confidence because the “bubble” that developed in home prices from 2002-2007 was as dramatic as any asset bubble we have experienced in this country since the 1920’s. Exacerbated by lax underwriting in the mortgage industry, the volume of refinancings and home equity loans hit an all time high in 2006, the last year there was an above average return in U.S. stocks, not coincidentally. Lots of dollars chasing a limited supply of investment assets (stocks and real estate), which drove prices up. The bubble in real estate began to deflate during 2007, as interest rates on adjustable loans were reset at levels substantially higher than initial “teaser” rates of 2004-2005. U.S. stocks peaked on October 9, 2007 five years to the day since the previous low point for U.S. stocks in 2002. After the tumultuous Q3 2008, which saw the S&P 500 index return -8.4%, the 12 month return fell to -22.0%. As of October 10, so far the bottom in the current slide, the trailing twelve month return for the S & P 500 Index was -43%. This makes the current bear market the third most severe in the past sixty years, trailing only 1973-74 and 2000-2002. As mentioned earlier, there are both similarities and differences between the current situation and those prior periods. What’s important to note is that all bear markets end when fear reaches a crescendo and selling pressure peaks. While it’s too soon to know whether this bear market touched bottom on October 10 or has yet to reach a lower level, we believe that current prices reflect high levels of fear and even despair, which historically have been associated with buying opportunities, i.e. favorable returns over succeeding three to five year periods. Such appear to be current conditions in today's equity markets.

So, was there any asset category that avoided dropping in value during this period? The list is short: Money Market Funds, U.S. Government Bonds, Bear Market Funds, and surprisingly, Real Estate Funds. The twelve month list is equally short; in fact, it’s mostly the same with the exception of Real Estate Funds (-14.5%) and the addition of Inflation Protection Bonds (+4.1%) and Comex Gold (+17.2%). All common stock categories were down during the quarter, mostly by double digits and several over 20%, especially international funds. The strongest sectors during the first half of the year, namely Natural Resources, Commodities, Gold & Precious Metals and Latin America, took the largest hits during Q3, down 32.6%, 27.7%, 32.1% and 37.4% respectively. For the trailing twelve months, U.S. stocks outperformed Foreign for the first time in several years, with Small Cap. losing less than Mid and Large. Value slightly outperformed Growth and Blend, but the range was fairly narrow, with Small Value losing 15.7% (best) and Mid Growth -24.8% (worst). The range for Foreign stocks was from -27.8% (Latin America) to -42.3% (Pacific/Asia ex. Japan). Specialty/Sector Funds ranged from -0.2% (Health Care) to -32.6% (Natural Resources) for Q3 and -9.7% (Health Care again) and -38.0% (Communications) for the past year.

Fixed Income returns had a much narrower range of returns for the most part. Long Governments returned 1.4% for Q3 and 8.8% for the trailing 12 months, tops for both periods. All non-Treasury Fixed Income categories had negative returns with High Yield (-8.2%; -11.3%) and Convertible Bonds (-14.5%; -20.7%) the worst performers over the past 3 and 12 months respectively.

Finally, defensive equity had its turn, with Bear Market category funds up 8.5% for Q3 and 21.6% for the trailing 12 months. However, the Long/Short category didn’t fare so well, losing 6.1% for the quarter and 8.7% for the year. Still, this was better than most Equity funds by a significant margin. Our principal recommendation in this category, Hussman Strategic Growth Fund, gained 3.4% for the quarter and 4.2% for the trailing 12 months.

Looking Ahead: Q4 2008 and Beyond:

I mentioned the word “capitulation” in my last update, saying that I believed we had not quite reached that point. Little did I suspect the events of the past three months, which now, in hindsight, appear to have been a true “giving up” on the part of a substantial number of investors. A recent Op-Ed article by Warren Buffett (New York Times, October 17) says it all: “ I’ve been buying American Stocks. A simple rule dictates my buying: be fearful when others are greedy, and be greedy when others are fearful.” He then goes on to explain that this is not a prediction of short term stock market performance over the next year or two. Rather, he says, “What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.” Our perspective is, similarly, intermediate to long term, the next three to five years and beyond. We believe investors will realize greater returns in stocks, both U.S. and Foreign, over the next few years than in bonds, cash or CDs. Of course, there is no guarantee of any specific outcome. But we believe that, as Mark Twain said : “History may not repeat itself, but it does rhyme.” As Buffet points out, stock markets have weathered severe storms many times in the past and always emerged to reach ever higher levels. We see no reason that the pattern will be significantly different this time.

James P. King, CFP®
October 21, 2008