Now that we are halfway through the year, I thought it would be a good idea to provide you with some perspective on the market, and our globally diversified, asset class portfolios.
I stumbled across an interesting statistic over the weekend: in June 2008, the US Stock Market had its worst June ever since the great depression. Worst June? It raised an interesting question, or rather a series of questions. What about March or May? How about June 23rd? Where did June 23rd fall in the history of June 23rds? Should we care?
It is now official, we are in the midst of a bear market, and the press loves it. Nothing like doom and gloom to help sell newspapers. However, if you read no further, rest assured, this too will pass.
I read a great article in the Wall Street Journal by Jason Zweig titled, “Stop Worrying, and Learn to Love the Bear” I suggest everyone read it now, before finishing with this letter.
One point in the article that I would like to address is the comment about how bad the “market” has been since early 2000. For most Americans, who have over 85% of their equity investments in stocks and mutual funds in large U.S. companies, which track the S&P 500 Index, returns for the past 8 years have been terrible. From April 2000 through June of 2008, the S&P 500 Index has lost 1.75% for an annualized average of -0.21%. And this is before fees, which average 1.28% for no load mutual funds, and much worse if someone is working with a broker.
Fortunately for our clients, we take an asset allocation, globally diversified approach. Our all equity model returned 10.10% annualized from April 2000 through June 2008. (Those numbers are after the mutual fund fees, but before our fee.) The 85 Equity model and the 70 equity model returned 9.80% and 9.40% respectively for the same period. Even more impressive, while the S&P 500 Index had a standard deviation of 13.68% for the period, the 70 Equity Model had a standard deviation of only 9.62%! This means that the better return was achieved with less volatility. Click here to link to a document with these figures, and performance figures for some of the DFA Funds for the same period.
My point with this is that even really good articles, like the one by Jason Zweig, do not necessarily represent what is happening with your portfolio. Not only does the media try to sensationalize data, but many times what it is reporting has nothing to do with our academically sound investment strategy.
So, what is happening with your portfolio? The decline in June has put your portfolio under water for the year. Looking at the twelve month trailing returns, the numbers are worse. While the trailing twelve month period is not as bad as those experienced in the 1972-1973 market crash, it is halfway there.
What is causing all of this? The current crisis is really driven by three main factors: high oil prices, fear of inflation, and the credit crunch. I truly believe that all of these will work themselves out over time, and that the current value of the market is overshooting the short and mid term negative effects of these issues.
To gain some perspective, let’s look at the last time the US was in the midst of not only high oil prices, but hyper-inflation and in a bear market: the 1970s. More specifically the 1973-74 global bear market. The following data is provided in charts and graphs if you follow this link. In the graphs, I show three portfolios and the S&P 500 Index. Here I will just talk about the 70 Equity Model portfolio and compare that with the S&P 500 Index. I am picking the 70 Equity Model since that is the most common model for our retired clients.
Over the two years from January 1973 through December 1974, the 70 Equity Model and S&P 500 Index lost 20.84% and 37.24% respectively. A $1 million investment would be worth around $800,000 at the end of 1974 in the model portfolio. The same investment in the S&P 500 would have dropped to nearly $625,000. But it was actually worse than that! For the 11 month period from November 1973 through September 1974, the 70 Equity Model was off 23.88%, and the S&P 500 Index was off 38.94%. (As a point of reference, at one point during the bear market of 2000 to 2002 the S&P 500 Index was off almost 45%).
However, just 4 months into 1975, the 70 equity model portfolio was back above water. The $800,000 had grown back to a little over $1 million. It took the S&P 500 Index until June of 1976 to be back even, then it went negative again in early 1977 and was not back above water for good until May of 1978, almost 5 ½ years! Obviously, a diversified, asset allocation, global strategy fared much better than the “market.”
If we remove the returns of a single month, January 1975, it takes the 70 Equity Model 13 months, as opposed to just 4 months to break even. Missing January of 1975 would have caused the S&P 500 to delay until June of 1979, or 6.5 years to get back even. In fact, if you remove only one single month, January 1975, from the 7.5 year period from January 1973 to June 1979, the S&P 500 Index would have had just barely edged a 0% return. If this was one’s investment universe, it would be understandable why so many people have a lousy experience investing in the “market.”
The reason I am pointing all this out is twofold. First, to go back to the beginning of this letter and restate the comments that the news, as it reports the “market,” is not talking about your investments. We actually learn from history and academic research, and improve upon portfolios from these lessons. It is unfortunate that the media, and even Wall Street, fails to learn from the past. Second, I would like to show what happened when we did have both a major energy crisis AND hyper inflation. Currently inflation is still under 4% in the US. During the 1973-1974 crash, inflation was in the double digits.
We are not in some “uncharted territory.” Rather, we are in a recession, and there is some real uncertainty as to which countries and companies will be the winners and losers as the world changes and adapts to the current situation. While the traders try to bet one way or the other, we will bet on all of it. Owning the world through broad diversification is a proven strategy through good markets and bad.
To help counter all the negative press, let me share some potential good news to ponder.
Oil Issues:
- Recently discovered off the coast of Brazil is one of the largest oil finds ever.
- Iraq is in the process of drastically increasing its current oil production; with some estimates that oil production will double every six months for the next couple of years.
- Coupled with the fears of global warming, this time around the high price of oil will probably allow for some real and lasting changes to how the world produces energy, i.e. opportunity.
Inflation Concerns:
- While certainly a concern, no one believes inflation could become as bad as it was in the 1970s.
- One of the major reasons for the market sell off in June was related to comments from the Federal Reserve that it plans to hold interest rates steady or maybe even increase rates to stave off inflation. The Fed is right; the market just threw a temper tantrum because it is not getting its way.
- A continued fall in housing prices is anti-inflationary, as is a recession.
Credit Issues:
- There is no lack of demand for high quality debt. There is just a lack of confidence in the determination of what high quality debt means.
- There is a great deal of cash just waiting for things to "turn around." When it happens it should be fast.
- Much of the recent downgrades in bonds have nothing to do with the likelihood that a bond will be paid back, but rather it is a technical issue with the way the ratings are handed out. It is like a change in a grading system, without a change in how one understands grades.
Much of what is going on in the credit and equity markets is a classic fight or flight response. Things are changing. There is uncertainty. What was “AA” may or may not mean the same thing as “AA” today. If your livelihood and premise of investing is based on predicting the future, you hate uncertainty. So what do you do? You fly! Meaning you sell and wait until you believe the uncertainty is gone and you can predict the future again. Fortunately for us, the world marches on regardless of what the “market” does. And eventually, the market will catch up.
Lastly, for our retired clients, I want to provide one more analysis of the portfolios looking back at the 1973-1974 market crash. What if you retired at the end of 1972? Let’s assume that your initial withdrawal rate was 6% of the value of the portfolio. Meaning a $1 million portfolio would distribute $60,000 per year to spend and pay taxes. Using the 70 Equity Model portfolio, it would have taken 5 years to get back to $1 million, taking $60,000 at the beginning of each year. Put another way, it took five years from the beginning of the bear market for the portfolio to recover, with the added drag of a $60,000 annual withdrawal. Spending the bond portion down to $0, the bonds could sustain a $60,000 per year withdrawal for over 5 years, thus allowing the stocks to go down, fully recover their losses AND build back up to replace the bonds. Meaning at the end of 5 years, the portfolio would have been worth $1 million again.
The purpose of this last point is to help illustrate how the portfolios are designed to be able to sustain systematic withdrawals in retirement and be able to recover from a major market crash. I do not know how much farther our portfolios will go down, nor do I know how long it will take for them to recover. However, I do know that your portfolio is doing fine, and will be able to survive the current bear market.
I understand that this is a difficult time. The priority in this time is keeping the discipline, and we are here to help. If you want to talk more about your portfolio and the current market conditions, please do not hesitate to call.
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