Fear Takes Round One

1Q 2008

It has often been said that financial markets are an ongoing social experiment pitting fear against greed. As we reflect on the first quarter of 2008, it’s hard to disguise the fact that global markets remain in a season of unrest. In such times, it’s easy for a crisis of confidence to emerge that overshadows sound long-term thinking. To appease internal fears, investors flee risky assets (stocks) and seek stability (bonds or cash).

A quick review of market returns for the past quarter perfectly illustrates how this scenario has played out. With the S&P 500 falling 6.0% in January, 3.2% in February, and 0.4% in March, we’ve now experienced five consecutive monthly losses in this widely followed benchmark for U.S. equities. You would have to look back nearly two decades (June 1990 to October 1990) to find another streak of such unenviable length. As an aside, we believe it’s at least worth hypothesizing that the heightened media coverage of today acts to create a self-fulfilling prophecy that extends market momentum (positive or negative). In conjunction with this fear-induced move away from equities of any kind, investors sought the safety of shortterm Treasury bonds. However, with yields on the 90-day note having now tumbled to below 1.4%, anyone holding these assets has effectively chosen a certain loss (net of inflation at roughly 4%) over any uncertainty that may lie ahead.

We don’t want to minimize this potential for near-term uncertainty that so many are trying to avoid. Indeed, the market volatility that we’ve been living through is elevated, even by historical standards. In the first quarter, the S&P 500 experienced moves of +/-1% during 51% of its trading sessions, a level that more than doubles the standard rate of occurrence over the last 50 years and was last achieved in 1934. To this, we add the potential for a U.S. or even worldwide economic recession. In fact, 71% of the economists surveyed by the Wall Street Journal in early March stated that the U.S. economy was already demonstrating characteristics of negative growth (weaker corporate profits, increased job loss, falling real estate values, declines in consumer spending, etc).

So what is it that provides us with the hope necessary to remain invested according to plan when others are heading for the exits? First and foremost, the markets have endured and eventually risen through each of the tumultuous periods in our history. We have no reason to believe that this historical fact will be compromised going forward; it just may take some near-term patience. Secondly, we have a Federal Reserve that is taking extraordinary, if not unprecedented measures to restore liquidity and promote growth in the system. Despite the known lag associated with changes to monetary policy, the economy certainly has a favorable chance at recovery later in 2008. Lastly, we’re keenly aware of the forward looking nature of the financial markets, and understand that some of the most rewarding returns an investor will ever achieve come in the form of “snap-back recoveries” that often commence when the environment still seems quite bleak.

A review of the ancient Chinese symbol for “crisis” provides an interesting perspective. While the top character of this two part symbol stands for “danger”, the bottom character can be interpreted as “opportunity”. It’s important for investors to understand that one can suddenly evolve into the other.