The Prelude to Capitulation

3Q 2008

While we did not enter the quarter expecting sleepy summertime markets, we surely wouldn’t have predicted or even imagined the scenarios that unfolded. By the end of September, we had witnessed several historic events: the government’s intervention with Fannie Mae, Freddie Mac, and AIG; failures at Lehman Brothers and Washington Mutual; two shotgun mergers that forced both Merrill Lynch and Wachovia into better-capitalized hands; a liquidity crisis driven by a prominent money market fund that “broke the buck”; and last, but not least, a $700 billion plus “rescue” package proposed by the Treasury to help stem an exploding financial crisis that appears to be threatening economies all across the globe.

So while we began the third quarter on the brink of declaring an official bear market, classically defined as a 20% decline from the previous peak, we exited the period squarely in the midst of one. As the S&P 500 registered its fourth consecutive quarterly decline, losing another 8.4%, the primary benchmark for U.S. stocks found itself 26.1% below October 2007 highs.

Ironically, despite being at the epicenter of the financial turmoil, the domestic markets fared relatively well compared with global peers. As investor worry escalated, and the “flight to safety” took hold, the U.S. dollar appreciated noticeably and funds began exiting international holdings in bulk. Stocks of developed international countries fell by more than 20% during the quarter, while emerging markets were hit exceedingly hard and shed nearly 27% of their value.

If forced to draw out a positive, you might cite the rapid slide in commodities. Following its sustained rally in recent periods, the Goldman Sachs Commodity Index was off 29% for the quarter. While much of the decline came from the expectation of diminished demand in a more sluggish world economy, the reprieve from near-term inflation pressures is welcomed.

In this environment of deleveraging, where almost all asset classes are losing value relative to cash or short-term Treasury bonds, many have drawn parallels to the Great Depression. We would argue, however, that the most prominent similarity between today’s climate and that historically troubling period is that, once again, the market is moving largely on all consuming fear, not facts. The primary difference we see is that the government’s actions in 2008, which have made available more than $2 trillion in backstops and liquidity, are entirely different from the hands-off mentality of the Hoover administration and the rigid detachment of the Federal Reserve in 1929 through 1932. Essentially, our downside is likely limited by such actions. That said, the investment community has been bludgeoned into paralysis by the market’s astonishing volatility. This collective stupor may very likely be the last stage before many investors finally let go — “capitulation”.

The brilliant investor Benjamin Graham, who cemented his legacy during the Great Depression, and later become Warren Buffett’s personal mentor, once stated: “stocks always sell at unduly low prices after a boom collapses…it happens because those with enterprise haven’t the money, and those with money haven’t the enterprise, to buy stocks when they are cheap”. No one can spot capitulation before it sets in. But it may not be far off now (especially considering early 4Q returns). Investors who have, as Graham put it, either the enterprise or the money to invest now, somewhere near the bottom, are likely to prevail over those who wait for the bottom and miss it. As it relates to your portfolio, we’ve likely helped you buy stocks recently via disciplined rebalancing out of existing fixed income holdings.