4th Quarter 2008 Commentary & Year End Review
Oak Funds Fourth Quarter 2008 Market Commentary & Year End Review
By Robert Stimpson, CFA
Apparently the Bears, which have overwhelmed Wall Street and its markets do not
hibernate during winter months. Already enduring one of the sharpest corrections
in 20 years, the stock market then doggedly achieved the worst quarterly decline
since the 1987 stock market crash during the fourth quarter of 2008. Despite steadily
falling throughout the year, the S&P 500 punctuated its full-year performance by
dropping an additional 22% in the quarter. By year end, the broad-based market index
had lost 37%, as the global economic downturn crushed stocks. Furthermore, the subprime
meltdown and resulting fallout shattered global confidence in the US financial system.
So, while it was a disastrous year for investors, the long-term damage to the ideals
of capitalism was also significant.
During the fourth quarter, the potential imminent collapse of the auto industry
(and related sub-industries), along with rising unemployment rates, aggravated existing
housing, credit, and retail market weakness to overwhelm stock prices. Government
efforts to shore up the financial system, unlock credit markets, and stimulate the
economy were also overlooked as risk aversion soared to new heights. In its wake,
cash and Treasuries were the only safe havens, and a flight to quality propelled
the bond market to its best quarterly return in decades. Levels of cash parked in
money market funds and sitting on the sidelines also soared.
It was simply a horrendous year for both institutional and retail investors. Regardless
of the discipline or approach, long-biased strategies dropped sharply. Within the
S&P 500, the best performing subsector was the typically defensive staples, which
fell 17.66%. The worst sector, and large weighting in the broad market index, was
financials, which fell nearly 57%. The challenging investment environment will cause
2008 to rank as the worst market since the Great Depression of the 1930’s. During
the year, century-old Wall Street institutions disappeared, merged, or were essentially
nationalized. Most of Wall Street was rezoned from ‘investment bank’ to ‘commercial
bank,’ in order to obtain more government support and accept oversight. An onslaught
of regulation is likely to emerge and the level of government involvement will climb.
Throughout the year, both the Federal Reserve and Treasury worked hard to forestall
the economic crisis. Congress’s efforts have been more political than economical,
but another stimulus package is expected in the first quarter of 2009. The Fed has
lowered interest rates to below one-half of one percent, while the Treasury pumped
hundreds of billions of dollars into unstable banks, credit unions, auto loan companies,
credit card issuers, insurance firms and more. Both government departments have
demonstrated a willingness and the ability to be creative in order to solve the
credit problems. This supports investor desires for a swift recovery; but, the timing
and development of a turnaround will be both uncertain and problematic. The subprime
debacle, a weak housing market, and the subsequent deleverage at the root cause
of the market’s woes linger in the minds of investors and sentiment remains poor.
Over the near-term, the news flow surrounding the economy is likely to remain bleak.
The unemployment rate is expected to creep toward levels not seen in decades, and
retail sales will be lackluster. This should not be too surprising since most economic
data is backward looking. The stock market however, looks beyond the last data point
and tries to forecast the future. And while it is not always right, the stock market
will typically emerge from its malaise before economic data turns rosy. We believe
this could occur in 2009.
A high-profile risk for the economy near-term is deflation, as falling commodity
prices, and poor growth lead to a spiral of falling prices that pressure profits
and wages further. Longer term, however, the risk of inflation is more substantial
for investors, given the significant levels of liquidity pumped into the market
and the low level of interest rates necessary to unfreeze credit markets. Fortunately,
the US moved quickly to cut interest rates and stimulate the economy. The rest of
the world was somewhat slower to act, but eventually followed suit. This suggests
that the US may be one of the first economies to emerge from the global economic
downturn. Lower commodity prices, high liquidity, revamped balance sheets, and attractive
valuations could lead to a powerful market in a recovery (similar to 2003). We continue
to position the portfolio to benefit from this situation, while also monitoring
the overall health of the economy.
The process of deleveraging exacerbated the market’s volatility in 2008. Billions
of dollars flowed into hedge funds and “alternative investments” over the past five
years, attracted by lower volatility, absolute return strategies and low correlation.
Utilizing cheap funding from abroad and leveraging high-yielding asset-backed securities
and/or commodity futures, the process of unwinding these positions has weighed on
the entire market. Growth investors like Oak Associates watched with concern, having
experienced a similar asset boom in the late 1990’s. In the post-bubble investment
era, assets flowed first into real-estate, and eventually to hedge funds. And while
Warren Buffet famously coined derivatives as “weapons of mass destruction,” it was
the leverage employed by hedge funds and the illiquidity of their instruments that
ultimately produced the fallout cloud which has plagued the stock market by calling
into question the stability of its core financial institutions.
The allure of hedge funds has undoubtedly changed. Their lack of transparency, illiquidity,
and poor returns that were supposedly independent or immune to steep equity-like
decline, must now be considered in their risk/return proposition. Reallocation from
these alternative investments will continue in 2009, just as the internet bubble
reallocation process took several years. With this redeployment will come great
opportunity. Billions will once again flow into another asset class and propel returns.
Currently, the safety of US Treasuries appears to be gathering most of these assets,
but the rising budget deficit and stimulus efforts should increase funding costs
of the US government, causing the attractiveness of these “safe” investments to
wane. Considering the attractive valuations of growth equities and strong balance
sheets, the sector should experience a renewed interest. It was also a victim of
hedge fund asset growth originally. At the end of the day, investing is a market
of relative opportunities and the risk/reward of growth stocks will become apparent
once the high levels of risk aversion abate.
Predicting the path of the stock market is always hazardous. Instead, we prefer
to prepare the portfolio to weather the current economic malaise and position it
for an market, which we believe, will inevitably recover. Given the depth of the
correction and significant steps taken by both the government and financial institutions,
it is prudent to prepare for a reversal of the current economic downturn. Whether
it comes early or late in 2009, or not until 2010, it is impossible to predict today
with certainty, especially since both bull and bear markets last longer than most
expect. But attractive valuations, pronounced pessimism, and tremendous world-wide
monetary intervention equate to a risk/reward proposition that is strongly skewed
to the long-term investor.
Finally, despite the difficult year for Wall Street and the average investor, history
is a valuable teacher. The stock market is well versed in financial crisis and not
only survives, but also tends to thrive. In the past twenty years, the market has
weathered the Savings & Loan Crisis, Latin American currency revaluations, a Russian-debt
default, the Asian contagion, the Long-Term Capital Management implosion, the WorldCom/Enron
accounting crisis of confidence, the internet-bubble burst, and now the sub-prime
debacle. This list is by no means all-inclusive or comprehensive, and it is likely
to expand with some event that derails the next bull market. We remain vigilant
for this market to emerge.
This material represents an assessment of the market environment at a specific point
in time and is not intended to be a forecast of future events, or a guarantee of
future results. This information should not be relied upon by the reader as research
or investment advice.