The fourth quarter of last year was a monumentally difficult period for stocks as we commented in our October client letter. Hedge fund liquidations, plus the cumulative effect of the many negative events which occurred during the course of the year (see enclosed exhibit), resulted in a “capitulation” selling of stocks.
The election results provided a potential directional change in governmental policies and new leadership at the Treasury. This should be a positive, given the disappointing leadership from Secretary Paulson. In our last letter we focused on the opportunities created by the decline in bond prices as a result of the “credit freeze.” Happily, both municipal and corporate bonds improved significantly in December and have continued to do so in January. This rally also benefited stocks to some degree because it reduced the competition from higher yielding alternatives, which can divert money from equity investments.
The stock market indices recovered approximately 20% from their low levels in November, although they subsequently gave up some ground. Clearly the environment is quite confusing for investors with a tremendous number of cross currents affecting the outlook for equities. It is a given that the economic news, as well as earnings announcements, over the next several weeks will be extremely weak However, with the thawing of credit markets and the government’s monetary and fiscal stimulus working through the system, the economic news will get better as the year progresses. If we merely encounter a protracted recession, rather than the doomsday scenario of a depression that many of our stocks are pricing in, our portfolios should do well going forward. Many stocks are even selling as though bankruptcy is a foregone conclusion. (One quarter of all listed stocks are trading below $10 per share.) We truly consider this to be a tremendous opportunity for capable stock pickers. As an example, one of our stocks, Mentor (MNT), was just taken over by Johnson & Johnson (JNJ) at a 95% premium to price the day before the offer. Finally, with $3 trillion invested in money market funds, this is the most cash we have seen on the sidelines in over 18 years. Just as we have been incrementally adding to bond positions in our balanced accounts, we are now doing the same with stocks in our equity and balanced accounts.