On March 5th we sent our clients a “special edition” portfolio update. Typically, we will send a portfolio update once per quarter along with performance reports. However, in the face of an extraordinarily difficult market environment we wanted to share our most current thinking about the overall environment and our positioning. Here are some excerpts:
- We understand that the powerlessness of watching the value of your wealth decline creates a strong desire to “do something” about it – to take control and end the pain. Going to cash may lock in losses, but at least it creates a certainty amidst a great deal of fear and uncertainty. These are the conflicting forces that every investor faces right now: the certainty of locking in a set (albeit painfully lower) level of wealth, versus the uncertainty of possibly more near-term losses and the hope of better longer-term returns.
- It is also important to understand that there is a great deal of economic uncertainty and that could take a further toll on stocks in the near term. It also makes it more difficult to forecast the longer-term value of stocks. What we can do about this is make assumptions that are so negative that we believe we have a good margin of error on the downside, and a high degree of confidence at least in the lowest end of our longer-term forecasted return ranges. We have done this work, which includes an intense focus on identifying the most negative scenarios we or other experts we talk to can envision, and factoring those into our analysis. So while we are never confident in what the shorter term will bring, we are confident that our scenarios fully take into account the possibility of a lengthy and extremely poor economic environment (where the earnings decline is comparable to the Great Depression). Based on that analysis, the stock market can still earn good returns from current levels over a five-year time horizon. However, capturing these positive returns will require maintaining that longer-term focus through what may continue to be a very trying period.
- It may seem impossible to imagine a market rally from here. It can happen, and it will at some point. By definition, investors are most pessimistic at a market bottom. There is a huge amount of cash on the sidelines, which is good. When everyone is hugely pessimistic there are few investors left to sell. Then, as bargain hunters start to step in, a powerful rally can develop. Our expectation is that we could see several rallies and declines before we move on to another bull market. We are confident in our longer-term expectations, but as we have been saying for several months now, we are prepared for a very rocky ride.
- So while we are confident that from current levels stocks offer good longer-term return potential, we don’t know what might happen in the shorter term. This uncertainty creates a dilemma that is very important to understand. Stocks could drop further, perhaps substantially, or they could rebound sharply. If we try to predict this and invest accordingly, we have to consider the consequences of being wrong. If we go to cash the market could rebound sharply before we can get back in. It is possible we could see a rally of 20%-30% before concrete signs of sustained economic improvement begin to show up. This is because the market is forward-looking and nearly always reaches a bottom well before the economy reaches a bottom. If that happens, we could see a material portion of the good multi-year return potential that we believe exists realized in a short time. At that point we’d need to decide whether the market’s turn was going to be sustained, and get back in, or continue to wait and risk losing further upside. If we did get back in, we could be whipsawed if the upswing proved to be temporary, as commonly happens during severe bear markets.
- On the other hand, if we remain invested, our analysis gives us confidence we will earn a good return over our five-year investment time horizon, independent of what the short term brings. We also know that we will continue to see tactical opportunities amidst the near-term weakness, and that our active managers [in our mutual fund portfolios] will have opportunities to add value by buying stocks that have been oversold due to fear rather than fundamentals. Longer time horizons have the highest value when short-term fear is greatest, because that is when the greatest opportunities are created, but those are also the times when a long time horizon is the most difficult to sustain.
- Like you, we find this environment literally gut wrenching. Our response, we believe, has been to raise our game to a level consistent with the challenges we face. We are focused, thinking clearly, and obsessively analyzing data and information every day to make sure we understand the risk and opportunities as fully as possible. We believe that if we continue to stay intellectually honest, work extraordinarily hard to make deeply informed and rational rather than emotional investment decisions, over the longer term that work will pay off in the form of good returns on your behalf.
