Market Commentary for the week of March 16, 2009

Now that Bernie Madoff has been incarcerated, do you feel more safe about investing?

As Citigroup rises 30% in price-per-share (from one dollar), are you ready to declare the “bull market is back?”

As the market bounces off of a thirteen year low, are you ready to commit to its turnaround?

I ask these questions to try and highlight the difference between events-driven investing and macro investing. Without equivocation, we are happy about the current events turnaround. But “happiness” and “current events” are no substitute for fundamentals and a large aperture perspective. Besides, if it’s bounces you like, we’ve already had three of them since last summer, all to no avail.

This time, it’s real.
There is no doubt, however, about the pain and devaluation having been inflicted by the bear market which began in 2007. In that short period of time more than 50% of market capitalization has been eroded. The aggregate gains in the global equities markets during the past decade have evaporated. Pension and private savings have been permanently injured. The question today, in spite of the current events, is “how much more severe can the damage be?”

The destructive nature of this bear, and the economic crisis that parallels, is a peculiar blend of swift inequity along with quantitative rebalancing. It was simply impossible to build perpetual capital gains upon a foundation of exorbitant leverage and unrealistic expectations. Anyone in their thirties has now seen this happen twice in their lifetime, the first being the tech-wreck a decade ago.

We know from historical perspective that the average return in stocks over time exceeds the average return on most other investments. We should know, too, that the type of volatility we are currently experiencing is part of those historical averages. It should come as no surprise that asset allocation is the easiest way to mitigate that volatility while still participating in the potential for historically nominal capital gains.

No one, certainly not I, begrudge the speculators who acknowledge the incumbent risks of equity investing. On the other hand, we have little sympathy for leveraged enthusiasts who play with other people’s expectations, and do so quite poorly.

It’s also an opportunity.
To be fair, as the market and economy decline, there are signs of a potential turnaround. Savings rates are growing, globally, although not yet matched by an appetite for investing. The flip side to every bear is a bull. That is why depressed valuations, and a level playing field, might create the next opportunity for growth. The breadth and magnitude of the global decline recalibrates all financial instruments to an equilibrium we haven’t seen in decades.

But anxiety is stronger than fundamentals. I caution against anointing short cycle upswings as being more powerful than the secular bear phase in which they exist. As earnings momentum dissipates, so too does the fundamental underpinning of momentum-driven capital gains.

“Why didn’t we see this coming,” I am often asked. Because fear and anxiety are not pre-indicators of a market decline, they are lagging indicators. As long as the markets performed, no one complained. Readers of my essays know that I harangued at great length and for several years about the “quantitative unsustainability of equity price increases.” That is why I rebalanced asset allocation two years ago away from risk. But, alas, the fall was all consuming. Bonds, stocks….even money market funds became suspiciously vulnerable.

Although it could take awhile before the economy turns around, it will turn around. The gift of this crisis is that the next generation should not be seduced by the same possibilities. Will we ever learn?