Market Commentary - 19/12/2008
Nowhere to hide?
Many will look back on 2008 as the financial systems “annus horribilus”. Indeed at times the entire financial system as we know it has been close to a systemic failure (economists and financial analysts refer to ‘systemic’ risk as the risk of a collapse of the whole financial system). Nobel Laureate in economics, Dr. A. Michael Spence, described the story of 2008 succinctly when he wrote:"Systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current [2008] crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."*
Spence alludes to an important point here, namely, that there has largely been no hiding place from the asset destruction this year. With the exception of cash and some government bonds, all other major asset classes have experienced a fall in capital value, coupled with heightened price volatility.
It is interesting to note that one of the current preoccupations of some in the investment world is an increasing need to look for precedence for where we are and where we’re going to end up. No doubt, it’s one of the peculiarities of a bear market that we seek ever longer historical timelines to justify a particular argument. In recent months I’ve seen numerous tables and graphs showing the performance of equities over 25, 50 or 100 years. For example, one table, using research from Yale University, illustrates the discrete yearly performance of the US stock market going back to 1825.
Now these are all very interesting, not least because they help us gain a sense of perspective – albeit an all too familiar sense that each consecutive generation is perfectly happy to make the same mistake as their forbearers. I have seen that there are similarities between the Panic of 1873, for example, and the current financial crisis. The news media seems intent on likening today’s predicament to the 1970’s or the Great Depression.
Ultimately all these analogies focus on the negative comparisons, but there is very little attention paid to any positives. Consider the Black Death, for example (I appreciate that this was a very long time ago indeed). Terrible though the Black Death was for those living in 14th century Europe, for the survivors, particularly the peasantry the aftermath presented unique opportunity for betterment, as they could demand higher wages and take a greater role in medieval society. And here’s the comparison: although we’ve seen some significant casualties in the business world, and are very likely to see more, the opportunity this creates for surviving companies is significant. Good businesses with strong balance sheets may find that they are able to increase market share during the coming year, providing investors with an opportunity to buy these companies shares at attractive valuations today.
Of course 2009 will probably see unemployment rise; and one should not forget that for many of those who lose their jobs, this will be the first recession of their working lives. We can expect further falls in house prices and the deterioration of sterling. There is no way to avoid the consequences of borrowing too much in the good years; and individuals and businesses will have to adjust.
As investors, however, we have to look forward and that is what stock markets do – they make predictions about the future earnings of companies and price their stock today accordingly. We do believe, therefore, that investing in equities is important for most of our clients; and we also believe that inflation, which has disappeared for now will come back with a vengeance in 2010 as the huge glut of liquidity that has been pumped into the financial system by government begins to take effect.
The case for being diversified still stands. While there has been little hiding place from the financial crisis, the old adage of ‘not having all of your eggs in one basket’ has undoubtedly spared diversified investors the worst and most extreme of capital losses. The importance of focusing on fundamentals during 2009 will become more evident, in our opinion. If investors time horizons are right then the coming year is going to present some great investment opportunities; and while putting out to sea in the middle of a storm might seem foolhardy, there will be longer term advantages to being one of the first boats out on the water.
*Source: PIMCO, November 2008
