What the heck is going on out there!

credit-crisis

From a near record close on October 31st, the S&P 500 plunged 6.1% QTD, mostly in the last 24 hours.  Hardest hit are the financial service stocks, with notables such as Citigroup down 29.5% QTD, Merrill Lynch down 25.1%, Freddie Mac down 23.9% and two of our long time favorites AMBAC down 60.8% and MGIC Investment Corp down 42.2% QTD.

The declines are all related to the "credit crisis" which, to recap, started with junk mortgages issued to unqualified borrowers, which were then packaged into Mortgage Backed Securities, which were then sliced into Collateralized Debt Obligations (CDO's) which were then stamped with investment grade ratings and sold to hedge funds, who purchased them with borrowed money to capture the spread.  Every participant in this process made money right up until this summer, when investors discovered - Surprise! - that the underlying mortgages were no good. 

As this whole system unwinds, investors who have nothing to do with CDO's are none the less getting rocked by the more aggressive ones.  The analogy that we like employ in times like these is as follows:

An ocean liner has sunk and the survivors are in a lifeboat. .. Half of the passengers are sitting in their seats, pulling on the oars and bailing if necessary.  The other half are frightened by the waves and are frantically throwing themselves from port to starboard.  With each iteration, some water splashes in and occasionally a passenger falls out.  Over the horizon is land; if the passengers keep cool, they'll get to safety.

How does this apply to the stock market?  The US Stock Market, through crisis after crisis (World War's I and II, the Great Depression, the Kennedy Assassination, the 9/11 attacks) grew at an 8% annual rate from 1900 to the present, and 10%/year from 1945 to the present.  We reasonably project the stock market to average 8% annual gains for the indefinite future.  Our firm, and firms that run straightforward long only portfolios, separate accounts and mutual funds, are like the passengers pulling on the oars.  If we do our job buying reasonably priced stocks in companies we expect to grow at reasonable rates for at least 5 years on average, and if we spread our investments around by industry sector and stock market capitalization, we should be able to deliver those historic returns for our clients (and get to land.)