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October 14, 2008
Through September, the market downturn was rather orderly. There
were a lot of losers this year, but there were some winners too.
However, since the first of October there has been a run on the
stock market that rivals what we saw in 1987. The difference
between then and now is that in 1987 the market fell 22% in a
day and in 2008 this has taken place over several weeks. Everything
is going down at the moment except the value of government securities.
Domestic and international stocks, small stocks and large stocks,
value stocks and growth stocks, high-quality corporate bonds
and high-yield bonds are all declining in price.
Why is the market going down so fast? Quite simply, investors
have lost confidence in the financial markets. With the stock
market down almost 40% from a year ago, there is only one stock
in the Dow (Wal-Mart) that is higher than it was a year ago.
Is American business really worth 40% less than it was worth
a year ago? The answer is no. A year ago stocks were reasonably
priced; not too high and not dirt cheap. The most unusual part
of this decline is that unlike the large breaks in the market
during the past 40 years (1973-74, 1987, and 2000-2002); it was
not preceded by a sharp run-up in stock prices that stretched
valuations. Most stocks were not overpriced before this downturn.
A decline like we have seen in October is driven by fear of the
unknown and has little to do with the fundamentals of business.
Yes, there are some industries that have severe problems. Banking
and Wall Street are in disarray. However, many businesses are
doing fine and their stock prices have declined also. Some very
big names have disappeared for all practical purposes. We are
witnessing what happens when panic selling occurs while leverage
is being taken out of the system. Too many people are trying
to squeeze through a very narrow door.
It’s easy to read the press or look at monthly brokerage
statements and be discouraged. However, just as the much higher
prices of recent years have not proven to be permanent, the much
lower prices of today should not be viewed as permanent. What
will make stocks go up again? Eventually, investors need more
return than is offered in the safe haven of treasury issues.
The only reason to own a treasury security today is for safety.
A six-month treasury bill yields less than 1%. While investors
may be willing to accept low yields for a short period of time,
few people can live on 1%. When markets begin to settle down,
investors will leave the safe havens and return to areas offering
the possibility of higher returns. An important indication that
stocks are cheap is a pickup in transaction activity. We find
it interesting that Wells Fargo and Citigroup bid fiercely for
Wachovia, a bank that just a few weeks ago was viewed by many
as toxic. Warren Buffett has invested $8 billion in preferred
stocks (of General Electric and Goldman Sachs) in recent weeks.
At some point prices get so low and reasonable even the scared
money that is on the sidelines is compelled to re-enter the market.
That day cannot come soon enough for anyone. We should add that
valuations for many companies are cheaper than they have been
since the 1980s.
What you get for your money today is extraordinary in many cases.
This does not seem to matter at the moment, but it will matter.
Cheap prices will attract buyers.
Most of the readers of this letter are well aware of the downturn
in stock prices, but some may be surprised that the credit markets
may be in even worse shape than the stock market. Several weeks
ago, the commercial paper market stopped functioning. Commercial
paper is used by businesses to fund short-term needs and is 1.6
trillion dollars in size. Money market funds own about 40% of
these assets. A run on money market funds triggered massive sales
of commercial paper because money market funds had to raise cash
to meet redemptions. A combination of everyone selling and no
one buying coupled with losses on commercial paper from bankrupt
companies such as Lehman Bros. caused some money market funds
to “break the buck”. It has long been sacred for
investors that a dollar invested in a money market fund means
a dollar out, plus a little bit of interest. When some funds
were unable to meet this unwritten commitment, chaos ensued.
The government’s announcement that they will be intervening
in the commercial paper market should go a long way towards returning
this market to normal. The government has also enacted an insurance
program for money market funds. Investors should be aware that
there are limitations on this insurance. Money market funds that
invest in commercial paper have always been a concern of ours.
Most of our accounts use government money market funds. These
have a lower yield than non-government funds, but the buck should
never be broken.
We have touched briefly on a few of the major
issues in this letter (and violated our rule of trying to keep
these reports
to one page!). Clearly, anytime stock prices fall so sharply,
there is reason for concern. We know many of our clients are
nervous. While we don’t have all the answers (particularly
to the question of “When exactly will this end?”)
we are here to talk with you. Part of the reason you have entrusted
Lafayette with your assets is that when you have questions, someone
is on the other end of the phone to provide answers. We welcome
the opportunity to discuss whatever may be of concern to you.
Don’t hesitate to give us a ring.
Mark Hughes Larry
Judge Rob
Noyes Ric
Ordway
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