Disaster Foreseen

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With 20/20 hindsight we know that July and October 2007 marked a rough double top for common stocks with the Dow Jones Industrials just over the 14,000 level in both months. With perfect foresight that would have been a brilliant period in which to lighten equity allocations. All major stock market indexes fell by more than 50% over the subsequent year and a half, so any significant reduction in equity exposure in 2007 saved investors huge amounts of money.

The stock market reached that 2007 peak after rallying for four full years without so much as a single 10% decline. Investor sentiment had skyrocketed to dangerously euphoric heights. Our quarterly commentaries written in April, July and October of 2007 issued warnings that, if heeded, led prudent readers to reduce their common stock exposures. Portfolios under our management reflected that caution and were appropriately light on equities as we went into the worst market decline since the Great Depression. The performance of our Controlled-Risk Flexible Allocation portfolios (most of our clients) proved the success of that approach. (Click here to review.)

Let’s review several of the comments and forecasts that we made in those crucial commentaries.

In April 2007 with the Dow near 13,000 and still ascending to its peak, we indicated the potential for a continuation of the rally by pointing out that “… positive momentum had been reestablished … and that … momentum … dictates the short-term path of least resistance.”

At the same time, we made it clear that we did not share the enthusiasm of investors who were aggressively bullish: “Our reticence is based on an evaluation of the potential stock market rewards at this point relative to the risks that would have to be assumed to obtain those rewards.”

We concluded our April 2007 commentary as follows: “We urge the investor to be cautious. The speculator can take his/her chances, but we would suggest an eye be kept on the exits. We anticipate at least one more major stock price decline, possibly from higher levels, before the long weak cycle that began in 2000 eventually concludes. Remember, too, that aggressive equity allocations from here will prove more profitable than risk-free income only if the stock positions are sold before such a major decline or if the markets never again get back down to today’s levels. We believe both scenarios to be unlikely.”

About 1000 Dow points higher, we wrote in our July 2007 commentary: “[U]nique conditions … provide a framework for potentially explosive stock market moves … in the months and quarters ahead. Current conditions should force all investors to examine carefully their personal appetites for speculation.”

We went further and highlighted some potential specific causes of future economic and market difficulties: “A compounding of the problems in real estate or increased concern with the ability of hedge funds to repay their loans could … restrict the availability of loans. Just as the expansion of liquidity contributed to rising asset prices, a restriction of that supply could depress prices.”

Eleven weeks before the October market peak we accurately forecasted that: “… a broader catastrophic unwinding of leverage in a debt default environment could lead to the greatest loss of asset value in world history.” We continued: “This is not a ‘normal market’ question like: Will I make 15% this year if things go right, or could I lose 5% if things go wrong? It is rather a question of whether you could make explosive returns if, in fact, we have entered a new era in which central bankers can provide massive liquidity with no negative consequence. Off-setting such a prospect, if things go very wrong, is the specter of a violent unwinding of unprecedented debt levels with huge, unpredictable financial consequences. Because of the massive intricate chains of derivatives that wrap around the world, which regulators admit they can neither quantify nor get their arms around, a major financial accident could produce its consequences overnight.”

Countering the common belief in the “buy and hold for the long run” approach, we concluded: “Because of the giant levels of debt and leverage in the system, allocations that have historically been considered prudent for investors may in fact today involve far greater levels of speculation than ever before.”

These thoughts were offered long before the collapse of stock prices, the demise of Bear Stearns and Lehman Brothers and the emergency rescue of the financial system by our Fed and Treasury and the other central banks of the world.

We wrote our third quarter of 2007 commentary just days after the October stock market peak which preceded the horrific decline that persisted into the first quarter of this year. We concluded that commentary as follows: “If the uncertain outcomes to the housing decline and/or the credit crisis should lead to a change in investor attitudes, a resulting stock market decline could be magnified greatly by unprecedented levels of leverage.” That is, in fact, exactly what happened.

We invite our readers to review these commentaries in their entirety. Toward that end we are archiving all prior commentaries on this site. We are working our way from most recent to older documents, developing an index as we go. Those interested in researching our thinking over the long term will find that we have anticipated the unfolding economic and market stories with considerable accuracy. While past performance does not necessarily foretell future success, we continue to apply historically sound principles in our evaluation of evolving economic and securities market conditions. We hope that it will result in continuing strong portfolio performance results for Mission and Marathon clients.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.