Hard Times: Q & A on Perspectives and Possibilities

By Ernie Ankrim, Chief Investment Strategist
Russell Investments
Global Leaders in Multi-Manager Investing

November 21, 2008

These are hard, painful times. Most Americans have never experienced this big a shock to our economy and the markets. As you can imagine, I'm constantly being asked some important questions. Investors pose some. The media brings up many others. (Thank you, John Spence, a very fine writer at Marketwatch.com, for your excellent questions.) So I'd like to address several of the questions I find most meaningful. The answers, I trust, will provide both historical perspective and a glimpse at what may lie ahead in the next year.

Are We in for a Depression?
Actually, there's no technical description for a "depression." The National Bureau of Economic Research (NBER) is the arbiter of the official declaration of a recession. The committee that makes the official call explains:

"A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough."

Since the "depression" of the 1930's, the U.S. has suffered 12 different recessions. The longest lasting of these were the 16-month recessions of 1973-75 and 1981-82. What earns the '30's experience the tag "depression" was its length: 43 months. I don't expect we will again experience a contraction that will be as dramatic (e.g., unemployment rates reaching 25%) or that lasts that long.

As to the recession we're in, I believe it started between December 2007 and March 2008. The NBER traditionally tells us when recessions begin and end between eight and 24 months after the fact. As I write, they have yet to tell us when the recession began. I expect—with serious possibilities of forecast error that it will end sometime in the second half of 2009. If I'm right, the recession will have lasted between 17 and 21 months, making this the longest recession since the '30's.

Have We Ever Seen a Market Plunge as Dramatic as This Past October's?
The term "dramatic plunge," like "depression," has no technical description. But we can consider documented downturns in equity values and how long they lasted. Using the top and bottom index values and the dates on which they occurred allows us to look at five of these covering the past forty years. 

Major Periods of Equity Declines Since 1968 (S&P 500)

Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Note that sharp downturns vary. The one in October 1987 lasted only 14 days during which the S&P 500 dropped 31.5%. The bursting of the Tech Bubble in 2000 produced a market downturn of 768 days and a drop in the S&P of 47.4%.

I believe that the current market downturn may strike investors as even more painful than previous experiences because market returns over the last five years haven't topped 15%. Contrast this with the returns before the 2000 selloff which followed the returns of 1994-99 when the smallest yearly returns were 21%.

As I write, our period of equity depreciation has reached 408 days. Will it match 1968-70 or 1973-74 for duration? Only time will tell. Given its magnitude, it certainly belongs in the company of the most painful declines in 70 years.

How Does the Plummet of the Financial Sector Compare with that of Technology Stocks Almost a Decade Ago?
Financials have fallen from the premier position they held. But their decline isn't nearly as great.

Tech/Financial Weighting Changes to Russell 1000® Index

Should Investors Now be More Focused on Dividends?
Returns deriving from dividend yields have been substantially higher in preceding decades. What's more, we had price appreciation. Today, some current dividend yields are astonishingly high. Representing a major inversion of roles, S&P dividend yields are now above government bond yields.

Dividend Comparison by Decade
Compound annualized returns to S&P 500 

*Doesn't add because of compounding effects

But a major caveat: Current dividend yields are based on current prices and trailing dividends. Proceeding through the recessions, it is reasonable to assume that dividends for many firms may be reduced or suspended. Thus, the current yield is likely higher than the yield that will be received by investors.

What Do You Make of all This Volatility, Even Within Sessions?
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by the S&P stock index option prices. And the VIX is way up! This past November 20, the VIX closed at 80.86. That's almost at the all-time high (intraday) of 83.49 set this past October 24.

Historically (going back to 1990), the VIX averages about 19. In the past, the VIX went over 45 on only three days. This past September, the VIX went over 45 once—then every day since October 12 with an average of 63.36.

This volatility reflects rampant fear. It also tells us that drawing near—term conclusions about which way the market is heading—and what to do—is riskier than ever.

How are Active Managers Faring?
Even the best active managers have found no place to hide. No asset class is enjoying substantial returns—even in the modest single digits. The bond market is flat, too. We had a rally in Treasuries, but you can't make a lot of money under these conditions. Across the board, we're looking at the most uniformly bad investment experience of my nearly 40 years of adult life.

When Will the Economy and the Markets Hit Bottom?
Let's clarify something here. The economy and the financial markets don't operate in unison. As I wrote recently in Timing the Economy: A Very Dangerous Game, the market anticipates the economy and generally goes up, or heads down, months in advance of the economy. What's more, it's pretty much impossible to time either of these.

This being said, the next three to four months should continue to bring a barrage of disappointing news, including higher unemployment and lower earnings. I wouldn't be surprised to see more firms closing stores or seeking bankruptcy protection.

Now, let me briefly return to my first point. Historical data tells us that the financial markets start improving well before the economy hits bottom. When will the economy turn around? I don't know. But I can state that history shows waiting for evidence that the economy is turning will put you behind the market turn.

So What Should Investors Do?
Many people have lost a great deal of wealth. If they need income now, they may have lost the option to hold risky equities or investments without further distress. I don't chide anyone for getting sufficient cash together for the next one or two years. You have to live.

People with a longer horizon—at least three years—will do best to consider retaining some exposure to the market. I remember the period of January 1973 through September 1973 when the markets went south by 47%. My father-in-law swore off equities for the rest of his life. He kept to it and lost out on a lot of potential returns over the years.

Getting overly conservative—and most investors are doing so—is risky. This is especially true when the yields to the safest assets are close to zero, while the dramatic explosion in injected liquidity may well bring us inflation concerns after we're through this recession. Protection against inflation almost always requires taking more risk (like in stocks or riskier bonds) than the most conservative investments.

Real buying opportunities are found when everyone else is selling. There are also opportunities outside of the riskiest assets; investment-grade bonds are on sale, as well. I have no doubt that present conditions offer great buying opportunities, although only the most iron-willed investor would stroll calmly into equities.

If you're a long-term investor, hold as much risk as you can tolerate, recognizing that the current volatility may make a slight reduction in risk appropriate. No doubt, the going will be very tough in the short-term. But for those of us with many tomorrows ahead of us, joining the crowd as it runs for the exits might end up compounding the pain of this ordeal. 

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

The information, analysis, and opinions expressed herein are for general information only. Nothing contained in these materials is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

The Russell 1000® Index: Measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.

The S&P 500 Index: An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

The CBOE Volatility Index®: a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It was introduced in 1993.

Copyright© Russell Investments 2008. All rights reserved.

First used: November 2008

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