The Crash of 2008

The seeds of the current financial debacle were sown during the booming real estate market earlier this decade. With housing prices moving ever higher, mortgage lenders gave loans to anyone who asked for them. These loans were sold to other financial institutions and bundled into derivatives called collateralized debt obligations (CDOs). Many of these CDOs carried AAA ratings, yet offered higher interest rates than other securities with similar ratings. In search of higher yields, banks and other firms stocked up on CDOs, often with borrowed money. It all unraveled when the real estate market turned down exposing the tenuous quality of the underlying mortgages. Many companies, including household names like Bear Stearns, Lehman Brothers, Merrill Lynch and AIG, have disappeared or had their charters fundamentally changed. Surviving financial firms have stopped lending, precipitating the worst global economic crisis since the Great Depression.

While these events are reasonably well understood, it is less clear how we should respond. Our approach to investing is based on the classical theory of finance, which holds that markets are fairly efficient and investors can expect to be rewarded over time for taking on market risk. This theory generally does a pretty good job of explaining how markets work. However, in extreme circumstances, investors act in irrational ways leading to market bubbles and subsequent crashes. According to Andrew Lo, a financial economist at MIT, "financial crises may be an unavoidable aspect of modern capitalism, a consequence of the interactions between hard-wired human behavior and the unfettered ability to innovate, compete, and evolve." If this is true, how should we respond? And should our investment approach be modified?

We construct our client portfolios primarily with the DFA family of funds. These funds provide passive exposure to broadly diversified baskets of domestic and international stocks or bonds. Each DFA fund is designed to capture the returns of a specific asset class, unlike conventional index funds which merely replicate market indexes. Although not actively managed, these portfolios are tilted toward small cap and value stocks which have historically outperformed the market averages. We also advocate substantial exposure to international equities reflecting the growing importance of these assets in the global economy. This contributed to gut-wrenching losses in 2008, as international stocks fell 46% in dollar terms, and emerging markets dropped 55%.

We avoid active investment strategies that have not been shown to consistently add value in rigorous analyses. Active fund managers, who attempt to beat the market averages via stock selection and/or market timing, have not fared well in the recent downturn. For example, each of the following well-known stock funds trailed the S&P 500, which fell 38.5% in 2008: Legg Mason Value Trust (down 55.1%); Dodge & Cox Stock Fund (down 43.3%); and Longleaf Partners Fund (down 50.6%).

How about market timing? There is some evidence in the academic literature that short-term market predictions can be made at a slightly better rate than pure chance due to momentum effects, but there is no evidence that anyone can consistently forecast the market in a way that benefits investors. In any given year, a market timer has about a 50% chance of guessing correctly whether the market will go up or down. However, market timers are as likely to miss good years as they are to avoid bad years, and over time, their returns usually lag a simple buy-and-hold strategy.

In the end, we remain strong believers in our approach. Over long time periods, DFA funds have delivered on their promise. For example, the DFA Small Cap Value Fund has gained an average of 9.9% per year since its inception in 1993, compared with a 7.8% annual return for the Russell 2000 index. Historically, periods of economic stress have often presaged higher returns. Stocks are more attractively priced now than they were a year ago. The dividend yield on the S&P 500 is 3.5%, higher than the yield on 30-year U.S. Treasury bonds for the first time in 50 years. However, there remains substantial risk in the equity markets. We are in the midst of a global recession and the future impact of government intervention in the markets is uncertain. We expect market volatility to remain high in 2009. We also expect that long-term investors will be rewarded for their patience and discipline.

As always, please feel free to contact me with any questions or comments.

Jeffrey J. Brown, MD CFA
Principal, Shearwater Capital