The Death of Equities?

As you know, stock prices have plummeted in recent days after a series of cataclysmic shocks to the global financial system. As of October 10, 2008, the S&P 500 was down 42% from its highs one year ago. International and emerging market stocks have fared even worse, down 46% and 53%, respectively, from their highs last October.

The stock market is a relatively efficient system for gathering information from a myriad of sources. As new and unpredictable information becomes available, it is quickly reflected in equity prices. Until recently, there was hope that the mortgage crisis could be contained while keeping the rest of the economy on track. It now appears likely that we are headed into a global recession and the expectations of this recession are only now being priced into the market.

People invest in the stock market because it has historically provided a higher rate of return than the essentially risk-free return offered by U.S. Treasury bills. Since 1927, the average annual return of U.S. stocks has been about 10% compared to 4% for one-month Treasury bills. The difference in these two returns is referred to as the equity risk premium. As shown in the table below, the risk premium has varied greatly over different time periods.

The equity risk premium was essentially non-existent from 1965 to 1981. In the latter stages of this period, inflation was rampant and there was widespread pessimism about the stock market. In 1979, BusinessWeek ran a cover story entitled "The Death of Equities." The article stated that stocks were no longer an attractive asset class and that "the death of equities looks like an almost permanent condition."

However, this would have been a bad time to get out of stocks. From 1982 to 1999, the S&P 500 had an average annual gain of 18.5%. Unfortunately, returns like this can't last forever. Since January 2000, the S&P 500 has had a negative return. Once again, pessimism is pervasive. Although I cannot predict when the market will turn around, stock prices get more attractive with every drop in the Dow. Most of the publicly-traded companies that comprise the major stock market indexes are profitable, stable businesses. At some point, stocks will rebound and once again deliver a positive equity risk premium for disciplined investors with a long-term view.

I can understand the pain you are no doubt feeling as a result of your portfolio losses. I appreciate the confidence you have expressed in Shearwater Capital and assure you that we will continue to provide the best advice we can during this challenging time.

As always, please feel free to contact me if you have any questions or comments.

Jeffrey J. Brown, MD CFA
Principal, Shearwater Capital

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