Client Letter – Q4 2008

Happy New Year!  Yes, you are still alive and breathing!  The year 2008 was the second worst ever for the U.S. stock market. Only in 1931 did the Standard & Poor’s 500 Index fall by more than 37 percent, turning in a worse showing than 2008. Our overall returns for the full year ranged from -10% to -42%, depending on the level of risk in your portfolio.  The average return (for a 50% equity / 50% bond portfolio) in 2008 was approximately -20%.  So, the market did go up a bit in December.  As you can see from the chart below, the worst performing asset classes in 2008 were the international and emerging markets stocks, but these same asset classes had the best 10-year returns.  The best performing asset classes in 2008 were short-term bonds.

The following chart shows the 1-year, 5-year, and 10-year performance of many DFA funds (representing different asset classes) compared to the S&P 500 Index:

Market Returns for the period ending December 31, 2008

 DFA Fund / Index 1 Year Return 5 Year Return* 10 Year Return*
S&P 500 Index-37.00-2.19-1.38
DFA U.S. Large Value-40.80-2.052.15
DFA U.S. Small Cap-36.01-1.994.84
DFA U.S. Small Cap Value-36.79-1.517.32
DFA Real Estate (REITs)-37.360.597.55
DFA Int’l Large-41.442.081.25
DFA Int’l Large Value-46.333.344.75
DFA International Small-43.873.417.03
DFA Int’l Small Value-41.685.079.52
DFA Emerging Markets-49.208.539.49
DFA 2-Year Global Bonds4.083.284.06
DFA 5-Year Global Bonds4.023.544.71

*Note: Returns for periods greater than 1 year are annualized.  Top 3 returns are in bold.

The loss of trillions of investors’ wealth has many running scared as the New Year begins. Adding to the fear is a year-old recession that appears to be deepening with increased unemployment and uncertainty about the timing of a turnaround. Now, however, investors face a new year: what are the possibilities for our portfolios?

Many investors may say they expect the market to continue to decline. In fact, that happened after 1931: in the next year, stocks fell an additional 8.2 percent. However, that is not the norm. Many of the best years in the stock market have come after miserable years. Two of the best came after the worst years. In 1933, the best year ever, stocks rose by 54 percent. Two years later, they gained another 48 percent. It is also notable that the second best year came at the height of a recession when stocks rose by nearly 53 percent in 1954. The same happened in the recession year of 1958, when stocks went up by 43 percent.

Roger Ibbotson, professor of finance at Yale, notes that the odds are always good for a positive year in stocks.  The market has gone up during 59 of the 83 years since 1926, or 71 percent of the time. Moving the time horizon out over five and ten years increases the odds of positive returns (for example, see the 10-year returns in the chart above). Although there is no way of knowing when the market will begin to rise again, Ibbotson urges investors not to wait to invest until things are clear. “Unless you have more knowledge than the market, the long run starts now,” he wrote in Wealth Manager magazine in December.

It is also instructive to look at the last severe recession and bear market to hit the United States. Back in 1973-1974, the market fell by 43 percent over 21 months. This was also the last time that the U.S. economy posted three consecutive quarters of negative growth in Gross Domestic Product, a measure of the growth or decline in all goods and services. The first decline in GDP occurred in the third quarter of 1974, well after the stock market had experienced most of its decline. The economy went on to contract for another two calendar quarters. However, an investment made in the S&P 500 Index during that first quarter of economic decline in 1974 would have returned almost 31 percent over the next year, notes U.S. Trust, a subsidiary of Bank of America. “The point is that markets bottomed well before the economy,” U.S. Trust says. “It goes without saying 2008 is quite different from 1974, but the concept of markets looking forward will apply at some point during this bear market.”

Many experts also note that the federal government has taken, and promises to take, significant action to shore up the economy and financial markets. During the last quarter of 2008 significant easing in interest rates, increase in money supply, and financial backing for financial institutions took place. The incoming Administration has pledged to spend significant sums to spur the economy.  Let’s hope that these measures have a positive impact in 2009.

I have included several important tax-related documents in this quarterly mailing. First, for clients with taxable losses or gains, I have provided a Realized Gains and Losses report, which shows the net proceeds and cost basis for taxable securities that were sold during 2009. Second, for clients who do not deduct our fees from an IRA account, I have provided a report that shows the investment fees you paid during 2009. Make sure that you give these reports to your accountant or tax preparer. I will also send a copy of these tax reports to your accountant, if you have authorized me to do so.

Chris signature

About Christopher Jones

Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.