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10.11.2002 2002 Third Quarter Client Letter
October 11, 2002
We are in the midst of the “Perfect Storm”. There is no where to run and no place to hide. Both U.S. and International equities including small and large cap, value and growth have all been battered.
On October 9, the S&P500 was down 32%. This is a two sigma deviation event; a rare event that occurs less than 5% of the time. The historical annualized return of the S&P500 is 10.7% with a standard deviation of 20.2%. This means with one standard deviation or one sigma, 68% of the time the S&P500 annual return will be within 10.7% plus or minus 20.2% (upper limit: 10.7%+20.2% = 30.9%) and (lower limit: 10.7%-20.2% = -9.5%). Likewise, two standard deviations or two sigma means 95% of the time, the S&P500 annual return will be within 10.7% plus or minus 20.2% times 2 (upper limit: 10.7%+ {20.2%x2} = 51.1% and (lower limit: 10.7% - {20.2%x2} = –29.8%). Interpreted differently, the S&P500 will be down more than -29.8% or be up greater than 51.1% only 5% of the time.
Since 1926, the S&P500 has surpassed the 2-Standard Deviation bands four times, twice on the upside and twice on the downside (1931: -43.3%, 1933: +54.0%, 1937: -35.0%, and 1954: +52.6%). Today, with the S&P500 down 32%, we surpassed the lower 2-Standard Deviation band of -29.8%. If the S&P500 finished 2002 down more than -29.8%, then this would be the fifth time the S&P500 has been outside the 2nd Standard Deviation bands in seventy-seven years or 6.5% of the years.
Is the economy collapsing? No. The economy continues to grow. The following table illustrates the S&P500 annual return and Gross Domestic Product (GDP) growth during the three of the last four 2-Standard Deviation events and currently. In 1931 and 1937, the S&P500 declined more than the 2nd Standard Deviation band. Negative economic growth occurred during these time periods.
| Year |
S&P500 Return |
GDP Growth |
Year |
S&P500 Return |
GDP Growth |
| 1930 |
-24.9% |
-8.6% |
1937 |
-35.0% |
5.3% |
| 1931 |
-43.3% |
-6.4% |
1938 |
31.1% |
-3.5% |
| 1932 |
-8.2% |
-13.0% |
. |
. |
. |
| 1933 |
54.0% |
-1.4% |
. |
. |
. |
| 1934 |
-1.4% |
10.8% |
2000 |
-9.1% |
3.8% |
| 1935 |
47.7% |
9.0% |
2001 |
-11.9% |
0.3% |
| 1936 |
33.9% |
12.9% |
2002 |
-32.0% |
2.2% |
Through June 2002, the economy has grown 2.2%. The problem lies with the lack of corporate earnings growth to match the optimistic corporate earnings expectations. Security prices are based on the present value of future earnings. If these earnings don’t meet the high expectations, then security prices will decline.
Are Certificates of Deposit or Bonds the asset to own?
Now is the time an investor may rather be in CDs or other stable returning investments. You might say this is the time to sit the rest of the bear market out. If you think future returns of CDs will be higher than equities, then you must agree CDs are riskier than equities. Why? You can’t have higher returns with less risk. Markets do not work that way. Unless the economic system is collapsing, equities will outperform fixed income over time.
The U.S. Government 30-year bonds are now yielding 3.8%. This means that owning U.S. Government bonds at this time would result in an annualized return of 3.8% over the next 30 years. The historical annualized return for these bonds is 5.3%. If these same 30-year government bonds would deviate back to their historical annualized return by going down in price, the decline would be -21.5%. During these difficult times when U.S. Government Bonds are the safe haven, they pose tremendous risk if interest rates increase.
There are two fundamental principles of successful investing: Diversification and Discipline. Capital markets are miraculous at changing individual investor’s emotions enough to cause them to abandon discipline. The investor that manages their emotions and maintains discipline will prevail.
If you would like to discuss your goals and expectations and your specific investment strategy in more detail, please don’t hesitate to call.
Thank you for your continued trust and support,
Trevor K. Holsinger, CFP
President
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