"Apparently there is nothing that cannot happen today."

—Mark Twain

It's difficult to find words to describe the pure bloodbath witnessed in stocks over the past few days, past few months, past year. Since November 4 alone, the S&P 500 is down over 25%; it has lost roughly 49% on a year-to-date basis, and is 52% below its October '07 closing high. Although tired of hearing the word "unprecedented," the large-cap index is on pace for its worst calendar year return for any period studied since 1928.

In our view the driving force of this decline is uncertainty and fear. There are many questions, but not many clear answers. It is unclear how long and how deep any recession will be or how many jobs could be lost. It is unclear when the credit markets will begin functioning more normally or housing will bottom. It remains unclear what the impact of the government's numerous programs enacted over the past few months will be or the ultimate fate of the big three automakers. Moreover, there remain questions about when the selling, including that by hedge funds, will subside.

Recently, we had the opportunity to hear a savvy hedge fund manager's perspective of the current market environment. He believed there were a number of "ridiculously" cheap priced stocks; though he also said investors' mentality reminded him of 70s. In his view, many investors believed stocks were attractively valued back then, but they were afraid they would be cheaper "tomorrow." We will term this Stock Deflation. Deflation is a persistent decrease in the general level of prices of goods and services. So even if something appears like a bargain today, the thought is why buy today if a better deal may be had tomorrow.

Yet, eventually investors usually recognize value—but the timing is uncertain. The same hedge fund manager gave the example of Warren Buffett who was buying Washington Post stock during another brutal market in the early 70s. Around the time of his purchase, the stock market placed an $80 million value for the company, when many others on the Street, including Mr. Buffett believed its collection of media assets were worth closer to $400 million. Part of the reason others didn't buy was the thought the price of the stock, like most things in the market, could become cheaper tomorrow; so there was essentially a buyers strike (much like today). And in fact the stock did go down quite a bit more after Buffett's initial purchase. Yet, even though he didn't get instant gratification, Berkshire's original $10 million investment from 1974 had grown to $205 million in 1985, for an annual return of 32%, according to Roger Lowenstein.

Coming into this year, we clearly underestimated the severity of issues facing the economy. Yet over the past few months we have repeatedly mentioned that we believe "time" would be a key element to a longer-term market recovery: The two most recent mega bear markets (‘73/'74 & ‘00/'02) lasted 21 and 31 months, respectively, versus the current bear market of just 13 months.

However, even in the worst bear markets, there are typically strong shorter-term rallies. Indeed, October 10 had many signs of a panic low. On that day, we saw over 75% of the issues on the NYSE make new 52-week lows; there was record trading volume; extremely oversold conditions; and a reversal in price action that resulted in an all too brief rally. Then last week, it appeared stocks had successfully retested the lows, and we thought odds favored at least a short-term rally (though we still believed time would be a key element in a longer-term recovery). Yet, with the lows breached this week, that near-term thesis was proven wrong.

So the question to ponder now is where from here. The reality is no one knows for sure. Figure 1 displays a graph that depicts investors' emotions throughout a market cycle. During periods when investors are most exuberant is typically one of the worst times to invest for the long-term, since expectations become unrealistically high and stocks are generally priced for perfection. Conversely, when the outlook is the bleakest, stocks are often valued in a way that any incremental good news can have a major positive impact. The issue is one never knows exactly what part of the cycle we are in, and to be honest, there were a number of times earlier this year that it would have been difficult to imagine a greater level of pessimism. At a minimum, we believe that investors are well beyond the desperation phase and potentially closer to the despondency stage. What we could be seeing is that the last move down tends to be the sharpest: 44% of a bear market's loss, on average, occurs in the last 25% of the cycle, according to a study from Birinyi Associates.

1 | 2 | 3 | 4 |