The Perfect Storm

Article written for Paragon's 4th Quarter 2008 Newsletter
by Dave Young, president

photo by smile my day

2008 delivered the perfect storm to create one of the most difficult markets in modern history.

A severe credit crisis, overseen by inept incoming and outgoing politicians, coupled with the media that constantly emphasizes the worst possible scenario combined to push the S&P 500 to its worst performance since 1931.

It didn't matter whether an investor was invested in stocks, corporate bonds, real estate, municipal bonds, energy, commodities or currencies. They all suffered significant losses in 2008. The 38.5% decline in the S&P 500 put the index below the level it was at 10 years ago.

The meltdown wasn't confined to the U.S. Around the world, 26 of the 32 countries we track recorded their worst losses in history. Likewise, 16 of the 18 global sectors we track also recorded their worst losses ever.

To put this in perspective, consider the following:

--Warren Buffet, considered an icon of wise investing, lost almost half of the market value of his portfolio between the middle of September and the middle of November.

--Bill Miller, one of the only managers to beat the S&P 500 for 15 consecutive calendar years through 2006, was down almost 60 percent year to date through December 3rd.

--Dan Fuss of Loomis Sayles is a renowned bond manager. Bonds are traditionally very conservative and are used to stabilize portfolios. His highly regarded bond fund was down an incredible 28 percent through December 5th. He described this market as a "once in a 50-year" buying opportunity.

--Icon Funds, a value-based mutual fund manager, put a report in December stating that stocks are 60 percent undervalued.

How did we do?

Considering the S&P 500 lost -38.5%, the average U.S. diversified stock fund lost -40%, the NASDAQ lost -41% and the average international stock fund lost -46%, we did relatively well last year. Managed Income, our conservative portfolio, outperformed most bond portfolios except those that are made up of treasuries. Top Flight, our growth portfolio, beat the S&P 500 extending its record of outperformance to eight of the last 11 years.

From an absolute perspective, we didn't perform as well as we would have liked. Even though we beat most benchmarks we still saw our accounts decline in 2008. Both Managed Income and Top Flight suffered their largest declines since their inceptions in 1998 and 2001.

In my 20 years of investing, last year's market meltdown was one of the most difficult I have ever encountered. We weren't able to control downside risk as effectively as we have previously. There were several reasons that we were negatively impacted.

One way we reduce risk is to continuously adjust our equity exposure. When valuations are high we reduce equity exposuree and add cash. When valuations are low we reduce cash and increase equity exposure. As you can see by reviewing our track record, this has historically reduced our downside risk and increased our returns.

The fact that the markets have never reached excessive valuations prior to the 2008 decline made this bear market very difficult to avoid. For example, in the 1987 and 2000 bear markets many market sectors were overvalued which triggered our models to raise cash before those declines occurred. In 2007, with the S&P up only 5.5% on the year, the markets were at fair value. They weren't overvalued by historical standards. As a result there was no reason for us to move to cash like we normally do.

Another way we reduce risk is to move into sectors of the market which usually perform well during declines. This bear market was brutal because most of the safe havens we moved into for protection, like utilities, health care and bonds got beaten up just like the rest of the market. Unlike previous declines, this time moving into conservative sectors provided very little cushion.

There was nowhere to hide in 2008 for investors.

To be continued...