The third quarter of 2011 was the worst quarter for investors since 2008. You are going to hear that scary phrase a lot, so brace yourself. This is one of those times when I would like to swoop in with all kinds of good news and prove that things are not as bad as they seem. There are silver linings: stock valuations are the best they have been in a generation. Corporate results have been strong and their stocks are selling at bargain-basement prices. This most probably will prove to have been a great time to be buying stocks when we look back a decade from now. It sure does not feel that way now, and most likely it won’t in the near future.
We have spoken frequently this year about the dichotomy between the bottom-up attractiveness of so many equity investments, and the top-down gloom of our geo-political situation and the overall economic malaise this situation has delivered. In third quarter it was the latter that dominated the stage, and as a result we have seen a rapid drop in equity values.
The headline-grabbing Dow Jones Industrial Average was down 11.49 percent while the often-quoted S&P 500 was down 13.87 percent. Unfortunately these popular benchmarks paint a rosy picture on what really happened: small-cap stocks were down 21.87 percent while German stocks were down 25.41 percent and Hong Kong saw a 28.99 percent drop.
All of this is most likely an overreaction to a global economic situation that is probably better than most believe. Unfortunately, this overreaction can become a self-fulfilling prophecy. The volatility of the market itself can cause pessimism, and pessimism can cause a recession. The odds of slipping back into recession have increased significantly; today I would give it a 50-50 probability. Three months ago I thought the odds were slim.
Even if the U.S. manages technically to avoid a recession, we are still back at one to two percent GDP growth, which may be a distinction without difference. To us at Iron Capital this means the odds of continued downturn are significant. Let me say it again: it is time to brace yourself. Now is the time to be honest about how much risk you are willing to take. For some of you third quarter alone has gotten you to that point, while for others it will take more pain. Now is the time to make those decisions, not after the recession is here and the market is down another 20 percent.
Investing is not complicated. It is no more complicated than losing weight. In the latter you simply have to eat less and exercise more, and in the former you simply have to buy undervalued securities and wait until their value is recognized. These are not complicated things to do, but they are among the most difficult challenges we all face.
We are here to help. We are doing what we can to protect in the short-term while remaining focused on the long-term. Today that means we are bracing ourselves.
Chuck Osborne, CFA
Managing Director
