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October 8,
2001
Dear Clients
and Friends:
Market
Review
As we said
in our September 11th letter, a "significant" shock to
financial asset prices could be expected. When the markets reopened,
sure enough, they moved down about 14% in the first week of trading.
We also noted in the same letter a "rebound will follow,"
and sure enough in the second week the market recovered half of
the loss of the first week and continued to rebound in the third
week. This market action in September illustrates vividly rule #1
of successful investing - never let your emotions (fear and greed)
drive your investment decisions. People panic and sell at the worst
possible time. The predictable corollary, of course, is that they
wait for the markets to recover before they feel secure enough to
reinvest. Thus, they make that all too common and financially devastating
mistake of selling low and buying high.
The
Investment Environment
Prior to September
11th, we characterized the investment environment as follows:
- The economy
was in recession or near recession.
- Corporate
earnings were extremely weak and were probably headed somewhat
lower.
- Technology
and telecom fundamentals had fallen off a cliff.
- Stock prices
were in a fair-value range - neither cheap nor expensive.
While we had
no opinion in the outlook for stocks over the short-term, we believed
that returns over the following 12 months would be decent-to-good
with a return range of 10% to 20%. We believed this because:
- Over that
time period we expect the economy to begin to recover. The longest
recession during the past 50 years was 16 months.
- With a recovery
beginning, earnings comparisons in 2002 would be strong compared
to depressed 2001 levels.
- The stock
market is forward looking and has, in the past, almost always
rebounded three to nine months before the end of each recession.
- Stocks were
already almost down 30%. In the past, declines of this magnitude
have provided an excellent entry point for long-term investors.
- Although
we believed returns would be decent-to-good over the next year,
because stocks were only fairly valued (and not cheap), we thought
longer-term returns would be okay but not great. We continued
to believe that on a three-year basis double-digit returns were
not in the cards for stocks.
What has changed
as of the tragic event of September 11th?
- First, over
the near-term the economic slump will almost certainly be more
severe than it would have been. Business activity slowed dramatically
for a few days and the aftermath is likely to impact consumer
spending, business spending and capital investment. Corporate
earnings will be hurt over the short term.
- Monetary
and fiscal policy is likely to be significantly more supportive
than it otherwise would be. The political landscape has changed
dramatically so that, in the near-term, concern about depleting
the surplus will take a back seat to supporting the economy. It
is likely that we will see significantly higher government spending
that will help support the economy.
- For the
vast majority of publicly traded companies, we don't believe Tuesday
changed their long-term business prospects. Clearly the short-term
has changed, but it is the long-term business prospects that drive
long-term business values. If the tech bubble taught investors
one thing over the past 18 months it is that stock prices ultimately
are driven by long-term business values. Greed and fear impact
prices over the short-term, but these emotions are not sustainable.
- Stock prices
are down sharply around the world. At the very least, we believe
global stock values now suggest very acceptable intermediate (three-year)
returns relative to inflation.
Conclusions
- The Most Important Things To Understand Now
- The economy
will recover. There will be layoffs, consumers will spend less
and companies will invest more cautiously. However, this is how
economic cycles always end and new cycles start. Just as recessions
are ultimately the result of over-expansion (excessive optimism
relative to business opportunities), recoveries occur because
businesses hunker down too much in bad times. Ultimately this
causes businesses to begin expanding again to meet demand. And,
when consumers slow down their spending this ultimately leads
to pent-up demand. We've had wars, assassinations, political upheaval,
energy crises, financial crisis, terrorist acts, the break-up
of a military super-power and double-digit inflation. This event
may be different, but the global economy has, in the end, always
proven resilient. We're confident it will again rebound.
- The market
is unpredictable over the short-term. We've learned to respect
that. It often does the opposite of what people think. Though
it is hard to imagine a rally now, it is not out of the question.
First, cash on the sidelines is at a 20-year high. This suggests
that a lot of investors have already hunkered down and that some
of this money will make it back into the market eventually. Investor
pessimism is extremely high and this is a good contrary indicator
because when investors are extremely pessimistic they have usually
already done most of their selling. We don't expect a rally but
the point is that we don't know what will happen over the short-term
so it makes sense to base decisions on longer-term factors we
can confidently assess.
- The financial
markets are forward looking. That's why stocks are always a good
buy in a recession. Experienced, smart investors know that the
best time to buy is when there is maximum pessimism because that
is when stocks are on sale, and when pessimism is at "a maximum",
things can only get better. That is a nice saying but the reality
is that we can't precisely identify the point of maximum pessimism.
Still, it's our opinion that things don't have to go too far south
from here to be at an extremely pessimistic point.
- Emotionally,
the feelings of devastation remain, and will for awhile. But these
feelings will not last forever. In the meantime, while they remain,
as investors we must force ourselves to remove the emotional overlay
when making decisions.
- Believe
it or not, there is good news to note. Interest rates are low,
inflation is low, and corporations are highly productive, innovative
and lean. Finally, an unusually united and motivated Congress
is rushing in with billions of liquidity to help the economy.
As always,
please feel free to call us anytime. In the meantime, take a few
moments and glance at Ibbotson's chart of 75 years of historical
capital market returns of various asset classes. The graph illustrates
the hypothetical growth of inflation and a $1 investment in four
traditional asset classes over the last 75 years, through thick
and thin times.
Very truly
yours,
ZRC Financial
Services, LLC
A Registered Investment Advisor
By: 
Richard P.
Clarke
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