Fourth Quarter 2010 Letter to Clients

If you stop the average American on the street these days and ask him or her how the stock market performed in 2010, we suspect the response would be somewhere between “fair” and “poor.” After all, to look at the dispatches from the media during the course of the year, it was hard to draw any conclusion other than that 2010 was a downright dismal year for stocks.

The year began on a down note, with the Dow Jones Industrial Average dropping more than 3% in January, spawning a flurry of news reports that the so-called “January Indicator” was predicting a down year for the market. In short order, events seemed to conspire to bring that prediction to fruition. In the spring, a sovereign debt crisis in Greece began to spread across the Eurozone, tanking the Euro currency and threatening to engulf Europe’s larger economies in a wave of downgrades and defaults. May brought the so-called “flash crash” that saw the Dow plunge, and rebound, nearly 1,000 points in just a matter of minutes. This was followed by another big selloff in the market in late June as sovereign debt fears escalated.

By August, the market was underwater for the year and was heading into the dreaded September/October gauntlet – a time period, the media reminded us, that has seen some of the worst selloffs in market history. Right on cue, an obscure technical indicator ominously dubbed “The Hindenburg Omen” gained the media’s attention, supposedly indicating a big market plunge was coming. Economic reports, meanwhile, began to show a slowing of growth, and the Fed decided to pump even more money into the system by purchasing $600 billion worth of treasuries. Accordingly, the news cycle became obsessed with the possibility of a “double-dip recession.”

Yes, looking back on the news, it would be hard for you to draw any conclusion other than that 2010 was a terrible year for stocks.

And you would be wrong.

This past year, in fact, was a banner year for stocks. Consider the following index performance for 2010:

S&P 500 (large cap)


Russell 2000 (small cap)


DJ U.S. REIT (real estate stocks)


MSCI EAFE Small (intl. small stock)


As we noted above, however, these gaudy returns were hardly obvious ahead of time. Through August, it looked as though it would be a down year for stocks, with both the S&P 500 (blue line in chart that follows) and the Russell 2000 (gold line) in the red after a tumultuous eight months in the market:

Then, just when the media was doing its best to focus the attention of investors on The Hindenburg Omen and double-dip recessions, stocks took off and never looked back:
In other words, right when we least expected it – and right when the news cycle was obsessed with the catastrophe du jour – large cap stocks gained 20% in only four months’ time, and small stocks soared 30%.

Stock returns are sneaky like that. It’s only in retrospect that you realize a major upward move has occurred, usually when no one saw it coming. How many prognosticators do you recall making such bullish predictions during the market turmoil in August? None that we recollect.

Every year brings a fresh set of potential perils and pitfalls for stocks. Those problems may impact stocks for weeks, months, or – in the case of most of the 2000s – even years. But stocks do recover, and when they do, they recover with a vengeance. This is this story of 2010 and, in the larger sense, is the long-running story of the stock market itself.

* * * * *

The staggering budget deficits and government debt that the world’s developed nations have been piling up in recent years – especially since the financial crisis of 2008 – has raised anxiety levels for equity investors around the world.

That anxiety is rooted in the notion that, if governments are forced to adopt austerity measures to reign in the red ink – curbing spending, raising taxes, and hiking interest rates – then economic growth will be stymied and equity returns will suffer as a result.

But is it really true that low economic growth leads to lower equity returns? As counter-intuitive as it seems, there really is no historical evidence that a low economic growth environment leads to low equity returns. In fact, a recent study by Dimensional Fund Advisors found just the opposite to be true.

The study took a look at the 32 nations that comprise the developed world in the MSCI universe, dividing them into two categories: “low growth GDP” and “high growth GDP.” The study then looked at the average annual equity return for both groups from 1971-2008, as seen below. In what may be a surprise to many investors, the study found that stocks in low GDP growth countries actually outperformed the stocks of high GDP growth countries:

While it would seem that economic growth is the ultimate driver of a company’s stock price, the reality is that risk has far more influence on stock price, because where market participants perceive higher risk, they will demand higher returns. The same holds true for countries. As the DFA study noted:

Risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market. Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns.

In other words, a period of low economic growth for a country does not automatically doom that country’s stocks to anemic performance. To the contrary, the market will demand a higher risk premium for investing in lower growth countries.

Of course, there is the other end of the spectrum as well. As investors, we don’t want to pile our assets only into the riskiest corners of the world because there is something to be said for economic and political stability. One might have earned a higher return for investing in, say, Venezuelan oil stocks than American oil stocks through much of the 1990s and 2000s, right up to the day in 2006 when Hugo Chavez nationalized the Venezuelan oil industry.

This is where diversification comes in. We want to spread our assets around the globe in a strategic manner, such that we are capturing the return of the capital markets without taking on the risk of being too concentrated in any particular stock, sector or country.

The larger point to all of this is that a budgetary crisis does not necessarily spell doom for stocks. While we do not diminish the reality that this country’s ballooning deficit and national debt are serious threats to its economic well being and must be dealt with in the years ahead, investors should be wary of adapting their investment strategy to try to account for these concerns. History shows that, more often than not, such attempts will be wrong and will only serve to diminish returns.