Have you adjusted your portfolios accordingly ?

n a near perfect storm for equity investors, in the first quarter of 2008, the housing market collapsed, commodity prices soared, the credit markets seized up and liquidity disappeared. As a result, no matter how you spin it or how hard you try to sugar coat it, every major equity market indices got clocked (technical term), with the returns of many indices downright ugly. While learned market scholars can debate whether or not we are technically in a bear market (i.e. the S&P 500 has not had a 20% market drop) or if the US economy is either in, or about to, experience a recession (i.e. two down quarters of GDP), one thing is certain about the first quarter for investors: it stunk. There truly was no place for an equity investor to hide in the first quarter.

Don’t let anyone try to fool you. It wasn’t just the collapsing financial sector (-13.31%) causing market averages to drop, for technology stocks (-15.95%) actually put in the weakest performance for the period. Furthermore, in uncertain times, investors usually run to the safety of healthcare issues and the utility industry; this time around hiding in these sectors would have caused you losses of 11.65% and 9.77% respectively. Another defensive strategy is to invest in the biggest companies based upon the premise that they are safer: that plan coughed up poor returns for investors in large-cap growth (-10.18) and large-cap value stocks (-8.72) as well! Some of the widely-held individual stocks which contributed to the equity market’s shellacking: Sprint Nextel (-49.0%) stumbled on too much debt and too few customers; Countrywide Financial (-38.5%) and Washington Mutual (-24.3%) appear in competition as to who will have the biggest write-off due to loose lending standards, Apple (-27.6%) put in a rare rotten showing, while Intel (-20.6%) and Microsoft (-20.3%) just didn’t click for investors.

So what caused the rout? Well, unless you’ve just awoken from a six-month slumber or been beamed up from another galaxy far, far away, we’ll give you the Cliffs’ Notes version: the economy slowed, nervousness increased, the Fed cut rates to try to save the economy, but killed the dollar in the process, creating fear in the credit markets, causing liquidity to dry up, pricing for all fixed income securities other than US Treasures to falter, and the collapse of some highly–leveraged hedge funds. These problems created worries about the health of the US financial system, which led to ‘a run on the bank’ at Bear Sterns, whose stock lost almost all of its value in less than a week only to be ‘saved’ by J.P. Morgan, under the direction of our own Fed. There are longer, more detailed and flowery explanations possible, but you get the picture. Still, it seems better than saying “there was a credit crunch,” which would be too laconic an explanation for all the troubles and travails of the quarter.

We have warned in previous comments that business conditions were deteriorating, that there were plenty of excesses related to the housing bubble and collateral damage was likely to spread to other parts of the economy. We have been surprised, however, with how fast the slowdown occurred and the extent to which fear gripped the markets. In our opinion, the changing of the rules for shorting stocks (which previously could only occur on up ticks) added fuel to the fire and increased downside volatility. The good news is that the short-sellers who mercilessly tried to push stocks down to zero will someday have to buy back those shares.

If the market could catch a good wave to the upside, the resultant rally might knock your socks off (technical metaphor). Think about it for a spell; everyone knows the economy has slowed and the banking system almost melted down in March. Those investors worried about the front page headlines prophesizing gloom and doom have sold their stocks and are sitting on record high cash reserves (mostly in money markets) where they are earning less than 2% on their money. Hedge funds are deleveraging and getting conservative in an effort to protect principal and prepare for redemptions. Meanwhile, investors and portfolio managers who got caught taking too many chances in the past six months have finally gotten themselves protected for disaster. It is always like this at market bottoms.

For once, let’s look at the bright side. On a valuation basis, stocks are at the most attractive level relative to bonds in decades, insiders continue to buy oodles (technical term) of stocks (up 35% from a year ago and 49% from two years ago), the Federal Reserve is as accommodative as it’s been since the Depression (giving investment banks access to the discount window) and the Administration is pulling out all the stops to stimulate spending. On April 2nd, Treasury Secretary Henry Paulson even went so far as to indicate the Bush administration is willing to consider congressional plans to stem foreclosures by expanding government guarantees for mortgages (Bloomberg News). Already there is talk brewing in Congress for increased spending on our nation’s infrastructure, which could become a component of a new economic stimulus bill later this year (The Wall Street Journal – March 11, 2008).

Sure, there are risks investing in equities, but everyone knows that now and has adjusted their portfolios accordingly. Well, not everyone. Have we ever pointed out how badly the average equity investor does in relation to the S&P 500? It is scary, but it has been proven time and time again; investors who let emotions drive their investment decisions always seem to buy high and sell low.