Lessons of past downturns

Unsettling as the current recession and market correction have been, these are not the first bleak times experienced by most of today’s investors—nor are they likely to be the last. Lord Abbett Insights talked to five veterans of previous downturns to obtain perspective on today’s markets and highlight the special challenges and opportunities that may be found in the current environment.

Robert S. Dow
Senior Partner, Chairman of the Board of the Lord Abbett Mutual Funds

During his 37 years in the investment industry, Dow has witnessed multiple economic recessions and expansions, along with their accompanying bear and bull markets. His reflections on the 1973–74 bear market—until now, the worst downturn since the Great Depression—were included in a recent Wall Street Journal article that featured a gallery of fund managers who vividly remember the two-year period that was punctuated by soaring oil prices, runaway inflation, and war. The Dow Jones Industrial Average lost 45% of its value at the time.

Dow said the current downturn doesn’t feel as bad as it was during 1973–74, when he was an analyst and money manager. Then, the equity markets staged a prolonged, steady decline over two years. That contrasts to the current bear market, which has experienced periodic rallies that give investors reasons to be optimistic.

Another notable difference then was that most investors and fund assets were heavily concentrated in stocks, with minimal exposure to fixed income to potentially buffer the fall. Since that time, Lord Abbett has enhanced its fund menu to include a broad range of fixed-income funds to serve risk-averse investors who want an alternative to stocks. Today, investors are encouraged to be more diversified between and within equities and fixed income, and now have many more funds from which to choose.

But, said Dow, “extreme volatility can create extreme opportunities.” And, he believes, the current environment is rife with opportunity. Stocks and bonds are selling at historically low prices, and there are opportunities to pick up high-quality issues at extremely low levels. In some cases, high-yield bonds are selling at prices that are so low that even if they default, they likely will repay more than they cost to buy. Managers of equity funds are seeing the stocks of quality companies trading at valuation levels not seen in years, enabling managers to add these companies to their portfolios without having to pay a premium.

Milton Ezrati
Partner and Senior Economist and Market Strategist

This recession is different from others in the post–World War II period, according to Ezrati. While the other ten downturns since the 1940s began with contractions in the business sector, the current one has its roots in the over-indebtedness of the consumer, particularly with relation to the housing market. “Real estate often has played a role in previous downturns, but in the past, the consequences were largely felt in the business sector. Today, our business sector is in relatively good shape, at least outside of the financial and auto industries,’’ Ezrati said.

The origins of a recession can make a significant difference in the length and depth of a contraction, he noted. When recessions stem from over-extension in the business sector, companies typically cut back drastically. This makes for a sharp contraction and a similarly rapid 'V-shaped' recovery.

Most consumers, on the other hand, cannot reduce their spending as dramatically. Therefore, consumer-led recessions, historically, tend to be milder but longer, with a so-called 'U-shaped' recovery. “This particular recession is an anomaly, in that consumers have cut back somewhat more sharply than expected, which would suggest a roaring V-shaped recovery, accompanied by a big jump in the stock market, but that is not happening,” Ezrati said. Instead, mixed consumer-related data so far in 2009 suggest that a slow 'U-shaped' recovery may be occurring.

As of April 2009, the US recession was in its seventeenth month, making it the longest contraction of the post-war period. (The National Bureau of Economic Research considers the 22-month, double-dip recession of 1980–82 as two distinct downturns.) “We could actually see positive numbers much sooner than people expect,” Ezrati continued, “but they likely will be disappointing compared to past recoveries, which were largely driven by a rapid pickup in business.”

This recession also is atypical, according to Ezrati, in that productivity has jumped. Normally, productivity falls during a contraction, as sales decline faster than payrolls. But productivity rose in the fourth quarter of 2008, as businesses panicked and quickly laid off workers. That, combined with a moderate return to spending by consumers and a stabilising of the housing market by mid-2009, could mean the US economy might return to positive growth before the end of the year.

Zane Brown
Partner and Fixed Income Strategist

“We’ve invested through a number of slowdowns in the past,” said Brown. But the current downturn, he noted, is distinct in two ways: the severity of it and the destruction of investor confidence. “Those two things really have distinguished this slowdown from all others—at least in this generation and probably since the Great Depression,” he said. “Everything has been more acute and accelerated this time compared to previous downturns.”

That’s because this time investors found their most reliable and conservative investments, including their homes, impaired. In the ensuing crisis, investors abandoned everything but Treasuries and agency debt. At one point, 90-day Treasury bills actually offered a negative yield and investors were relieved just to get most of their money back.

The flight to quality pushed down prices of asset-backed securities, mortgage-backed securities, corporate debt, and loans—all perceived to carry higher risk. In previous downturns, these types of investment-grade securities did relatively well, but not this time. Consequently, yield spreads over Treasuries reached record levels across the spectrum of non-Treasury and agency securities. A similar disparity in spreads occurred in the high-yield markets in 2002 and in 1992, when defaults started to increase and spreads widened out dramatically. Each period was followed by strong performance in the high-yield market, as the bonds returned to more reasonable spreads and prices appreciated. (Of course, the market may not perform in a similar manner in the future.)

“We’re starting to see that unfold now,” Brown said. High-yield spreads relative to Treasuries have started to narrow somewhat, although they still remain wider than they were in the last two economic slowdowns. “We are likely to continue to see spread compression and relative price appreciation in the high-yield sector over the next several years.

Brown said that, gradually, reason is starting to return to fixed-income markets as the plethora of government programmes to support the credit markets is beginning to have an effect. Just as the downturn has been more severe than most, the amount of government effort and money being applied to returning these credit markets to normalcy also is unprecedented.

“We’re nowhere near normalcy yet, but we’re at least headed in that direction. And therein lies potential opportunity,” Brown said. “Even if we don’t get positive economic growth until early 2010, you’re likely to see improvement in the credit markets first before you see improvements in the economy. That’s why I think fixed income is on its way to better times.”

Robert Fetch
Partner and Director of Domestic Equity Portfolio Management

For Robert Fetch, the recent market environment underscores the potential opportunities. He recalled one of Warren Buffett’s sayings: “Be fearful when others are greedy and greedy when others are fearful.” After working through prior recessions, Fetch knew that worsening economic conditions could result in sharply lower equity prices—especially during severe economic contractions when investors are increasingly anxious. “I never forgot Buffett’s lesson of opportunity in times of reversal,” he said. “In fact, I think the recent market environment creates an attractive risk/reward potential, suggesting an unusual opportunity to assemble a diversified portfolio of high-quality companies without having to pay a premium.”

In the early stages of the equity market’s decline, Fetch advocated a defensive posture by selling stocks that had performed well in the first half of 2008, including those in the energy, metals, and agricultural sectors. As oil prices declined, that earlier positioning created an investment opportunity in select oil service and exploration companies. Meanwhile, economically sensitive stocks also recently have presented attractive valuations, including those in the transportation, restaurant, and retail sectors.

Despite the sharp retrenchment in consumer spending, one result of the recession may be a consumer who relies more on savings rather than credit to pay for goods and services. “Recessions typically are times when consumers strengthen their finances,” said Fetch. “They will eventually have the savings to make significant purchases, and that likely will help restart the cycle of economic expansion.”

Although the economy eventually will emerge from its slump, periods of market volatility—and the need for thorough analysis of risk—undoubtedly will remain. “We cannot dictate the magnitude or the time frame on which our investments will be rewarded,” Fetch explained. “But we can put capital in a position potentially to be rewarded, which is why it is so important to always evaluate risk in an effort to preserve as much capital as possible.”

Harold E. Sharon
Partner and Director of International Equity Investments

More than any other economic downturn Sharon has witnessed, this one is remarkable, he noted, for the extent to which governments around the world have resorted to heavy doses of monetary and fiscal stimulus, to essentially prime the pump for fixed investment and the return of the consumer.

After analysing the scope and effectiveness of these programmes, Sharon has trimmed his portfolio allocations to defensive sectors and increased his allocation to cyclical holdings. “Regional economic growth continues to favour those areas that have structurally higher economic growth and which entered the current recession with stronger corporate balance sheets and relatively low levels of consumer debt,” he said. “In general, this has favoured many Asian and Latin American countries at the expense of European Union and Eastern European countries.”

According to Sharon, it’s important to learn about and focus on the bigger enduring trends in the world—to position oneself in front of them—and stick with them. Even a sharp slowdown of world economic growth likely will not impede enduring investment trends that are based, for example, on large-scale and inevitable demographic shifts.

With that in mind, Sharon believes that this is the first time in a long while that investors can buy, at attractive valuations, world-class companies with healthy profit margins, balance sheets, and solid, if not growing, market positions. In some cases, share prices of such companies have fallen 50% or more over the past 12 months. “If a company passes our rigorous fundamental analysis and its investment merits are consistent with our current strategies, then we will look to add it to our portfolios,” Sharon said.

Sharon said another investment angle that is very important when looking at overseas markets is that many international companies pay out a greater portion of their earnings in the form of cash dividends than those in the United States. According to FactSet, as of March 31, 2009, 262 international companies with market caps greater than $2 billion offered dividend yields of more than 6%, versus only 59 such companies in the United States. (Of course, dividends are not guaranteed and may be increased, decreased, or suspended altogether by the issuing company.) Consequently, said Sharon, investors currently are being paid to wait until the enduring trends reestablish themselves.Once they do, the latent performance potential that Sharon sees in equities could be rewarding.

Note: Neither asset allocation nor diversification can guarantee a profit or protect against loss in declining markets.

US Treasuries are debt securities issued by the US government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

Additional risks: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

The opinions in this publication are subject to change, may not reflect the views of the firm as a whole, and should not be relied upon by the reader as legal, tax, or investment advice. Information discussed should not be considered a recommendation to purchase or sell securities. Readers should not assume that the securities depicted were or will be profitable. Consult a financial adviser on the strategy best for you based on your individual goals, investing time horizon, and risk tolerance.

Investing implies risk, including the possible loss of principal. A prospectus contains important information about a fund, including its investment objectives, risks, charges, and ongoing expenses, which an investor should carefully consider before investing. To obtain a prospectus on any Lord Abbett fund, visit us at www.lordabbett.com. Read the prospectus carefully before investing.