Ostriches and Stock Markets

Posted on March 10, 2009 by David Laidlaw 

Ostriches do not actually stick their heads in the sand to avoid danger. The Roman naturalist, Pliny, wrote that the birds believed they were concealed when they buried their heads in the bushes to hide even though their bodies were visible. Interestingly, the ostrich does eat sand to better chew its food and will also flop down to try to camouflage itself when it is not able to outrun a predator.

We do not advocate that anyone ignore the brutal realities taking place daily in the financial markets, but we do caution against selling common stocks at these levels. The rapidity of the current market and economic decline as indicated by such statistics as rising unemployment induces typical fight or flight responses in many investors. Rapid losses of wealth trigger fears that common stocks will become completely worthless and also can lead individuals to expect worst-case scenario outcomes in other aspects of their lives.

Sentiment and financial news are so negative now that the markets could definitely go lower. Last week’s 8.1% unemployment statistic is the highest number since the 1982 recession. There is a remote possibility that our financial system could malfunction to a degree that no financial assets had any value and that we reverted to earlier systems of barter and hard assets or systems where physical power dictated social standing. However, we do not believe this outcome is probable.

Many companies in the portfolios that we created experienced lower levels of earnings during the past year. However, 2008 earnings were only 12% lower on average than earnings achieved during 2007 before the recession began. The common stocks in the accounts under our management include viable businesses whose assets are significantly greater than their liabilities. The vast majority of the holdings also have low debt levels compared to their assets and operating earnings and should not face a liquidity crunch even under these stressed conditions.

Another item which suggests that stocks will rally at some point is the amount of money that is held in money market funds at brokerage firms and investment companies. The Investment Company Institute tracks the total amount of assets held in money market funds which serve as cash equivalents. The latest weekly report indicated that as of March 5th 2009, $3.906 trillion was held in money market funds. This amount is a historic high. At the beginning of 2008, before the bear market began, this figure stood at $3.159 trillion or fully 20% lower than now. The current figure is also almost four times greater than the $1 trillion that was held in money funds in 1997 when the stock market averages last touched the current levels.

At some point, the funds which are now in money market accounts will return to the stock market and stock prices will rebound from these depressed levels. Other investment alternatives may absorb some of these flows, but we believe that these alternatives such as real estate, Treasury Notes and gold are not anywhere near as attractive as common stocks. Flows from cash holdings to common stock investments will most likely occur over a long period of time given the severity of recent market losses. Investors will most likely reallocate assets to stocks with caution, but eventually stocks should rise from their current depressed levels.