Bear market anniversary reflections

The current bear market will officially be a year old as of October 09, 2008.

As this chart demonstrates (click chart to enlarge for ease of reading), the Dow Jones Industrial Average reached its most recent peak on October 09, 2007 with a close at 14,164.53. Since that day, it has dropped 34.6%.

During that time, most of the economy actually remained healthy, with most companies (outside of housing and finance) continuing to grow their earnings.

Recently, the stubborn refusal by the SEC to amend or temporarily suspend mark-to-market regulations, combined with a stunning elimination of the independent investment banking industry at the hands of the Treasury and the Fed has caused not just a full-fledged bear market but also a financial panic -- something the country has not seen since the Great Depression.

In the 1979 article by Milton and Rose Friedman cited on this blog recently, the authors asked "But what do the terms 'run' and 'panic' and 'restriction of payments' really mean?" They then defined a "run" on a bank as "simply an attempt by many of its depositors simultaneously to 'withdraw' their deposits in cash" and noted that one bank alone could meet a run by borrowing from other banks -- unless there is a "panic" in which the run spreads beyond the ability of banks to co-ordinate the transfer of deposits to meet the simultaneous runs.

It is clear from the events of the past weeks that the current situation meets the definition given by the Friedmans of a financial panic. Therefore, the Fed's emergency rate cut this morning, in concert with other central banks, is an appropriate response given the circumstances.

At some point, the financial panic will stop, the bear market will end, and the upward move in the market likely will be violent and rapid, as it often has been after previous bear markets depicted in the chart above.

However, it is possible and even likely (as we noted in the post about the insightful Friedman article from 1979) that the fallout of this financial panic will result in exactly the wrong lessons and reactions, just as the fallout of the Great Depression resulted in exactly the wrong conclusions and reactions.

Because of this possible outcome, we are more convinced than ever that the idea of just blindly buying "the whole market" and "all will be well" is wrong. The events of this year have clearly shown that there are very big differences between companies in terms of their quality and their leadership, which can manifest themselves in very different outcomes. We have always believed that those who are able to run their companies and return value to their shareholders and customers will come out ahead. We have written about this issue several times in the past, such as here and here and here.

While a bear market is gut-wrenching, and a bear market combined with a financial panic even more so, it is helpful to keep in mind that the current market drop is in line with those of previous bear markets shown above. We continue to emphasize that ownership of well-run companies through market cycles as part of a disciplined investment process is the best course of action for long-term success, and that bear markets and even financial panics do not change that.


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