Newsletter March 2011

Dear Reader,

On 21 December 2010, the S&P 500 closed above the 1,254 point level, the first time the benchmark index managed to get back to the level it had reached before the investment bank Lehman Brothers collapsed in September 2008. The market far happily continued its recovery towards the end of February 2011 when it reached the 1,319.88 point level.

 

The financial crisis, however, did not start with the Lehman Brothers bankruptcy. The S&P had reached its highest point one year earlier, on 10 September 2007 (at 1,565) before setting in its decline since then, with a few ups and downs in between. Around 3.5 years after it reached its summit, the market has still not fully recovered. This should not be surprising. When the market reached its previous high on March 27, 2000 (at 1,523), it took more than 7 years to get back to that level again.

 

Equities have performed dreadfully over the last decades, especially in comparison with safer asset classes such as bonds and cash. We need to go back 20 years in order to have equities perform better than bonds, and even more years for the outperformance to compensate for the risks assumed by equity investors.

Unfortunately, this comparison does not tell the whole story. Indeed, when companies in an index go bankrupt or cause non-repairable losses (such as corporate fraud), they are usually replaced with other companies entering the index (a "clean up" of the index). Those replacement companies may contribute to future index gains while investors are left with the losses. Stock market indices therefore do not fully reflect the real return realized on a portfolio of individual stocks, even if the portfolio replicates the index.

 

It would be interesting to perform an analysis of the real return realized on a broad market index, taking into account the full effect of fraud, bankruptcy or other non-recoverable losses. It is likely to paint an even more negative picture for the real returns realized by investors on equities over the last two decades.

The real story is of course even more complex. After the stock market correction of 2001-2003, financial institutions heavily promoted complex structured products that would offer a better risk/return ratio than equities. Those who invested with Madoff were not chasing high speculative returns, but were attracted by the steady returns and low risk profile generated by the (fictitious) strategy. The same goes for the many investors (including institutional investors) who purchased CDO's, or the hundreds of thousands of retail investors who bought structured products issued by Lehman Brothers.

Fraud, bankruptcy and corporate wrongdoing are non-negligible factors on real stock market returns. Sadly enough, when investors stayed away from stock markets after the 2001-2003 correction, they were lured into flawed structured products that caused losses on an even more massive scale.

The lesson of all this may be that abundant money always finds its way, if not in real profitable investments, then in the hands of fraudsters who promise better or safer returns. QE2 may help the economy to recover, and hopefully it will last, but let's hope it does not lead to another wave of losses in some product or asset categories.

Erik Bomans
Partner

 

 

 

 

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