America’s Tarnished Credit Rating

“In the short-term the stock market is a voting machine, while in the long-term it is a weighing machine.” – Benjamin Graham.

On Friday evening, the Standard & Poor’s debt rating agency  downgraded all U.S. government debt with more than a year of maturity, from the top AAA rating down to AA+.  To put that in perspective, now only 17 countries enjoy the AAA rating on their government bonds.  Typically, that means that they are considered the safest havens for cash, and therefore are able to pay the lowest interests rates on their borrowing. 

Here’s the list, and I’ve included the current yields on each country’s 10-year government bonds in parentheses.  This lets you see what the top-rated countries pay on their debt, compared with the 2.5% interest the U.S.  government has to pay on its 10-year U.S. Treasuries: 

France (3.41%), Germany (2.83%), Canada (2.93%), Australia (5.75%), Finland (3.19%), Norway (3.29%), Sweden (2.82%), Denmark (3.06%), Austria (3.30%), Switzerland (1.53%), Luxembourg (NA), Guernsey (NA), Hong Kong (2.29%), the Isle of Man (NA), Liechtenstein (NA), the Netherlands (3.17%), and Great Britain (3.11%). 

The first thing to notice is that the U.S. government is still borrowing at very attractive rates compared with the triple-A nations, and Treasury rates actually got better during the angry debate in Washington, as investors continued to beat down our doors to lend money to our government.  Why?  The downgrade and recent weakness in the stock market have made bond investors nervous, which usually causes them to buy the safest paper they can find.  The United States still offers the deepest and most liquid bond market in the world.

The second thing to understand is that, despite the high levels of government debt, there is really no crisis in the government finances or in the economy.  S&P officials made it clear that they were more influenced by the recent messy debate in Congress than the fundamentals of government finance.  They may have been particularly rattled by public statements by key members of Congress that it might not be a bad thing if the U.S. government defaulted on its sovereign obligations to its global lenders–sort of like one of us telling the bank that we’re thinking seriously about not making any more mortgage payments.  

David Beers, global head of ratings at S&P, said in a supporting statement that the agency was concerned about “the degree of uncertainty around the political policy process.”  A separate statement by the rating agency said that policymaking and political institutional control had weakened “to a degree more than we envisioned.”

Long-term, our government faces some difficult choices.  The question now is whether we’ll get action from Congress or more political posturing.  We’ll get an early look between now and Tuesday, as a new Congressional committee, made up of Democrats and Republicans, will be set up.  The committee will be looking for $1.5 trillion in deficit cuts that have not yet been specified through the debt ceiling compromise.   (A total of $917 billion in cost reductions has already been earmarked).

What should investors do?

What does all this mean for investors?  The investment markets were clearly rattled by the tone and uncertainty of the debt ceiling debate, with the S&P 500 losing 10.8% of its value over the ten trading days of the Congressional standoff.  Early indications are that global markets have been negatively affected by the S&P downgrade.

But a Money magazine report points out that when a country loses its AAA rating, that is not always terrible news for the nation’s stock market.  Canada, for example, was downgraded from AAA status in April of 1993, but the country’s stocks gained more than 15% the following year.  The Japanese government’s bonds were downgraded in 1998, and the Tokyo stock market climbed more than 25% in the next 12 months.

The awful nature of the debt ceiling debate, plus the downgrade, has clearly added fear and uncertainty to an already sluggish economic recovery.  The Treasury debt downgrade is a blow to U.S. pride, and a warning to Congress–particularly those representatives who think the U.S. can simply walk away from its obligations without consequences. 

However, as the decline in Treasury rates made clear, the downgrade is largely symbolic.  Congressional gridlock and partisan posturing could leave us with a long 15 months until the next time we have a chance to vote on their job security.  But it might be helpful to think back to last summer, when concerns about a double-dip recession and mild panic sent the S&P 500 down a long unhappy slide to a low of 1022.58 on July 2, 2010, with a few additional bounces along the bottom until a September rally.  Investors who sold out of the markets at that time missed significant–and largely unexpected–gains through the fall, winter and spring, as people gradually realized that the world was not coming to an end.  (Despite periodic “end of the world” stories promulgated in the press, the world never does end.)

Our Cloudy Crystal Ball

No one can predict stock market prices, because in the short term, emotions can rule the market, and they are visibly tilting toward panic right now.  Longer-term, market prices always tend to return to fundamentals, and it’s helpful to remember that corporate profits remain strong, new jobs are being added and the economy is still growing. 

The Price of Panicking

The U.S. markets weathered much worse than this in 2008, in 2000, during the first and second world wars and a lot of panic-stricken times in between.  Without the ability to see the future, our best prediction is that the Sun will continue to rise each morning, and the U.S. will emerge from this crisis like it has all the others.  In the past, investors who managed not to succumb to the panic like so many did last summer did extremely well.

The alternative is to get out of the market now (after prices have already declined) and wait to get back in, when the economic environment is settled, and things no longer look downright dangerous.  The price you pay for this respite from anxiety is usually very high.  By the time you feel comfortable  being an investor in stocks again, prices will typically be much higher than when you sold.

Selling low and buying high has never been a winning strategy.

Dow Jones Music Video

Is it possible to be as proud of a friend’s child as you would be of one of your own?

Adam Baff, whom I have known for 30 years, is the son of close friends. Adam has many talents, and recently he wrote the music and lyrics for the Dow Jones Music Video.

I think it is very well done and effectively uses humor, irony, and great visuals to express the many moods we’ve all experienced. No doubt, for many of us, the last few months have been “trying” (to say the least), but Adam’s tongue-in-cheek view of life in these United States gives us something to smile about. Adam’s band Downsize performed the music, and the video features Nicole O’Connell an aspiring model/actress.

The link to the YouTube video is here.

The song is available for purchase at Amazon.com and also through iTunes.

So, I ask again, is it possible to be as proud of a friend’s child as you would be of one of your own? Absolutely! Way to go, Adam.

Nobody is Buying Stocks?

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather.

As stock prices have declined this week, I have noticed some sloppy journalism. According to newspapers and TV programs, there is so much pessimism about the economy that no one is buying stocks. Clearly if everyone else is selling, you would be foolish to be a buyer.

To get a sense of this interpretation, take a look at today’s New York Times article Slump Humbling Blue-Chip Stocks, Once Dow’s Pride by Jack Healy.

Here are some relevant quotes with my comments:

“With so much uncertainty, investors are parachuting out of companies like banks, retailers and utilities, and abandoning stock markets everywhere from Asia to Europe to Wall Street.” (Parachuting? Nice metaphor.)

“No one is taking a back-seat approach. Everyone is just selling.” – Peter I. Cardillo, chief market economist at Avalon Partners.  (Everyone?)

“Nobody wants to be invested, that’s the problem. I don’t believe we’re at the bottom yet.” – Eric Ross, director of research at the brokerage firm Canaccord Adams. (Nobody?)

A similar story was portrayed in an article in the Wall Street Journal, Stocks Hit ’97 Level, Signaling Long Slump, on March 3, 2009 by Tom Lauricella and Annelena Lobb.

Here are a few quotes with my comments.

“It’s like an unending nightmare” – Kent Engelke, managing director at Capital Securities Management . (This is an exaggeration and seems to suggest prices will continue to drop.)

“The relentless decline is pushing investors to the sidelines.” (Not really. See explanation below.)

“I want to wait for a firm turnaround, and be as safe as possible,” Bijon Mishras, a financial-services consultant in New York. (Whoa, Nelly. Remember this quote and see how it turns out.)

“Nobody wants to buy a market today that they think is going to be down 2 or 3% tomorrow,” says Michael O’Rourke, chief market strategist at brokerage firm BTIG LLC. (Nobody?)

A Reality Check

Yes, the economic news coming out of everywhere is very bad, and yes, stock prices have had steep declines. But guess what? Every single time that someone sells a stock position, someone is on the other side of that transaction. Every single time. What do we call such a person? Insane? No. How about “buyer.” Sellers and buyers must be equal!

For every person who sells because he or she doesn’t like the prospects for the future (a.k.a a “pessimist”), there is someone who is buying (a.k.a. an “optimist”). That person thinks the investment is at a great price. Those two groups of investors or participants in the market have to be in equilibrium at all times.

When you look at it from that perspective, you don’t get the overwhelming sense of doom that the media creates — that there’s only one way for prices to go, and that is down. If that really is the case, then there are a lot of crazy people who are buying now.  I don’t think so.

The fact that prices have been going down does not mean that they will continue to go down. Just as in 1999, the fact that prices had been going up did not mean that it was a good time to buy stocks.

Risk/Reward

No one knows what tomorrow will bring, but unless capitalism ceases to function, stockholders will be rewarded in the long term for owning stocks and for taking risks. Yes, there is risk in owning stocks, as we have recently experienced. Since we’ve already seen the risk, how about staying around for the reward?

An old Wall Street proverb is that “Nobody rings a bell at the top or the bottom of a market.”

Are you waiting for that bell to ring? Don’t.

Searching for a Better Investment Guru

U.S. stocks declined yesterday to the lowest prices in more than 12 years. The Standard and Poor’s 500 closed at 700. You would think that now would be a very good time to have a reliable investment guru offer sage advice and words of wisdom. Times are tough, the economy is tanking and there is panic in the streets (Wall Street and Main Street, both). What is an investor to do? Should she buy, sell, hold? “Surely,” you think, “the ‘experts’ must know.” Unfortunately, you’d be thinking wrong; the correct answer is that he or she really doesn’t.

Last month, in an article titled Why the Experts Missed the Crash, Money Magazine published an interview with UC Berkeley Haas Business School professor Philip Tetlock. The professor has spent his career evaluating experts and authorities in a variety of fields, and he is not at all surprised that the vast majority of financial “gurus” failed to predict the recent steep market decline.

Here is a summary of the article:

Despite everything, we can’t shake the belief that elite forecasters know better than the rest of us what the future holds.

The record, unfortunately, proves no such thing. And no one knows that record better than Philip Tetlock, 54, a professor of organizational behavior at the Haas Business School at the University of California-Berkeley. Tetlock is the world’s top expert on, well, top experts. Some 25 years ago, he began an experiment to quantify the forecasting skill of political experts.

Tetlock has analyzed “not just what the experts said but how they thought: how quickly they embraced contrary evidence, for example, or reacted when they were wrong. And wrong they usually were, barely beating out a random forecast generator.”

Why did so many experts miss the economic crash?

The people intimately involved in packaging [financial derivatives like] CDOs must have had some sense that they were unstable. But their superiors seem to have been lulled into complacency, partly because they were making a lot of money very fast and had no motivation to look closer. So greed played a role.

But hubris may have played a bigger one. … In this case the biggest source of hubris was the mathematical models that claimed you could turn iffy loans into investment-grade securities. The models rested on a misplaced faith in the law of large numbers and on wildly miscalculated estimates of the likelihood of a national collapse in real estate. But mathematics has a certain mystique. People get intimidated by it, and no one challenged the models.

Money has written about human mental quirks that lead ordinary folks to make investing mistakes. Do the same lapses affect experts’ judgment?

Of course. Like all of us, experts go wrong when they try to fit simple models to complex situations. (“It’s the Great Depression all over again!”) They go wrong when they leap to judgment or are too slow to change their minds in the face of contrary evidence.

An Alternative to Finding a Better Forecaster

A good part of the article explores the question “What makes some forecasters better than others?” Professor Tetlock has a detailed answer, which makes interesting reading. He recommends looking for “self-critical, eclectic thinkers who were willing to update their beliefs when faced with contrary evidence, were doubtful of grand schemes and were rather modest about their predictive ability.”

But my answer to the same question is radically different. I believe that it is futile to rely on gurus who have been right more often than others. Various “experts” will be right or wrong at different times, and you cannot, regrettably, know in advance when that will be. So if in essence, the future is unknowable, and experts are so unreliable, you need to have a strategy that does not depend on “accurate” forecasts.

No one, yes no one, knows how markets will behave in the short term. Accordingly, my recommended approach has been and continues to be a disciplined long-term strategy. To understand why, it is absolutely necessary to have perspective on financial history:

• There have been many financial crises in the past; none have proven fatal.
• We have experienced a dozen other Bear Markets since World War II.
• Stock prices have rebounded from all previous declines, even steep ones.
• The stock market goes up in roughly 3 out of every 4 years.
• Stock market losses are temporary; stock market gains are permanent.

Furthermore, waiting for the “right time” to invest doesn’t work for most people, most of the time. The likelihood is that you will miss out on the really strong rebounds that happen when you least expect them. In other words, don’t wait until it looks safe to invest in stocks.

Accordingly, I leave forecasting to the “experts” who according to Professor Tetloc “barely beat random guesses – the statistical equivalent of a dart-throwing chimp – and proved no better than predictions of reasonably well-read nonexperts.”

I do believe in controlling what I can:

• Costs (through low cost mutual funds)
• Risk (through global diversification and sensible asset allocation).

I believe in staying the course so as to participate in the eventual and inevitable recovery.

In short, I do not have a forecast; I have a philosophy and an approach. It’s not perfect, nothing in this world is, but experience shows that it works better than any other approach.

The Fama/French Blog

Two prolific and very well respected Finance professors, Eugene F. Fama of the University of Chicago Booth School of Business and Kenneth R. French of the Tuck School of Business at Dartmouth College, have a blog worth noting: the Fama/French Forum. Their blog covers Finance and Economic Policy

Here is a recent Q&A on Recessions.

Question: The US economy is in a recession. Does it make sense to own stocks during a recession?

Answer: There is no evidence that market timing in response to economic events enhances expected returns. The market tends to lead economic activity. Stock prices tend to fall in advance of recessions and rise in advance of economic upturns. To time markets successfully, you have to come up with better forecasts of economic activity than those already built into stock prices. We don’t know anyone who can do this.

Moreover, investors who try to time the market by selling after news of a recession is already in prices are probably reducing their expected returns. Although realized returns are too volatile to make strong statements, there is some evidence that expected stock returns are relatively high during recessions and low during expansions. One can avoid the higher risk of stocks during recessions, but apparently only by passing up higher expected returns. —EFF/KRF

Investment Guru Predicted Crash

“There will always be someone predicting disaster and someone predicting great fortune. At one time or another, each will be closer to correct than the other. But it won’t matter to you if you understand this and have invested responsibly. You have a long-term plan; stick with it.” Peter Lynch.

In my previous post, one of the individuals quoted was Jeremy Grantham, a very successful money manager, who has been getting a great deal of media attention lately. He was among the “Fortune Tellers” featured in New York Magazine’s December 7th article, Oracles of Doom.

In addition, late last month, Grantham was the sole guest on PBS’s popular investment program, Consuelo Mack: WealthTrack. She described him as a modern-day “Cassandra,” noting that he predicted today’s depressed stock prices a decade ago.

I might be in the minority here but, in my opinion, being pessimistic 10 years in advance isn’t all that useful.

Now, don’t get me wrong, I think Grantham is very intelligent and quite eloquent. He’s also very convincing. The problem I have with him is that he has been bearish for so long, that eventually, he had to be right.

You can read more about his prophesies in Here Comes the Crash, an article published in the November 15, 2004 Fortune magazine.

Talk to Jeremy Grantham about the stock market, and you get the impression the sky is about to fall. For years the chairman and chief strategist of money-management firm Grantham Mayo Van Otterloo has been gleefully rattling listeners’ nerves with his claim that the excesses of the dot-com bubble still haven’t been unwound and that the market is headed for another precipitous drop. About a year ago his prediction became alarmingly specific. Shortly after this year’s election, he says, the market will sink into a “black hole,” losing about a third of its value over the next two to three years. He sounded this warning most publicly at the annual Morningstar investment conference in July. In late October, speaking from his elegant Boston townhouse, he told FORTUNE, “We’re still in the unraveling of the greatest bull market in American history.”

To be fair, from what was printed in the Fortune article, he has been right:

Using GMO’s computer models, he has made several well-timed calls. In 1982, with stocks selling at fire-sale prices and the economy recovering, he predicted the market was ripe for a “major rally.” That year the U.S. market kicked off its longest bull run ever. He also called the top of the Japanese bubble in 1989, the resurgence of U.S. large caps in 1991, and the rallies in U.S. small-cap and value stocks in 2000.

But, he has also been wrong:

He turned bearish on U.S. equities in the mid-1990s, prompting clients to shift money to other firms.

His prediction in 2004 was that “The low will come two or three years from now, at a level below 700 on the S&P.” That’s not what happened at all. In fact, the S& P 500 went up in 2003, 2004, 2005, 2006 and 2007. Finally, in 2008, his pessimism paid off.

A web site from CXO Advisory Group rates investment “gurus.” According to them:

Jeremy Grantham has been persistently very negative about the prospects for U.S. equities (apparently since 1994), but not for international equities.

Based on subsequent stock market performance and our judgments about his forecasts for overall stock market direction, Jeremy Grantham’s forecast accuracy rate is 48%, which is about average. His forecast sample size is very small, as is our confidence in this score.

Note that carefully: 48%. One could argue that an accuracy rate of 48% is not dissimilar from simply using a coin tossed in the air to determine your prediction.

Finally, if the stock market had gone up this year, I doubt that Jeremy Grantham would be getting this much favorable press.

Experts Who Predicted Recession

“The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith.

I took a look back through my files to see which market economists or analysts correctly predicted that we would eventually have such an awful recession and horrendous stock market decline. In his article, Last Christmas Before Next Recession, Paul B. Farrell of MarketWatch quotes economists and investment gurus who did not pull their punches. You won’t find a “on the one hand this and on the other hand that” quote among the lot.

Of course, this particular group is always making predictions. So please read the entire post, before you decide how “helpful” their predictions actually were.

The quotes are very slightly shortened (for dramatic effect).

Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co

“Everyone agrees that there are extreme imbalances in the U.S. and the global economy … The bulls believe that all will work out … The bears believe that sooner or later these imbalances will come home to roost. … The probable winning bet [is] a very mean reversal … for the next few years.”

Gary Shilling, economist

“A bursting of the housing bubble will probably be the expansion ender. Signs of the bubble’s demise are accumulating, making a … recession probable.”

Bill Gross of Pimco

“Now after 300 basis points and 17 months of tightening — which by the way is typical of prior bear cycles as well — it should only be logical to expect a slower economy …”

Alan Greenspan

“Our budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken. The consequences for the U.S. economy of doing nothing could be severe.”

Farrell goes on to recommend extreme steps to prepare for the bear market and recession.
“You need a wake up call: Total shift of consciousness, an extreme mental makeover, a massive attitude adjustment. … This is real war.”

He ends with this question, “Are you prepared to survive the recession and bear market likely to hit in 2006?”

Yup. You read that right. That’s 2006. The article was posted on December 12, 2005. Had the article been posted on December 12, 2007 that would have been really impressive. Frankly, being two years early in calling a recession is not at all useful. In point of fact, the S&P 500 had returns of 15.8% in 2006 and 5.5% in 2007.

So, what do you call people who are right, but two years early?

“Wrong.”

The Economy and the Stock Market

“Something that everyone knows isn’t worth knowing.” – Bernard Baruch. 

Baruch was referring to individual stocks, but I take his meaning to include the economy and “the stock market” as a whole. If something is already known, it will have no further influence on individual stocks or the stock market. It is only something new that will affect prices.

Larry Swedroe is the co-author of The Only Guide to Alternative Investments You’ll Ever Need.

In a recent interview with HardAssetsInvestor.com, he talked about commodities, portfolio construction and investing strategy. He also related his outlook for the U.S. economy as a whole to his view on future returns in the stock market. Surprisingly, he is optimistic.

I know, firsthand, that a great many investors are discouraged and/or disgusted with the downturn in the economy, in general, and the decline in the markets, specifically, over the past months. Some investors have fled the stock market for safer investments. And, yes, I realize that it is difficult to find any silver lining in the current dark clouds of the economy.

Certainly, the volatility of the stock market cannot make anyone feel peaceful. It’s clear that optimism is in short supply.

Nevertheless, Swedroe thinks this may be a good time to invest in stocks. Please, consider his logic, which I personally find very persuasive.

HardAssetsInvestor.com: What are your general thoughts about the economy and the stock market here?

Swedroe: The big picture is simply this: Clearly, this is the worst economic crisis we’ve seen since the Great Depression. But wait … did I tell you anything you didn’t already know? The markets know that too. This is the worst market since the Great Depression.

We all know the economic news is going to get worse. Unemployment is going to go up; retail sales are going to go down. But while everyone’s focusing on the bad economic news, they’re forgetting that the market has already understood this.

People are saying, why can’t this be another Great Depression? And it could; you can’t rule that out. But what people fail to understand is this: In the Great Depression, the policy responses were all in the wrong direction. We raised taxes and raised interest rates, increased margin and reserve requirements, and started a trade war. The policy responses this time, whether you agree with them or not, have not only been in the right direction – cutting interest rates, flooding the markets with liquidity, etc. – but they have been the most massive effort ever.

The effort is coordinated around the globe, and countries are pledging to maintain free trade. Every major country is enacting fiscal stimulus programs, all the central banks are cutting interest rates, etc. So while we have had a massive economic crisis, offsetting that are the largest policy responses in history coordinated around the globe. Policy responses take a while to work through the system, while the economic news will continue to look bad for a while.

Remember: Just when things look darkest, stocks tend to have good returns. Prior to this year, when consumer confidence has fallen below 50, the average return for stocks the next year was 16%.

Or consider this: When the unemployment rate is below 4.3%, the average return to stocks is 2%. When the unemployment rate is over 6%, the average return to stocks is 15%.

In the 11 recessions in the post-war era, the cumulative return to stocks is up 7%, and T-bills are up 5%. Returns were positive and better than the risk-free rate. Every time an investor sold stocks and paid taxes, they would have been better off sitting pat in stocks. The only way to do better would have been to forecast the recession, and who can do that?

I cannot guarantee that we will get out of this crisis, but we have gotten out of every other crisis quite well.

(Emphasis added)

Conclusion

Certainly, there is no shortage of bad economic news: Home prices are falling, unemployment is rising, the stock market has had one of its worst years on record, and the automobile industry is asking the federal government for bailouts, like the financial services industry before them. Where will it all end? Is there any good news?

Indeed. Unfortunately, we do not know when the good news will arrive. But, what we do know is that whatever negative that can be said about the economy is already known. If it is widely known, then the bad news is already reflected in current stock prices.

If history has any relevance, and I think it does, after a stock market decline, when pessimism is commonplace, is a very good time to expect stocks to have higher returns.

This may be counterintuitive, but it is true, historically.

Keynesian Economics, Part 1

“If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.” – Gregory Mankiw.

The economy is in recession, and some question if the Federal Reserve Board can use monetary policy to avoid a steep decline. Therefore, I think we will all need to reacquaint ourselves with Keynesian economics.

Gregory Mankiw is a professor of economics at Harvard University. His op-ed piece What Would Keynes Have Done? in today’s New York Times is a good summary and review of Keynesian economics and how it applies today.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

To read more, click here.

How Bad Is This Bear Market?

“Technically, a bear market is when stocks fall 20% or more from their highs. But there’s a saying that a bear’s true signature is making a fool out of everyone. Based on that, we’re all laughingstocks, because there has been virtually no way to avoid this bear market’s claws.” – Matt Krantz.

An article in today’s edition of USA Today, Bear Market Swipes at More Than Just Stocks by Matt Krantz, spells out just how bad the markets have been this year. Here is a summary:

Following a 445-point slide to 7552 Thursday, the Dow Jones industrial average is down more than 6,600 points from its high. The broad stock market is at it lowest level in 11½ years, with the Standard & Poor’s 500 index off 52% from its high in October 2007 and on pace for its worst year ever, S&P says. Only 13 of its 500 stocks are not down for the year, and more than 100 trade for less than $10 a share.

The pain extends far beyond stocks. Oil has crashed 66% from its record close in early July. Even the so-called safe harbor of gold is down 25.5% from its high in March.

This bear has trashed nearly every investment strategy and asset class. It has humbled some of the most powerful names in the stock market and blown holes through long-held tenets in investing. Market historians strain to think of previous bear markets that have disproved so many investing philosophies at the same time.

“There is nowhere to run and hide,” says Ken Winans of investment management firm Winans International. “You have gotten bludgeoned in every direction.”

The extent of the earth that’s been scorched is breathtaking. Brand-name investors such as Warren Buffett, Carl Icahn and T. Boone Pickens have suffered massive losses. Do-no-wrong mutual fund managers, such as Legg Mason’s Bill Miller, are down big. Hedge funds run by managers once thought to be infallible are having their worst years ever.

Even investors who saw the bear coming have been mauled. Those that rushed into commodities or foreign currencies to sit out problems with the U.S. economy have suffered massive losses.

The pros are struggling

Even investors who’ve sought professional help have been stung. Money poured into mutual funds, hedge funds and private-equity firms run by experts known for out-foxing markets in good times and bad. The bear has proved to be smarter than the fox.

Legg Mason’s Value fund (LMVTX), famous for the longest streak beating the S&P 500 under the leadership of portfolio manager Miller, is struggling. It is down more than 65% this year, the third year in a row that it has lagged behind the market. It now has just a one-star rating, out of a possible five, from Morningstar.

Eddie Lampert, the hedge fund manager for celebrities such as David Geffen and Michael Dell who was routinely compared with Warren Buffett just a few years ago, has seen his investments sour. His personal worth has fallen to $2 billion from $4.5 billion just two years ago, Forbes says. His hedge funds’ biggest investment, Sears Holdings (SHLD), has collapsed 70.5% this year.

Speaking of Buffett, the bear snagged the Oracle of Omaha, too. … Buffett’s personal worth is getting mauled, too. Forbes estimated his net worth at $62 billion in February, but that is based mostly on his large holdings of Berkshire Hathaway stock, which is now down $74,150, or 49%, from its high of $151,650 a share.

Commodities aren’t shelter

Investors who thought they saw the stock crash coming figured they had the answer: commodities. Fears of inflation and economic problems pushed many investors into gold. An ounce of gold soared 53.6% in the year leading up to its peak on March 18 as investors poured in. But investors who piled into gold in March have been dealt a 25.5% loss.

A similar story with oil. The price of crude was soaring earlier this year, and gas prices were a national fixation. At the closing peak of $145.29 a barrel on July 3, crude was up 51% for the year. With predictions of it hitting $200 or more, it seemed like a can’t-lose proposition. Speculators lost and lost big as the price crashed nearly $100 a barrel to about $49 now.

The Reuters/Jefferies CRB index of 19 raw materials dropped more than 4% Thursday, hitting its lowest level since April 29, 2003, according to Bloomberg News.

Global diversification is making things worse

We’ve heard it before. Own both U.S. and foreign stocks, and your portfolio’s ups and downs will be moderated. When domestic stocks zig, foreign stocks are supposed to zag.
But that hasn’t worked either. The iShares MSCI EAFE index fund (EFA), which tracks stocks in developed nations in Europe, Asia and the Far East is down 54.5% this year. That’s worse than U.S. stocks’ decline.

What about emerging markets stocks? Up-and-coming nations such as China, Brazil and India were supposed to be growing fast independent of the U.S. Well, the iShares MSCI Emerging Markets (EEM) index has fared worse, tanking 64%. Every major nation’s stock market is down this year, says S&P’s Capital IQ.

Buy-and-hold investors are getting hurt

Buy-and-hold investors know short-term swings are normal. They hold through tough times, knowing returns come to those who wait. But investors who invested in the S&P 500 10 years ago have seen the value of their stocks decline 35%. Even investors who used dollar-cost averaging and invested $500 a month starting Dec. 31, 1996, and reinvested dividends lost $13,225, or 17%, as of Oct. 31, says Winans.

Bonds are eating away at portfolios

Rather than buffering losses on stocks, corporate bonds are falling apart. The iShares iBoxx Investment Grade Corporate Bond fund (LQD), which invests in bonds with high credit ratings, has a negative return of 14.4% this year. That may not sound that bad, except investors buy bonds because they want very little volatility.

Sam Stovall of S&P says that it’s usually not wise to give up on investing in the depths of a bear market. While it takes five years on average for investors to get their money back after a 40%-plus decline, those who keep investing when stocks are cheaper are made whole faster.

Conclusion

A small point: The article overstates the damage to bond investments. Not all have suffered. In fact, Treasury securities have done quite well this year, as investors have fled to these very safe investments. (As the yield of a bond goes down, the price of the bond goes up.)

But the article is generally correct. Unless the stock market recovers from these low levels, which certainly could still happen, 2008 will go down in history as the worst year ever, as measured by the Standard and Poor’s 500 Index. I believe, though, that this is not the time to get discouraged and abandon your well thought out portfolio. In this instance, doing nothing is preferable to selling everything.

There are some opportunities out there. If you can do it, this is a good time to convert your traditional IRA to a Roth IRA. It might also be a good time to rebalance your portfolio. For more information on these two issues, you should consult your financial advisor.

Going forward, we all must re-examine our actual risk tolerance. When times are good, it’s easy to tell yourself that you can weather the (hopefully) temporary storms of declining stock markets. This year certainly proves that living through a substantial bear market, in real time, is another matter entirely.

Finally, if you are so worried about the stock market that you are having trouble sleeping, consider scaling back your equity allocation. That way you will still maintain some exposure to stocks, rather than making an emotional decision to “sell everything.”

photo credit: lexdennphotography

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