September 1, 2011

What Happened in August? Why 2008 Redux Did Not Happen

Baron Funds manager says high-frequency trading magnified last month's panic; calls stocks a bargain

(Photo: AP) (Photo: AP)

Ron Baron, a big name in the small-cap world, has a definitive answer for all those investors frightened by the stock-market gyrations of August: “Summer ’11 is not Fall ’08.”

In his latest quarterly letter to clients, the Baron Funds chief investment officer tries to make some sense of the precipitous market declines that occurred last month amid the protracted debt-ceiling debate, the S&P downgrade of U.S. credit and the banking and political crisis swirling over too-big-to-bail Italy and Spain.

Baron reminds investors how much worse things were in 2008. After the fall of Lehman, he writes, “We were startled to hear that significant declines in sales were taking place magnitudes larger than any we had ever heard about.” Businesses responded by cutting expenditures, firing workers and reducing pay while frozen capital markets prevented businesses from borrowing to sustain their operations.

In contrast, today’s U.S. banks have been successfully recapitalized (and Baron argues Europe has no choice but to recapitalize its banks); capital is available and cheap; growth businesses such as in Silicon Valley are hiring again; and corporate profits are beating consensus estimates.

Best of all, Baron argues that stocks are a bargain: "The S&P 500 Index has increased a total of only 6.4% over the entire past twelve years! Earnings during that period have more than doubled! This means valuations are about half what they were twelve years ago. Stocks now also yield more than ten year Treasury bonds. This has been a rare event during the past fifty years."

So how did fears of a dysfunctional government in Washington and European debt contagion obscure the comparative strengths we enjoy today versus 2008? Baron blames high-frequency computer trading. Representing more than 70% of daily exchange volume, computer trading “allows investors to "panic" and buy and sell at inopportune times.

The Dow fell 4.4% in August, saved from a far more severe drop by the 7.4% end-of-the-month rally; 400-plus point moves on four consecutive days kept investors on edge early in the month.

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