Today we flip the calendar not only on a new month, but we also turn the page on a new quarter. Quite frankly, the new quarter couldn't come too soon. Good-bye and good riddance to Q3, and welcome to Q4!
Even after last week's bounce, for the market as a whole, the third quarter was the worst on record since the crash of 1987. The Dow Industrials were down 15.8% in the quarter, the S&P 500 was down 15.0%, while the tech-heavy Nasdaq Composite surrendered another whopping 30.6% over the last three months.
The Rule Breaker didn't fare much better in the quarter, losing 29.3% of its value in the third quarter alone. It wasn't any one stock that brought the portfolio down, either. Of the eight positions the portfolio started the quarter with, six of them lost at least 30% of their value.
Our biggest loser was Amazon (Nasdaq: AMZN), which in the last three months went from over $14 to under $6, nearly a 60% dip. And just to illustrate how bad the market was (and why it's sometimes worthwhile to have money "on the other side of the table"), the best-performing stock in the Rule Breaker was the portfolio's only and now-closed short, Affymetrix (Nasdaq: AFFX). Affymetrix started the quarter in the portfolio as a short at $22.05, was covered by the portfolio two weeks ago at $14.95, and still ended the quarter down almost 30%, a handsome profit in a short amount of time.
Why was it so bad?
Two main reasons stick out in my mind as the underpinnings for this quarter's terrible performance. First, the economy has been tapping the brakes for several months. It was only a matter of time before such conditions were going to impact profits, in turn affecting stocks. In the case of the Rule Breakers, AOL Time Warner (NYSE: AOL) stands out as an excellent example. The company just last week watered down profits and warned it had finally succumbed to the lack of advertising that has been laying to waste nearly all Internet media firms.
Secondly, the third quarter had to absorb the terrible events and immediate aftermath of September 11. Even though we may not want to admit it for fear of letting them win, the fact remains that the terrorist attacks have exacerbated the ill health of an already feeble economy. Not only did the attacks physically destroy a great deal of physical and human capital, but they also sent the economy into a state of essentially suspended animation as we were all glued to our television sets, watching the news.
This couldn't come at a worse time for some companies that were already whistling past the graveyard. Witness Amazon, which is now a very highly leveraged company at an absolutely critical time in its lifecycle. If the company fails to gather enough consumer enthusiasm or fails to keep costs down over the next six months, Amazon is in dire danger of burning through what's left of its once impressive cash horde. As unlikely as it once seemed, bankruptcy is a real and increasing danger for Amazon, and the probabilities of this bad outcome increased greatly after September 11.
The economic climate is not just affecting AOL and Amazon. Rather, all of the Rule Breaker companies are affected by the state of the economy in one way or another. Even Amgen (Nasdaq: AMGN) is affected, if for no other reason than that the sinking stock market has made the valuation of the company's buoyant shares much higher relative to other investment opportunities.
Will Q4 be any better?
I'm not an economist (I just play one on TV), but I have reason to believe that the fourth quarter will bring some sunnier days than the third quarter. Of course, with the third quarter being as bad as it was, that may not be saying much!
Looking at the economy at large, oil prices are at their lowest levels since 1999, and interest rates are also the lowest they've been in years, both important factors that have strongly reversed their trends of a year ago. Companies doomed for failure are also doing just that -- failing -- today, which will clear the decks for the stronger "survivor" companies to thrive with less competition. The hangover from the stupendous misappropriation of investment capital in the late '90s is starting to wear off.
As investors, we can also take heart that much of the current economic pain has already been priced into stocks at these levels. Some of the recent market drop is certainly warranted due to the fact the "9/11 effect" is likely to take a bite out of third-quarter earnings as they are reported in the coming weeks. That said, I just don't see how a few bad weeks translates into eBay (Nasdaq: EBAY) and its iron-clad business with numerous competitive advantages being worth some 30% less than it was three months ago.
Moreover, the market always looks ahead, and right now it is looking squarely at the coming weeks when companies are due to come to the confessional to tell all just how bad the just-completed quarter was. But if an economic recovery comes in, say, the second quarter of next year, the market will start to perk up in the months ahead of such a recovery.
When exactly will the economy and the stock market rebound? Like any Fool, I haven't got a crystal ball. I just continue to keep a focus on the companies I own, making sure that their competitive advantages and cash-flow-generating powers are not diminished for the long haul. Those companies in a solid position may take a hit during this economic storm we are experiencing, but they are also set to shine brilliantly in the years ahead when the economy gets back on track like it inevitably will... eventually.
Paul Larson owns two of the seven current Rule Breaker stocks. Wanna know which ones? Check out his online profile -- brought to you by the letter C, the number 11, and The Motley Fool's progressive disclosure policy.
