Where to Begin?
June 30, 2008
As the first half of 2008 comes to a close, there is but one good thing to say: Thank God it’s over! Turning the page to a new calendar month does little to change the complex state of affairs we are experiencing in the economy and in the financial markets, but without a doubt we are all hoping for a better second half of 2008.
For the third time in nine months, global equity markets have reached bear market levels, defined as a 20% decline from the previous peak value. In January, in March, and again last week, equity prices dropped under the weight of the gloomy global economic outlook, the ongoing struggles in the housing and banking industries, and the seemingly unstoppable appreciation in the price of a barrel of crude oil.
In previous sell-offs, the U.S. Federal Reserve has stepped in to provide support. This time, however, the Fed has already cut benchmark interest rates and made available other lending facilities designed to help credit market participants. Following this most current sell-off, the Federal Reserve stood its ground partially to defend the U.S. dollar and partially to prevent inflationary pressures from spreading from raw material prices to the broader economy.
Looking back at the commentaries we have provided so far this year, several themes are worth repeating:
- Diversification across multiple asset classes has helped soften the blow from stock declines.
- Although no other asset class outside of commodities has been able to completely offset the decline in equities, commodities still have held overall portfolio returns at levels that can be quickly turned around with the return of normal market conditions.
- Stocks are very volatile in short periods of time. This again illustrates the importance of matching asset class with investment horizon. As of the end of May and as recently as three weeks ago, the market benchmarks were flirting with positive returns for the year.
- Selling into strength and buying into weakness is the most successful course any investor can adopt. The time to prepare for cyclical downturns is not at the point of reaching a bear market but when returns are strong and the outlook is nothing but positive. Successful long-term investing is highly dependent on controlling your emotions, avoiding reactionary decisions, and maintaining a contrarian point of view.
Granted, the problems we have today are significant and are structural in nature. None of the economic issues faced by the global economy–and felt most acutely in the U.S.–will be solved overnight, nor will they come without change and compromise. It may be a slow grind through the transition while markets move in wide trading ranges with limited upside progress and until enough of the primary foundations are in place to sustain growth. Notwithstanding, the array of investing opportunities that these solutions may create could be the best in a decade.
In this type of environment, portfolio management will likely need to be modified. Yes, asset allocation remains an important first step, but we will likely need to focus more on “bottom-up” opportunities, on trading and rebalancing more frequently, and on managing downside risk with more specific definition. More than anything else, we can no longer look at U.S. markets as the primary driver of growth and return and must instead think globally in all allocation and selection decisions.
It is possible that much of the bad economic news—perpetually higher energy prices, rising unemployment, higher individual income taxes, more regulation, greater dependency on foreign capital, less international trade, lackluster corporate profits, continuing weakness in the housing markets both in the U.S. and other wealthy regions, and rising bank failures—is already priced into certain sectors of the market. We therefore plan on being opportunistic in managing your investments. At the same time we remain very cautious, mindful that bear markets (like bull markets) historically over-shoot in their corrections of market excesses. In other words, the current market could just as well go down another 10- 20% before recovering. Nonetheless we know from historical observations that markets turn around at points of emotional extremes, so that $1 invested in stocks today may do much better than expected over the next several years as issues are resolved and people come to realize that things did not turn out as badly as forecasted.
Before you come to the conclusion I am drinking too much bullish Kool-Aid and not dealing with reality, let me acknowledge that in 23 years of daily involvement in financial markets in one role or another, I have never seen things this bad. The period of 1977-1981 would be the closest parallel, but even then there was a clear path forward. Today, the world is in transition from being largely U.S.-centric to being a more balanced playing field with much higher stakes. A true pessimist may believe that there is nothing but downside ahead until we bottom out in a global depression. The best advice for him is to pay off all of his debts, spend as much money as he wants on the things he enjoys, buy gold, silver and a good gun with what is left over, and be prepared to defend his turf. Naturally I think the odds are against this situation, so we are staying invested and endorse tactical re-balancing and opportunistic market entry and exit.
Professionally our job is to understand your goals, the time horizon over which you wish to achieve those goals, and your level of risk tolerance. We then prescribe an investment policy that forces you to remain objective and non-reactionary, especially during extreme highs and lows. Every individual is unique so what is right for one person may not be right for the next. But without challenge I can say that buying when others are fearful and selling when others are greedy will do the trick over time within a well allocated, globally diversified portfolio.
As we meet in the weeks ahead to review your investments and finances, we will spend time revisiting your personal goals and objectives and making sure that the strategies we have prescribed are still in line to give the highest probability of success. We will prune and purge holdings to position your portfolios for the recovery ahead reflecting new realities. We believe that the markets will indeed recover–perhaps not as fast as we would all like, but they will–so being positioned correctly will enhance returns over the next several years. With this mindset, buying low-yielding government bonds or holding nothing but money market reserves may feel better in the short-term, but in truth it will lock in negative real returns harming long-term portfolio growth. The single biggest mistake individual investors repeatedly make is to be aggressive in rising markets and overly conservative when values decline. Being practical rather than emotional is necessary to realize the returns, growth and income needed over time.
The question I am increasingly asked these days is: “When will a sustainable recovery get underway?” Before we can begin in earnest to see a sustained recovery, the present deleveraging of the financial markets must run its course. The steady progress through each decade of the past 100 years to tame the boom-bust business cycle and dampen recessions for the global economy has been highly successful. The improvements in transportation, inventory management and productivity of labor and technological integration have stabilized Main Street unlike any previous period of economic history. Unfortunately, the relative stability on Main Street led to a false sense of comfort on Wall Street, which in turn launched an unprecedented era of leveraged speculation. It is the accumulated products, tactics and strategies of this era that are being unwound in the financial markets as we speak.
Once the deleveraging process has run its course, we believe that the road to recovery begins with energy policy. The U.S. must adopt an energy policy that is tailored to the realities of today. This means not only considering the environmental effects of any energy source but also the development of our own vast resources. This makes as much sense in simple demand-supply economic analysis as it does geo-politically and environmentally. I would much rather have a publicly traded U.S. or western European organization developing new sources of energy than leave it to the rogue states of the world to pursue whatever policy they want to obtain control over the resources they crave and we need. Furthermore, a solution that addresses supply makes long-term sense. Drilling here and drilling now may not immediately drop the price of gasoline, but it will break the back of the speculative trend and do wonders 5-10 years out. The world economy is not likely to survive on just clean energy forms; there is simply too much need for broader and more efficient solutions.
Once the energy markets see a credible plan, the forecasts of permanent deficits in supply can be amended. This will take pressure off inflation giving the U.S. Federal Reserve and global central bankers greater flexibility to lower benchmark interest rates. A lower inflationary premium means that mortgage rates can become compelling, and this brings new home buyers into the housing market and stabilizes prices. With greater price stability and fewer delinquencies, the banks put more money to work. Households with lower fuel and food prices will again have discretionary income to spend which in turn spurs business investment. In these ways, growth returns to the economy although it may be another year before we see measurable results.
So, with the big picture overwhelming, we suggest revisiting your time horizon and objectives:
- For those of you continuing to accumulate wealth toward retirement, these pullbacks are golden opportunities to increase selectively your holdings at discounted prices.
- For those of you counting on your portfolio for income, the allocation strategies we recommend include high cash flow from dividends and interest and in many cases feature at least two or more years of expected income in non-stock investments, so the opportunity to ride out the storm is very high.
- For those of you looking primarily to preserve capital, we have been cautious not to over-extend the allocation to stocks in the first place. As such the declines seen in equities have had only a minimal impact on your portfolio.
We would love to discover the secret formula to make market volatility go away but, alas, we know it does not exist. What we can do is remain strong and smart and avoid being overcome by emotion during this trying time. We must study and learn from the past, apply all that we know, and move forward with perseverance, objectivity, and faith.
Jack E. Payne, CFA
Chief Investment Officer