Financial Symmetry News & Views

Posts Tagged ‘Economic Crisis’

Feeling a little nervous about the recent drop in the market? You’re in good company as it’s perfectly normal in this type of environment.  In fact, we’d be surprised if the drop had not made you nervous as that is what the majority of people feel after a rise over 14 months long.  Here are a few tips to remember that should calm your nerves:

Reverse Your Emotions

Successful investing requires turning emotions on their head.  When most people are nervous is the time to see opportunity, and when most people are fearless is the time to be scared.

The stock market did worse during the 2000’s than it did in the 1930’s! Do you remember how you felt in September of 2002?  Or even last February 2009? These periods are when many people were giving up on the stock market.  Fear had brainwashed their rational decision-making skills. If they would have realized in 2002 that their investments were about to go on a multi-year bull market ride, would their fear have been as pronounced?

On the other hand, people’s attitudes of early 2000 and October 2007 were ripe with optimism and fearlessness.  This is a direct contrast to the fear and pessimism that are now dominant.  Optimism makes people overpay for opportunity, while fear makes them overpay for safety.

It’s important to recognize that we will continue to have economic scares in the future (as we always have in the past).   Economic Cycle Research Institute had a recent write-up about the lag effect in people’s perception after a recession.

Take Inventory of Your Short-Term Holdings

What percentage of your investments are in safe areas?  The basic rule of thumb is to have 3-6 months of your living expenses in a safe place with little risk.  This allows you some breathing room for the money you have invested in the markets.  Knowing that you have a cushion of cash and bonds to access for your everyday expenses gives riskier investments time to ride through the stock market dips.

*Photo Credit: pasukaru76

If you invest in your employer sponsored retirement plan you have probably heard of Target-Date funds.  These funds are characterized as investments that change the allocation of stocks, bonds, and cash according to your specified retirement date.  In theory, these funds should progressively reduce risk exposure as the target date approaches.  However, there are no universal allocation standards, so the returns have varied widely from plan to plan.  This was highlighted by the market downturn in 2008 when funds with a target date of 2010 lost an average of 25%, with some posting losses of over 40%.

While the concept of these funds is great; taking the guesswork out of retirement planning for the average investor; further research, transparency, and likely regulation is required.  To that aim the Senate Special Committee on Aging will be introducing legislation that would require fiduciary responsibility for target-date fund managers. This is a step in the right direction, but there are still many other concerns that warrant attention.  In October 2009 Morningstar’s vice president of research Jon Rekenthaler testified before the Senate Special Committee on Aging.  You can read his testimony here:

“Five Concerns About Target Date Funds”

http://advisor.morningstar.com/articles/article.asp?docId=17632

The gold standard discussion in the mainstream media over the last year or so has been driven by the extreme measures taken by the Federal Reserve to shore up our banking system during the credit crisis.  Brad Delong, an economics professor at U.C. Berkeley has an interesting summary of why the gold standard monetary policy can lead to harsh economic conditions.  Some of the interesting points he cites:

(1) Countries that went away from the gold standard sooner fared much better during the Great Depression than those that held longer (like the U.S.)

(2) Average inflation, under the gold standard, is determined by the pace at which gold is mined

http://www.j-bradford-delong.net/Politics/whynotthegoldstandard.html

Bill Ramsay, CFP®, recently participated in his third Triangle Business Journal roundtable event.  The 2009 Financial Roundtable: Wealth Strategies was held at the Triangle Business Journal office on September 29th, 2009, with the full article appearing in the October 16th, 2009 issue.

Bill also participated in the Triangle Busniess Journal’s rountables on August 23, 2007 and July 18, 2006.

Please contact our office at (919) 851-8200 for a copy of the full article.

Paid subscribers of the Triangle Business Journal may click here to access the full article through their website.

Back in March, many investors were wrestling with the emotions of wanting to preserve whatever money they still had.  Generally, this thought process involved convincing themselves that cash or CD’s were safer investments than stocks.  Using a little hindsight, those decisions to move into “safer” investments, do not seem as appealing after a 50% increase in the S&P 500 index since then.  This type of behavior is a classic example of the typical mistakes that investors make at turning points within the markets.  In a recent Wall Street Journal article, “Playing it Safe Can Hurt Returns,” you can see examples of how impulsive moves to safe investments can negatively influence your investments.

There are two primary types of client relationships in the world of financial investments.  The sales model represented by brokers versus the fiduciary model represented by Registered Investment Advisors.

The following is a good example of the pitfalls of the sales model:

CIT Debt Sold to Widows Has Fine Print Pimco Resists

Notice that FINRA, the self regulatory authority for brokers says:

“….it’s investigating whether the risks associated with the securities were adequately disclosed.”

Well here is an example of so called disclosure:

CIT Group Inc. Prospectus Supplement

It is our opinion that it is ridiculous to expect most Americans to be able to adequately interpret 72 pages of “disclosure” (and this is only the supplement to the initial disclosure document).

Yet the world of FINRA regulation provides the framework for a Prudential spokesman to proclaim:

“As with all bonds, investors choosing to sell the notes before maturity may sell them at market value to other investors and face certain risks, which are fully disclosed at the time of issue…”

In other words, buyer beware.

The inherent problems and conflicts of interest with the sales model is why we choose to operate as Registered Investment Advisors.  Our regulatory framework is the Investment Advisors Act of 1940, which requires that we act in our client’s best interest.  We believe this is the best framework for client relationships.  The SEC is responsible for supervision under the Act, and they have unfortunately been underfunded for the last several years.  We hope that will be corrected as we feel more of the public should be served by Registered Investment Advisors.

All data is not created equal.  The following chart would seem to indicate
that US stocks are more expensive and overvalued then they’ve ever been.

http://www.chartoftheday.com

The rest of the story is that the last 12 months of earnings are not
representative of what earnings will be going forward.  Our best estimate is
that at current price levels, the PE ratio is actually around 13 to 17.  Most
definitely not the most expensive market in history.

Much of our research effort involves separating good data from bad data,
which is essential to gain and maintain a competitive edge against other investors.

Summary written by Financial Symmetry’s Bill Ramsay.

Hyman Minsky was an economist who developed a theory about financial markets that seems to nearly perfectly describe the path of this crisis. In fact he wrote extensively about it in 1986, right before Greenspan became our Fed chairman. It is too bad that Greenspan apparently hadn’t read Minsky or didn’t put enough weight on his teachings or the problem might not have become so large.

Currently there are countless descriptions, speculations and rantings about the causes of the financial crisis and what should or should not be done. Many are good. Many more are bad, often due to ideological beliefs and/or lack of understanding money and financial systems.

The following article is perhaps the best I have read so far. It comes from Paul McCulley of PIMCO. In it he describes how Minsky’s hypothesis applies to the current crisis.

Enhancing your financial security in a tough economic environment

When there is snow on the ground, you can’t see the bulbs that will bloom in the spring. But you’ve seen the flowers before and know that they will bloom again.

We certainly have a lot of snow and ice covering our economy right now. But we’ve seen businesses flourish and know that they will again. No one can say with certainty when that will be, however we do know that the financial markets turn up well before all the snow is gone.

However, most of us do need to reevaluate our financial plans, as we are now less wealthy than when this recession began in late 2007. This means looking for ways to improve our financial positions by analyzing net worth and cash flows, as well as their interaction. In doing so there are four main areas of focus:

• Income
• Expenses
• Debts
• Investments

Income

Generating income allows you to add more to your net worth either through additional savings or debt repayments. If you are currently withdrawing funds from your net worth, having additional sources of income allows you to withdraw less.

Expenses

Expense reduction is one area that you probably have the most control.

You should pay particular attention to expenses that are the lowest priority for you. One example is having both a cell phone and a landline. Many people are choosing to eliminate their landline. Going to restaurants less often may be another place to cut that’s relatively painless.

Also, by calling your cable company, you could lower your monthly bill by $15-20 a month if you mention more attractive deals their competitors are offering. Everyone’s priorities are different, so it is important to consider which activities, goods, or services are most meaningful to you when evaluating where to trim expenses.

Debts

Reducing the cost of your debt means looking to have the lowest interest cost after taxes. Mortgage rates are now near 5%, and since they are tax deductible the after tax cost for most people is under 4%. Transferring money from investments to pay down debt will only enhance your long term financial position if the interest rate on your debt is higher than your future investment returns.

Investments

The final area to evaluate is investment strategy. Earning higher returns will enhance financial security, while earning lower returns will not. Because investors have experienced losses in their investments since late 2007, many people fear that investments will not provide them good returns in the future. However, it is important to look at various options for your investments not based on what they have done in the recent past, but based on how they are likely to do in the future.

Primary Assets

Broadly speaking there are three primary assets classes that can be held:

1) Cash

Cash options range from US Treasury bills to bank CDs. The interest rates on cash are currently around 0.2% to 3% per year. While any positive return over the last 1 ½ years would have been preferable given the drop in stock prices, clearly earning 3% or less per year is not likely to be a decent long term return.

2) Bonds

There are many different types of bonds, with US Treasury bonds being considered the safest. Current interest rates are in the 1-3% range, so like cash, this is a poor long term bet.

Treasury Inflation Protected Securities (TIPS) bonds look a little better to us, as they earn a stated interest rate plus the inflation rate. Because at this point deflation is the greater fear, the federal government is likely to do everything possible to have some inflation. So we think inflation protected bonds are likely to average around 3-5% over the next few years.

High quality corporate bonds are currently yielding about 6.5%, and we think their return will be somewhere between 3-7% over the next several years.

Low quality corporate bonds are in some cases yielding close to 20%, however the risk of bankruptcy which would cause principal losses possibly exceeding any interest paid makes us hesitant to commit substantial funds here.

3) Stocks

One of the most significant ways to measure the long term opportunity in the stock market is to look at the total value of the stock market relative to the size of the economy.

The best measure is total stock market capitalization as a percent of annual GDP. The lower the ratio the better the long term opportunity, while a higher ratio indicates less opportunity. That ratio currently stands at about 54%. To get a sense of how the stock market has performed from similar periods, the 1970’s and the 1930’s offer some insight.

Lessons from the Past

By late 1974:

• the economy was in recession and under extreme stress due to the oil embargo, high inflation and a crisis of confidence in the United States
• the stock market had declined significantly and the market cap to GDP ratio was the same as now, about 54%
• One year later the stock market had gained over 30%, and averaged 12% per year over the following six years.

By late 1931:

• the economy had been in recession for almost two years
• the stock market had declined significantly
• the market cap to GDP ratio was the same as now, about 54%
• One year later the stock market had declined 34%. However, it still averaged a positive 11% per year over the following six years.

We know that no two market conditions are the same, and this one is not going to exactly match either the 1970’s or the 1930’s.

However, we do have to consider that either one of these outcomes is a possibility. We are seeing a much more proactive government now then in the early 1930s, so we think that a depression outcome is a low possibility. Interestingly, in either case returns were strong over a six year period. In fact in both cases the four year average annual return was about 11%.

So, you can see that we should be optimistic for stock returns for the medium to long term, but we should also have contingency plans in case the shorter term continues to be poor, as you don’t want to be forced to sell while prices are low.

Strategic Planning

What does this mean in terms of strategy?

Given the potential for high returns on stocks, we should be allocating as much as is consistent with your risk capacity and tolerance.

Given the uncertainty of short term returns, it also means ensuring that short term cash flow needs are met — either through current income or an appropriate cash allocation.

Our Risk Capacity measurement is a conservative approach as it recommends a lower stock allocation if you are withdrawing funds from your investments.

For example, if you are withdrawing 5% of your funds each year, then 65% is a good maximum stock allocation, which means 35% or roughly 7 years of withdrawals are in cash and bonds.

If, on the other hand, you are withdrawing 10% per year, then 45% is a good maximum stock allocation, which means that you would have over 5 years worth of withdrawals in cash and bonds.

So what should you do?

If you are adding money to your investments, you should not be forced out of stock positions, and we hope that understanding the longer term opportunity will help you not to be scared out.

We do need to know if there is likely to be a change to your investment cash flows, as it can affect your allocation strategy.

If you are a Wealth Management client, we are tracking your cash flow and regularly updating your forecast to see if we need to make adjustments.

For our other clients, we have been sending worksheets showing your investment cash flows for the last several years and ask that you try to estimate what you think they may be going forward.
We’d also be glad to help you create a forecast or upgrade you to Wealth Management where we will maintain a dynamic forecast that takes into account your recent cash flow patterns.