There’s an old Chinese curse that says, “May your children live in interesting times.” Is it panic time? Has the world changed? Is this a new paradigm? I won’t pretend I can predict how this economic downturn will stack up against ones we’ve seen before. But I do have a few observations.
First, markets are, certainly, erratic—but they’re working. I believe they’re always moving toward equilibrium. For that to occur, prices have to be set, securities must be bought and sold, and trades clear. All that is happening pretty smoothly around the world, despite the anguish sellers are suffering with sharply lower prices. Markets often don’t get pricing right in the short run. That’s the nature of measurable risk. A few statistics might help.
For 17 years (January 1965 to December 1981) the returns for the S&P 500 Index and the one-month T-Bill were both about 6 percent per year. There was a lot of pessimism about equity markets. However, there’s no sensible risk/return story to explain why stocks should have a zero risk premium. Certainly nobody predicted that the following 18 years would perhaps be the best period ever for U.S. stocks.
From January 1982 to December 1999, the return for the S&P 500 Index averaged 18+ percent per year and the one-month T-Bill was still about 6 percent per year. People were too optimistic, since we think the S&P 500 cost of capital should be about 10 percent per year. When you get 18 percent on S&P 500 stocks, you should enjoy it, but certainly not count on it in the future.
From January 2000 to September 2008, just under nine years, the return on the S&P 500 is almost flat, and one-month T-Bills are returning about 3 percent per year. Again, a zero return premium for stocks isn’t the market expectation.
This brings me to my second point: Because it’s impossible to predict markets, diversification is critically important. I use index type mutual funds to help implement my asset allocation strategies, because they’re broadly diversified and not concentrated in individual companies. As a result, although my portfolio has been affected by declining stock prices, I’m nowhere near the crisis that has affected many others, nor are most mutual fund companies suffering the kinds of financial reversals that other financial institutions may be experiencing.
Finally, yes, this time is different. This is a liquidity crisis and will eventually affect all areas of our economy, even though the whole thing was caused by—and has only yet affected—about 20 percent of our economy (by market capitalization). Many challenges will need to run their course. A liquidity crisis tends to feed on itself. There will be a huge amount of deleveraging. All levels of government are experiencing big budget defects and they’ll have to raise taxes.
Meantime, countervailing forces are beginning to form. Lower oil prices will help restore consumer purchasing power. The launch of government and private initiatives will deal with the liquidity issues. Hopefully, the world’s central banks will lower interest rates and enhance liquidity to combat slowing economic growth now that inflation threats are rapidly receding. The SEC has lowered margin requirements and prevented some short selling. And most money market funds continue to maintain a $1 net asset value, and have limited exposure to Lehman Brothers, AIG or Washington Mutual.
As provocative as today’s headlines may seem, they’re not unique. The failure of well-known financial institutions during market dislocations is actually quite common. History offers abundant evidence that market economies are resilient. The world will find a way to manage its financial affairs.
One of the biggest mistakes people make is failing to keep their heads. If I’d predicted in January that home prices would fall up to 30 percent; that oil would exceed $150/barrel; that gold would approach $1,000/ounce; that Bear Stearns would go belly up; that Fannie Mae and Freddie Mac would implode; that Lehman Brothers would become the largest bankruptcy in history; that Hedge fund losses would be the worst in 15 years; that Russia would invade Georgia; and that Countrywide Mortgage would be taken over by Bank of America—all by September 2008—my guess is you’d have estimated the market should be down 40 percent or more as opposed to the 25 percent or so it’s actually down (as of September).
What can you do now?
FDIC insurance protects assets in banks up to certain limits, so title accounts and CDs accordingly and move assets to other institutions to keep them under the limits. Also, CDs are insured up to $250,000 per individual, and many are offering higher interest rates right now than U.S. Treasuries. But U.S. Treasury bonds are secure—the government can always print more money to pay off debt. And firms like Schwab and Fidelity aren’t investment banks, but more like holding companies for your assets. They also carry a significant amount of insurance.
What have you most likely done already?
More money is lost in the markets by those trying to anticipate moves in either direction than by those who stay the course. But if you’ve concluded you took more risk than you had the “stomach” to take, then you should not perpetuate that mistake, and should lower your risk profile.
Remain true to time-tested portfolio management disciplines that have guided markets through difficult times before. Continue significant diversification among and within asset classes as the best protection against overwhelming losses.
Alas, there are no guarantees on Wall Street. All you can do in these challenging times is take advantage of the resources and information and make rational decisions about your investment portfolio.
Irv Rothenberg, CPA/PFS, is the managing principal of Wealth Management Consultants, LLC in Santa Rosa. The office has been located at 3550 Round Barn Blvd., Suite 212, for the last 20 years.
Contact him at (707) 542-3600 or irv@wealth
