February 24th, 2009
Dear Clients & Friends:
It Is Scary
It’s hard to know where to start. To say the market has been deeply troubling since last October would be a gross understatement. Everyone, and I mean everyone, has been financially devastated by the vicious erosion of financial asset values. The collapse of housing values and mortgage defaults has not only decimated the housing market, it has resulted in trillions of dollars in losses to banks around the world. Playing no favorites, the related stock market fall has further eroded the financial resources of individuals and major institutions. For example, the Harvard endowment fired 25% of its staff after reporting a 22% loss from June to October (twice the prior biggest loss in 1974) and that’s just prior to the big subsequent market selloff. And, as you well know, it’s not just the institutional gorillas who are suffering.
Everyone’s portfolio values are down significantly. I don’t have to review your portfolio to know you’ve taken a significant loss. As an entrepreneur, my personal equity investments are primarily my business, my IRA, and our pension. For the last year our firm’s pension plan (heavily equity oriented) is off over 30%, my IRA (100% in the Russell 3000) is off almost 50%. My “safe” municipal portfolio (managed like our clients by Thornburg) has barely managed to break even. There is much pain and concern amongst investors around the country right now, and we understand, because we too are experiencing the pain and concern.
How do I feel? Probably like you and every other investor in America: frustrated, concerned, and even angry. I also know that many of you are more than concerned--you’re frightened. I wish I could say it’s silly to be scared. Unfortunately, with some of the most dramatic market losses in living memory, I can’t. It is scary.
Before I continue, let me forewarn you that much of what I have to say is a repetition of things I’ve written over the years. I make no apology as the recent market volatility has not changed our fundamental beliefs regarding good investment practice. In fact, we believe that it is our sticking to good practice (and common sense) that is the core of the significant value we bring our clients.
Optimism?
Déjà vu all over Again
I obviously started my letter on a down note, so where on earth might anyone find something “optimistic” to talk about? Well, I’ll begin with the paragraph above beginning “How do I feel?” Although it certainly sounds contemporary and accurately reflects my thoughts today, it is straight out of a letter I wrote in October 2002.
By March of 2003 the world didn’t look all that much rosier and I wrote, “…in the midst of a schizophrenic world where the bulls are cautious and the bears are optimistic. The market is more volatile than any time since the Great Depression. The most popular expression today is Geopolitical Uncertainty - GU (the modern version of the Chinese curse “may you live in uncertain times”). Last week, even the Fed effectively gave in to the cult of GU, noting that it would hold rates steady because, given all the uncertainties surrounding the Iraq situation, policy-makers could not assess the risks on the economy going forward. All of this is exacerbated by the run up in oil prices as a result of the recent problems in Venezuela—a $5 to $10 war premium. Uncertainty has effectively put a hold on corporate America – 1
inventories are being whittled down, employment held steady or reduced, and capital spending all but frozen.”
Looking back only to last September I wrote about our concerns regarding the shilly-shallying of the politicians,
“We think that after our Representatives finish gorging themselves on pandering to the media and electorate they will finally agree to a compromise bill fairly similar to the one rejected on Monday. However, based on the original rejection, we’re less naïve than a few days ago and recognize that they may continue fiddling as the markets and economy continue to suffer in a fog of uncertainty. Should that happen, recovery may be slow in coming. As miserable as that will be (and it will be) the important element of that belief is “we will recover.” We have absolute confidence in our economic system and the American people. As I told many of you, we’ve managed to survive World Wars and lots of others, Black Monday, prime over 20%, the Savings & Loan implosion, Presidential assassinations, 9-11, Tech bubble, and more. This too shall pass; albeit, far more painfully than necessary if Congress doesn’t act. If we’re wrong and the World does permanently come to an end, there will be no safe harbor so we’re not spending any time planning for it. “
I consider these echoes from the past optimistic because they so clearly demonstrate that although this time the causes may be different, from a fundamental standpoint, we’ve “been there done that” many times in the past. We haven’t changed our belief one iota. We have absolute faith that we will recover and our planning is based on that belief.
Recover? Really?
Everyone needs to decide for themselves if they too believe in “recovery.” Why do we believe that you should? Primarily, because in spite of the scary headlines, the world has not really come to an end. Consider what you actually own. Our largest stock position (representing about 50% of the stock portion of the portfolio) is the Russell 3000 i-Share. From early October 2007 through Friday 2/20/2009, that investment was off about 50%. That’s a staggering loss by anyone’s measure. If it represented the share of a single company, it might be a major warning sign of impending bankruptcy. However, it does not. Rather it represents ownership of the U.S. economy. The reality is that “Russell 3000” is only a name. What’s really in the portfolio and what you own are very small investments in almost 1,500 companies.
Based on a $1,000,000 investment in the Russell 3000 i-Share, even the largest positions (below) represent very modest investments in any one company.
Exxon $43,800
P&G 19,300
General Electric 17,700
AT&T 17,600
J&J 17,500
Microsoft 16,200
Chevron 15,900
Wal-Mart 13,100
Pfizer 12,400
JP Morgan 12,100
IBM 12,000
WellsFargo 10,160
And smaller amounts in another
1,500 or so firms.
In terms of valuation, according to JP Morgan’s weekly update, as I write this letter, 31% of S&P 500 companies and 58% of MSCI EAFE companies are trading at less than 1 times book value
Granted, over the next few years, something disastrous might happen to a few of these thousands of companies, but I believe you need not lose sleep at night worrying that they will all go belly up.
Great Depression?
If not optimistic at least I might persuade you not to be too pessimistic.
Are we in the midst of our own Great Depression? Not even close. How do I know? First, take a look at the following statistics (From Payden & Rygel’s First Quarter 2009 “Point of View” report):
I could provide even more statistics that would demonstrate that our economy is significantly stronger than during the Great Depression; however, for me, the most persuasive reason was a chat with someone who was around at the time. A few weeks ago I was on the phone with a long time client, a very sharp gentleman in his 90’s. When I said something about how many commentators were drawing parallels between the economy today and the Great Depression, he fumed, “Harold, that’s nonsense! I was a kid during the depression and I remember it well. One night my parents went to bed with money in the bank, the next day they woke up and there was no bank and no money! Today not one person has lost a penny in their bank accounts! Not only that, unemployment was running in the 20 – 30% range. Today we worry that it may reach 10% or 11%. It is certainly bad out there but it’s no Great Depression!”
Suppose for the sake of argument we assume that if not a Great Depression that we’re in the midst of a mini-Great Depression. What might that mean for investing today? There is an old Wall Street saying that the time to buy is when there is blood in the street. Why would such a miserable environment be a time to buy? For an answer I’ll reprise a story I wrote about last July. Jason Zweig (formerly of Money) made his maiden contribution in his new role as The Wall Street Journal’s personal finance columnist. His column, The Intelligent Investor was titled “Stop Worrying, and Learn to Love the Bear.” Subtitled “Take It From Graham and Buffett”
“These Miserable Markets Are a Gift From the Financial Gods,” Jason quoted Warren Buffet, “If a stock [I own] goes down 50%, I'd look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month." Jason went on to say, “Knowing he owns good businesses, Mr. Buffett wants prices to go down, not up, so he can buy even more shares more cheaply before the bounce back…painstaking investors -- literally, those who can take the pain of a bear market that seems to drop another 1% every day -- will ultimately triumph, by patiently amassing greater and greater equity positions at better and better prices.”
Turning back to the Great Depression, take a look at how investors fared. It lasted 110 months from August 1929 to June 1938. The bottom was somewhere around 1933. Any idea what returns were that year? 54%! That right, your eyes aren’t failing you. The return was +54%. Subsequent returns were:
1934 -1.4%
1935 47.7%
1936 33.9%
1937 -35.1
1938 31.1
Certainly no guarantees that we will see anything like that in the near (or even long) term; however, market history suggests that indeed the best investment opportunities are when the markets seem at their worst.
In spite (or perhaps as a result of) the flood of negative news, professional investors and economist continue to see light at the end of an admittedly long tunnel. A recent example was reported in the newsletter of my friend, Ben Tobias (Ben’s Banter). Ben is a nationally respected planner based in Plantation, Florida and he wrote his thoughts about an industry wealth management conference he had recently attended in Las Vegas.
I attended numerous sessions where economists, albeit with one exception, thought that our markets are currently braced for a rebound and one of significance. Charts and figures were brought out from previous market downturns and recessionary periods, as well as analyses from the current period. It looks to many that we have either already seen the bottom of the market on November 20th [just about
where we are today], or, if we have further declines, that the markets should not get much worse than what we saw at that time; this is a view with which I whole heartedly agree. Interestingly, the absolutely awful news that we have been hearing about the economy during December and January, was one of the main reasons why the group is so bullish – this type of news during “normal” times would cause the markets to take a nose dive; thus it seems that the markets are probably undersold. Again, it is important to point out that even with these predictions about a market rebound, it was felt that this recession will be the longest lasting and most severe recession since World War II.
Why would experts like Warren Buffet and the economist Ben listened to seem to get more optimistic as the news darkens? Because the deals get better. How so? Having survived the carnage, today you own America at 1997 prices. The market may go down, possibly a lot, over the next few months or even years, but do you really believe that owning America at 1997 prices is likely to be a big risk when you need some of that money five years or longer from now (remember our 5 year mantra)? I don’t think so. If I am wrong, it will only be because global disaster has overwhelmed the world. I don’t believe there is much planning anyone can do for Armageddon.
What Not To Do
Soon I’ll tell you what we’re doing and what you should be doing, but first I want to talk about what not to do.
Don’t Buy High and Sell Low
We recognize that it’s tempting to say “I hear you, but I’m just going to get out of the market until things cool down, then I’ll get back in when things look better.” We’d like to do the same. Unfortunately, that takes two correct guesses. Not just when to get out, but when to get back in.
One day someone may successfully time the market, but to date, over the last 100 or so years, no one has yet done so. If you doubt me, I challenge you to name the 10 best market timers of all time. How about the 5 best? The one best? No one can name them because they don’t exist.
The catch is, markets move back up just as quickly as they move down, so those attempting to market time will ultimately join the tens of thousands of other failed timers and end up selling low and buying high. Below is a chart I know you’ve seen before but the lesson is still valid.
The next chart is an eloquent measure of how successful investors have been in their effort to market time. It’s based on a study that compared the returns of investors in stock funds to the returns earned by the funds; i.e., how would an investor have fared had he placed his money with the manager and left it there for the duration. The “Investor Behavior Penalty” of 7.1% is a result of investors’ unsuccessful market timing. Rather than buying low and selling high (the theory), they bought high and sold low (the reality).
How about if you’re willing to miss a little of the recovery by sitting on the sideline until a recovery is well established? You might not be comfortable with a 10% or even a 15% recovery in order to feel confident that the risk is past but 20% should provide plenty of protection. Wrong. The Dow closed at 7552 on November 20, 2008. By January 2, 2009 it was up to 9034 – or about 20%. It just closed last Friday, February 20 at 7365 – or a loss of about 18.5% since Jan 2. Just another example of how attempting to market-time is perhaps the fastest way to sell low and buy high.
To put timing in perspective of today’s markets, here’s an interesting bit of recent history from the 4th quarter review of Bruce Berno, a Cincinnati, Ohio practitioner.
Finally, a chart that may help you remember how you and your friends and the media tends to react as we go through these economic cycles and demonstrates why we make the investment mistakes that we do.
Don’t Confuse Certainty With Safety
When it comes to the market, there is no true safe harbor. The risk that comes with the equity markets is well documented and readily evident in times like these. As a result, some investors flee to the certainty of fixed income. However, bonds are subject to both credit risks and interest rate risk; if the world goes belly up, bonds go with it. If rates go up you’re stuck with a bad deal until maturity. In fact, we believe there is a better chance of losing money over the next few years in longer maturity bonds than in stock. Finally bonds are subject to inflation risks. Investors confuse certainty with safety. Bond returns may be certain, however historically, inflation erodes the real value of the investment. It is poor consolation to get all of your money back in 10 to 20 years only to discover that the $10,000 from your maturing bond barely gets you a Happy Meal at McDonald’s (admittedly an exaggeration, but you get my point).
Unfortunately, for most investors, we find that if we were to move to bonds, once we factor in inflation and taxes, the only way they are likely to be able to maintain a lifetime real cash flow is to significantly reduce their standard of living. We don’t consider that a very “conservative” solution. The moral? In planning for your retirement needs, don’t confuse Certainty with Safety. An all bond portfolio may provide you the certainty that your principal will remain stable; however, it most likely will also insure that you cannot maintain your standard of living. There is no single safe investment. The most an investor can plan for is a reasonably safe portfolio based on balancing the principal preservation attributes of bonds with the growth potential of equities. In other words, for investment safety, diversification continues to rule. Safety = Good Planning
The following chart is a summary of a study done by T. Rowe Price. Using Monte Carlo simulations, the study estimated the likelihood of long term success of an investor following three different strategies after suffering significant losses in the recent bear market. Option 1 simulates the results for an investor who continued taking his planned withdrawals but did not increase them for inflation; Option 2 reflects an investor who continued to take inflation adjusted withdrawals and Option 3 simulated the results for an investor who ran for “safety” and switched to bonds at the bottom of the market. With the major caveat that this is simply a simulation and no guarantee of actual results, the point is that switching today to bonds may very well be the riskiest action anyone can take.
T.Rowe Price also considered the alternative of moving to cash by looking at the relative performance of remaining in stock at the bottom of the last market melt down (9/30/02) versus moving to cash. The results are below:
Don’t Fall For the Pot of Gold at the End of the Rainbow
Remember Madoff and Stanford. There are no free lunches and if anyone really has “the answer” they wouldn’t waste their time trying to sell it to you. They would simply follow their own advice and would soon own the free world.
Worry About the End of the World
I obviously can’t guarantee that it’s not upon us. I can however guarantee that there is no investment that will help in that event. If you expect a global meltdown but that humanity will survive, then you might consider gold, but only the real thing (e.g., Maple Leafs or Krugerrands) and don’t let anyone know you have it or where you keep it. In a meltdown world holding a piece of paper that says you own gold will be the equivalent of holding a worthless promise.
If your world view is even darker, you might visit www.the-end.com. Developed by a Mr. Weinland it offers the “answer” along with a free copy of his book 2008 – God’s final witness in which “…revealed in this book…detailed accounts of the final three and one-half years of man’s self rule on earth… Some of these prophecies concern the demise of the United States over the coming year, which will be followed by man’s final world war… billions will die! This time will far exceed even the very worst times in all human history.” I must admit, this is not a contingency we plan for.
What Do We Believe?
Pretty much the same thing that all of our more thoughtful friends, academics and professionals around the country believe. Namely, we will eventually work our way out of this miserable recession and the only
way to earn market returns over time is to be in the market. Here are excerpts from recent letters by professional friends we respect and a few comments by respected money managers.
Dave Yeske, San Francisco
We're also not seeing something unprecedented, notwithstanding the media's tendency to sensationalize. Government has intervened again and again in the past, as was the case with the resolution of the savings and loan crisis of the 1980s and 1990s (as I noted in a previous email). And this market decline, while on the high end, is also not the largest I've seen. This is, in fact, the fourth time in my adult lifetime that the Dow has declined by more than 30% (the Dow is currently down 39% from its recent highs). Consider the following list:
Ending Date Decline
Feb 2003 (49.1%)
Dec 1987 (33.5%)
Oct 1974 (48.5%)
The average gain over the 24 months following each of these three declines was 47.7%. And that's probably my main point: we could wish we hadn't experienced the declines of the past year, but we are where we are and what we have to focus on now is whether the future holds a greater probability of loss or gain. Based on both historical precedent and the visible dynamics at work in the world economy, I believe that by far we now face more upside than downside.
Ross Levin, Minneapolis
We think stocks are cheap for a number of reasons:
- According to Leuthold Group, stocks are currently trading in the third decile. While they could fall to the first or second decile, this still makes stocks very reasonably priced;
- The yield on the S & P 500 is twice what it was at the market top of March 2000 while the ten-year Treasury is yielding only 60% of what it was paying back then;
- Volatility is at the level that we typically see close to bottoms. Volatility is at the level last seen after the crash of 1987;
- Central banks world wide are banding together to put liquidity into the system;
The net outflows from stocks have been significant. This usually signals we are close to bottoming;
The market will not come straight back though. When we have strong days, fragile investors will want to sell and move into “safe” investments. This means that it will continue to be volatile, even though I believe the long-term trend is upward.
Mark Freedman, Boston
We believe that the belated steps that Congress, the Federal Reserve and International leaders are beginning to take will help, but it will take time. We could be wrong, however, and if we are the steps that we have taken will have limited value. As you all know, Leslie and I take the stewardship of your assets, your dreams and your future seriously. We are honored by the trust that you have placed in us and have been deeply appreciative of the support that you have given us. We have worried and fretted, and yes have been a bit scared. We believe that we will get through this and if this is anything like the past, it can be a great opportunity in the markets.
Marty Whitman, Manager of the Third Avenue Fund
If my planner friends sound marginally optimistic, they don’t hold a candle to some well respected money managers. Mr. Whitman, a professional investor for over 50 years and one on the nation’s most respected managers recently quoted in the New York Times, “This is the opportunity of a lifetime. The most important securities are being given away.”
Ken Heebner, Manager of CGM Funds
In the same Times article, Mr. Heebner, who is described as “a mutual fund manager who has one of the best long-term track records on Wall Street” says that the sell-off has gone much too far and stocks are poised to rally powerfully if the downturn is less sever than investors fear….Mr. Heebner expects world economies to contract over the next year. But he said the market plunge in the last week [early October] was no longer being driven by rational analysis. Stocks are probably falling because of a combination of panic and forced selling by hedge funds that must meet margin calls from their lenders.
What Are We Doing?
All of our clients are familiar with our five year mantra (“5-years, 5-years, 5-years). For any reader who is not familiar (or you forgot) it’s simply a reminder that we believe the greatest risk of the market is having to sell at the wrong time. In our planning we’ve already carved out adequate liquid reserves in money market funds and short term bond funds separate from your investment portfolio. However, given the political uncertainty and the potential for continued market volatility exacerbated by that uncertainty, we recognize that the markets for the next few months to next few years may be rocky. We continue to maintain a significant liquidity exposure.
That’s our response to short term concerns - how about long term? As I said earlier, we have absolute faith in the survival of the American economy. I’ll now add that we have every faith in global investment markets’ long term robustness. That means we believe the current panic selling is likely to be the precursor to one of the best buying opportunities in decades. As a consequence, we will continue to follow our investment policy. However, we recognize that, no matter how fundamentally and intellectually sound our investment actions may be, we also recognize that this is a very scary time and you may feel that some more proactive action is necessary. As we are financial planners, not money managers, we believe that emotion is an integral part of the investment equation therefore we have modified our rebalance process and we have developed a number of different strategies to partially hedge against an continuing bear market.
Rebalancing Policy
Our current rebalancing policy is triggered automatically when the portfolio investments move past the criteria set by your Investment Policy Statement. The investment Committee has temporarily modified that policy to provide for a client’s approval prior to rebalancing. Should you not wish to rebalance, we will develop a new Investment Policy to reflect the higher fixed income allocation. Should we do so, it is with the understanding the new policy will remain in effect even after market recovery.
Hedging Alternatives
Option 1 – Over the next few weeks we will determine the level of interest by our clients and, if there is adequate demand, we will structure with one or more banks the design of a structured bond to provide a 15% buffer against future market losses. This investment will be used as a replacement for a portion or the entire current core holding in the Russell 3000 position. Based on preliminary pricing with a high quality issuer, the investment would provide the market return over a 13 month period as measured by a change in the S&P 500 index (not including dividends) up to a cap of 23% and protection against a loss of up to 15% (again, this is an estimate based on current market conditions. In the volatile environment of today, the final offering may be significantly different).
Option 2 – We will liquidate a portion of the Russell 3000 position to purchase a position in the Rydex Inverse 2X S&P 500 fund or ETF (RYTPX/RSW), a no load fund designed to provides a return of approximately 2 times the LOSS on the S&P 500. That is, if the market is down 10%, the investment will provide a return of approximately 20% less the cost of the investment and dividends (approximately 1.75%/year). Of course if the market is up 10%, the investment will lose approximately 20% plus the cost of the investment.
Option 3 – For those clients who wish to maintain a full market exposure but would like to exclude specific market sectors that they believe remain more vulnerable, we will purchase (if available) positions in investments that short those specific market sectors. The result would be to cancel out the sector exposure in the portfolio.
Option 4 – Although expensive, we can implement a hedging strategy based on the purchase of Put options on the S&P 500. This would provide dollar for dollar protection for loss on the S&P 500. As of today (23 February) the approximate cost would be:
Protection Through Approximate Cost
May 2009 9.2%
September 2009 13.3%
December 2009 15.2%
June 2010 18.3%
Option 5 – A permanent change in your Investment Policy to reduce market exposure and increase your bond allocation. This is likely to be the most risky alternative to your plan’s long term health and requires that we update our MoneyGuide planning to determine the likely impact on your future income.
The important caveat to these options is that “We do not recommend them!” We continue to believe that your current investment policy remains appropriate and that should we implement any of these options the result is very likely to be a long term reduction in your portfolio returns. However, if you consider this risk a reasonable cost for implementing some form of hedging, we will work with you to incorporate it into your portfolio.
Communications
In addition to this letter, we will continue to proactively be in touch with you via emails, newsletters, market updates, quarterly reports and phone calls. In fact our next conference call is scheduled for March 10th and Lane, Matt and I will be chatting with Dr. David Kelly, Managing Director and Chief Market Strategist for JP Morgan Funds. If you’ve not listened to our past calls, you can find the audio files (as well as all of our letters and updates) on our web site www.evensky.com.
I know this is once again a long missive, unfortunately I don’t know any other way to address all of the important issues and concerns raised by the current market environment. We will be calling you in the next week or so to follow up and see which, if any, of these possible strategies you might like to consider. We will also be calling to encourage you to set a time to meet with us to update your MoneyGuide. We can’t predict tomorrow’s market returns nor can we influence its direction; however, with your help, we can assist you in determining what if any adjustments you might consider making as we all work our way through the next year.
I’ll close with a final thought and another excerpt from one of my earlier letters.
We are deeply appreciative that this is your money and that it is your lifetime of hard work that has put this together. As we’ve told you we not only provide advice, we provide judgment and that is what is reflected in this letter. However, we understand that ultimately the decision is yours, hence our proposing options for your consideration.
As for our judgment, here’s (from my October 2002 letter) what we’re telling you to do:
“EAT YOUR BROCCOLI.”
I know no one likes to be told to do things they find unpleasant. It matters not that the experts say “it’s good for you.” Medical experts understand this, but they continue to repeat their mantra for health. We’re doing the same; in this case, “eat your broccoli” translates into our old familiar refrain to “stay the course.” We know this advice is unpleasant, so we offer it with a heaping spoonful of sugar: namely our knowledge, expertise, resources, judgment, and most important, our care, concern, and ears. As always, please don’t hesitate to give us a call even before we reach you.
Cordially Yours,
Harold Evensky, CFP®
President
Please remember to contact Evensky & Katz if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure statement discussing our advisory services and fees continues to remain available for your review upon request.
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