ProVise Management Group, LLC, an SEC Registered Investment Advisor

PROVISE BULLETS ©

(December 31, 2008)

• The bear market of 2008 was not unprecedented even though the Dow, S&P 500, and NASDAQ were down 33.8%, 38.5%, and 40.5%, respectively and had a significant amount of volatility.  In 1931, the last time the market was down this much during a calendar year, the Index fell 43.3%.  In the five years following 1931 (1932 – 1936), the S&P 500 gained 176% for an average annualized return of 22.5%.  Obviously, there is no assurance or implication that this type of return will occur over the next five years, but history has shown that the more the market declines, the higher the rebounds tend to be.  (Source:  BTN Research)

• Almost without exception, everyone is delighted to see 2008 come to a close and have their eyes focused on the future as we begin 2009.  2009 is the last year of the first decade of the 21st century, and it has been a decade fraught with pitfalls.  We’ll save that story for this time next year when we review those significant events, both from a historical and monetary standpoint.

Having said that, let’s look at where we were nine years ago as we rolled through Y2K leaving 1999 behind us.  By any measure, the U.S. economy and stock markets were booming along with other world markets.  By March 2001, however, we entered a downward spiral in the economy and the markets.  This was punctuated by September 11, 2001, but to the surprise of most people, the spiral continued for a third year and did not end until October of 2002.  During that period of time, many of the markets fell from their exuberant highs to almost half of their previous values.  In the case of the NASDAQ, this fall was even greater. 

During the last half of the ‘90s people began to feel very wealthy because of the size of their stock portfolios.  They were feeling the “wealth effect”, as it is referred to by economists.  What difference did it make if you spent $100 on a bottle of wine for a casual dinner, or stayed in a Ritz Carlton hotel room that cost $1,000 per night?  The portfolio had increased at a rate of 20% a year or more for the previous four years, and in 1999 alone the NASDAQ almost doubled in value.  When people “feel” wealthy they have a greater tendency to spend more money for the same goods and services.  Is it really necessary to stay in the $1,000 per night hotel room and buy that $100 per bottle of wine, when something which costs one-third or less would probably be more than adequate for most people? 

During the 2000 through 2002 bear market people learned to make do with less, and even though a lot of people kept their jobs and their day-to-day lifestyle really didn’t change that much, they “felt” less wealthy.  Thus, they experienced a “negative wealth effect” which caused the economy to contract during that period of time.  In order to spur some economic activity, the Federal Reserve Board under Alan Greenspan’s chairmanship began to lower interest rates culminating with a rate of 1% which remained at that level for an extended period of time.  At this point, consumers began to appreciate the “value” of borrowing money.  After all, if you could borrow at such low rates and invest somewhere else, it seemed you could potentially make a significant amount of money.  While the stock market began a five year recovery in October of 2002 through October of 2007, it was during 2003 that we saw a dramatic increase in the stock market.  The other four years were positive, but often struggled to earn reasonable returns. 

Thus, many investors turned to real estate, leading to the real estate boom which created yet another, but different “wealth effect”.  Homeowners borrowed against the rising equity in their home to make purchases and do things.  Investors were indiscriminately buying real estate, not with the intention of living in it, but to flip it and make a profit.  In the beginning, this concept worked.    Once again, rather than being conservative and buying a $25 bottle of wine, people began to “feel” wealthy and became financially exuberant.  As the real estate market started to unwind in 2006, especially for the speculators, the stock market continued its ascent until October of 2007. 

Now, with the prices of real estate lower by 25% to 30% in many places around the country and with the stock market down by 40% or more from its all-time highs, the negative wealth effect is taking place once again, as people are now paying the price for spending the equity in their homes, and in the worst cases, by borrowing to extend their lifestyle.  After all, when you’re in the middle of a boom (a/k/a bubble), it’s very hard to see the eventual end.  As a corollary, when you’re in the middle of a bust, it’s also difficult to see the eventual end.

So, here we are at the beginning of the last year of the first decade of the 21st century.  What lies ahead?  Nothing is ever easy, and if it is, it probably isn’t real, or it won’t last very long.  We are in the midst of a very difficult economic environment.  We are likely to see the momentum of the negative economic activity continue into early 2009.  Economic momentum is a powerful force.  It takes a lot to stop it and even more to turn it around.  The significant amount of borrowing by consumers, investors, and corporations around the world did not happen overnight.  The deleveraging that has occurred has been painful for everyone.  In the short-run, financial plans and asset allocation are not working the way they are supposed to.  We believe they will in the long-run, but it’s hard to see that during such extremely difficult economic times.

Unemployment, which is a lagging economic indicator, is likely to approach 8% to 9% before the end of 2009.  We are likely to have negative growth in the U.S. economy for another quarter or two.  Credit is likely to remain tight during the early part of the year.  Consumers are likely going to be very careful about how and where they spend their money, if they spend it at all.  But, all of this will eventually pass and will lead to a very prosperous time in the U.S.  In fact, one could argue it could be even more prosperous and perhaps “more real” than what we have seen in the past. 

Eventually, the money that the government is investing into the economy will move from the banks and insurance companies to businesses that want to borrow it.  As consumers cut back on their spending, businesses will produce less.  But consumers and businesses won’t cut back on their purchases forever. Businesses must continue to invest in themselves.  Every-day staples of life will still need to be replaced by consumers, i.e., a broken washing machine, a leaky roof, etc.  Banks will get back into the business of lending money, but they will be more cautious than they have been in the past.  This is a good thing.  Consumers will begin spending money, but will likely more often pay in cash rather than use credit.  While they are being careful with their spending, they will also likely increase their savings.  Some of that savings will find its way back into the stock and bond markets. 

At least four times in the last ninety days, after transaction costs, investors have actually been paying the government to return their money.  That is to say, it cost more to buy a 30 day Treasury Bill than the investor was going to get back.  The Ten Year Treasury currently sits at around 2.1% with no upside potential, while the dividend on the S&P 500 is approximately 3.2% with a potential for an upside.  Investors will begin to demand a better return on their money not simply a return of their money.  When this happens, interest rates on government paper will likely go up as money leaves the guarantee of Treasury Bills, Notes, and Bonds and moves into other investments.  When this occurs, there will be a bear market in government paper, just as there has been a significant bull market in government paper over the past 12 months during the “flight to quality”.  This will come as a shock to many investors who bought longer-term government paper.  They will still get interest when due and their principal back at maturity, but in the meantime should they wish to sell, they might not get back what they paid for the bond.  As the money moves, it will likely go to corporate bonds first, as investors believe once again that quality companies will repay their loans.  When this happens, interest rates on corporate bonds will come down and corporate bond prices will go up, which may lead to a bull market in corporate bonds, and in some cases, municipal bonds.  As more money is made available to corporations, they will begin to produce the same amount of goods more efficiently, which will lead to profits, which will translate into earnings, which will eventually increase stock prices.  Then, businesses will start to re-hire workers, as there will be some pent up demand in the system.  As the credit markets free-up, as the employment numbers start to go back down, and as people begin to spend more, the economy will rebound and we will move into a new economic cycle which will likely be very positive.

Regardless of whether you agree with the bail out of Wall Street, some consumers, some taxpayers, or any bail out whatsoever, the fact is all of these bail outs are occurring.  With all the liquidity currently being pumped into the economy working its way through the system eventually these massive amounts of money can only do one thing…bring prosperity and perhaps another bubble (a story for another day).

The beginning of a new year, although only calendar in basis, always bring some hope that bad things will be left behind and better times lie ahead.  As painful as 2008 has been in the markets, especially the last four months, better times are ahead.  We are not being Pollyannaish in this cheerleading.  We have had our share of sleepless nights and difficult conversations.  While perhaps not unprecedented in history, these past months have certainly been unprecedented since the Second World War.  It’s something many of us are experiencing together for the first time, but given the American economic engine, free enterprise and the ingenuity of the American people, we will get through it, and as always, will emerge stronger for it at the other end.

In spite of it all, we have much for which to be thankful.  We live in a country full of freedoms that many others can only dream about.  We live in a country where you can be rewarded for your success and not have it taken away by the government (except in the case of taxes of course).  We live in a country where we can practice our religion of choice without fear of persecution.  We live in a country where terrorists find it hard to get traction on our soil.  We live in a country with the best Armed Forces in the world.  We live in a country that gives more to charity than most of the rest of the world.  In short, in spite of all of our problems, where else would you choose to live, love, work, and raise a family?

We want to wish all of you a very happy New Year and to thank you once again for your continued relationship with our firm.  Notwithstanding the difficulties faced in the past, nor those we may face in the future, challenges can be turned into opportunities and the opportunities can be turned into a prosperous economy once again.

As always, we encourage you to give us a call if you would like to discuss anything further.  We will visit again soon.

RAY, KIM, ERIC, BRUCE, and LOU

©12/31/08 ProVise Management Group, LLC

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