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Introduction

In late 1776, as the American Colonists faced one of the toughest points in their struggle for independence, Thomas Paine famously reflected that “These are the times that try men’s souls.”  The Colonists were losing most of the battles they fought, the soldiers were unpaid, disorganized, and starving, and the foundling federal government was still powerless. At this point in time the overwhelming probability was that the British would crush the rebellion and restore colonial rule.

Paine went on to write in his pamphlets, “The summer soldier and the sunshine patriot may, in this crisis, shrink from the service of his country; but he that stands it now deserves the love and thanks of man and woman.”

Why the history lesson? For most investors the current market environment is, indeed, a time that is trying their souls. A global credit freeze, loss of confidence in the market itself, questions about the unprecedented degree of governmental intervention, and rampaging, seemingly out-of-control volatility are causing widespread panic, paralysis, and paranoia.

The result is somewhat inevitable (though not, I hasten to add, entirely rational) – markets around the world are falling precipitously. If greed (an extremely over-used word right now) was the catch-phrase for investor behavior of the past 3-5 years, its evil brother fear has taken over.

Many of our past stated concerns about the market are playing out – the consequences of the abuse of leverage primary among them¹. But you may also remember the investment philosophy we have consistently – and somewhat stubbornly – recommended for taxable high net worth investors:

• Broad diversification;
• Maintenance of appropriate liquidity to meet investor objectives and cash flow requirements;
• Intelligent use of active and passive manages;
• Prudent use of non-traditional or alternative investments because of their diversification benefits;
• Discipline to an agreed-upon asset allocation and investment policy;
• Long-term investment discipline;
• Do not try to time the markets; and
• Pay close attention to fees and taxes – the only aspects of investment return that are remotely controllable.

Let’s face it – discipline to the above investment principles is very difficult in the current chaotic market. The natural human inclination is, as Peter Bernstein puts it², to emulate the cockroach and run like hell at the first sign of danger. It works for the cockroach but it is a dangerous strategy for mammalian investors.

A Brief Summary of a Not-So-Brief Series of Unfortunate Events

The volume of articles and research discussing the causes of the current market conditions is overwhelming, and in talking to clients we should be cognizant of the fact that they are being fed a relatively non-stop stream of fear-inducing news about “corruption”, “greed”, “collapse”, “meltdown”, “credit crisis”, and “depression”. And that is just the rhetoric from the two men who want to be our President (how ironic that both feel they have to make things look as bad as possible in order to get elected!). Any good news or optimism that may exist is either not highlighted or is simply lost in the tidal wave of bad news.

In my opinion, there is no single root cause to current market turmoil. The old saying is that “Victory has a thousand fathers but defeat is an orphan.” But I think this current “defeat” has plenty of parentage, including:

• Misguided legislation that led to the over-promotion of home ownership (Community Reinvestment Act, among others);
• Misguided and special interest-influenced governmental intervention (Freddie and Fannie);
• Misguided Fed policy (keeping rates too low for too long);
• Misguided accounting rules that (1) encouraged the use of off-balance-sheet entities that allowed firms to hide the magnitude of the toxic assets on their books, and (2) forced quarterly mark-to-market write-down of illiquid (but not necessarily toxic) assets;
• Antiquated, conflicted, and hopelessly out-of-their-league ratings agencies (which assigned AAA credit ratings to F- asset pools);
• Antiquated and politically-influenced regulatory agencies;
• Severe misuse and abuse of leverage (Derivatives, MBS, CDOs, Credit Default Swaps, 30:1 leverage ratios by large financial firms, etc.);
• Risk management systems that inadequately captured non-traditional forms of risk (fat-tail events, liquidity, leverage, etc.);
• Mortgage broker and borrower malfeasance (no-doc and liar loans); and let’s not forget
• Greed – and not just on “Wall Street”.

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