November 30, 2008
WHEW! NOW WHAT?
The credit crisis precipitated an unprecedented two month meltdown in worldwide financial assets and gave evidence to the proverb “may you live in interesting times”. Probably, your 401(k) became a 201(k). After having lived through the 2000-2002 bear market and then seeing your net worth creep up over the next 5 years to approximately the value you had in March 2000, you have seen it plummet once again. You must be like most of us, shell shocked and scared at the apparent arbitrariness of the sale of all assets with apparently no place to seek shelter, other than in cash. Even the apparent safety of money market funds did not escape the financial fury as some money market funds did not yield their par value.
My suggestion is to stay calm and answer these five questions:
1. Have my long term needs changed?
There is no way to mitigate the pain of watching your assets decline 20% or more during a severe market downturn. But, you must remember bear markets are as much a part of the business cycle as bull markets. If your long term goals such as retiring or financing college are still several years away, you may not need to make any changes in your investments. It may be difficult in the moment, but waiting out the market downturn may be your best course of action.
2. What are my immediate needs for liquidity?
If you depend on a portion of your investments for current income, you may need to meet with your financial advisor to help you take steps to meet your current income needs while not disrupting too severely your long term needs, also. The worst thing you can do is overreact; overreacting to a stock market decline can bring losses that you will regret incurring when the market rebounds, as it will, if history is a guide.
3. Has my tolerance for risk changed?
If volatile markets bring too many sleepless nights, then maybe you need to change your portfolio to a more conservative stance. Alternatively, if you are viewing a major decline as an opportunity to buy stocks at a significant discount, you may be willing to take a more aggressive approach with your investments.
4. Does my current strategy match my attitude towards risk?
5. Are you following an investment strategy that is suited for any market environment?
It is easy to let the current state of the market influence your investment strategy. In a bull market you may want to load up on stocks, in a bear market you may want to sell all.
The best way to invest through any type of market is to follow these principles:
What Do I Think Now?
I have always believed in the power of demographics and, as such, I have not deviated from the generalities I stated in the early 1990s. Like Harry Dent, I said the most important trend affecting our economy was the effect that more than 70 million baby boomers had on whatever they did. In the 1990s, I predicted a boom in the stock market because the “Boomers” (as those who were born between 1946 and 1964 are known) were working and consuming at a fevered pace. They were entering into their most productive years. The Dow rose from 1,000 in 1987 to approximately 11,000 in only 13 years. I believe the internet bubble merely coincided with the natural surge and did not cause it, it merely exaggerated it. The Dow then plummeted to approximately 7,000 in 2002, so in a 15 year period from 1987 to 2002, the Dow only went up an unheard of, 700%.
I believe the economy and the stock market resumed its growth in 2003 because the Boomer work force produced high productivity with resulting low inflation and low interest rates as a result. The Dow clawed its way back and rose to almost 14,000 in October 2007 when it started to fall in anticipation, we presume, of the much heralded recession.
Prior to the meltdown, I believed the future would encompass a recession starting in 2009 and deepening in 2010 and lasting 10 – 14 years because of the aging of the Boomers; a period of time that may resemble the years between 1967 and 1981. Two of the most famous Boomers born in 1946, Bill Clinton and George W. Bush, turned 62 this year; they became eligible for Social Security. The generation that did not want to trust anyone over 30 is now twice that!
I thought there would be one more boomlet before the recession started. Now, I believe the credit crisis meltdown has merely advanced the recession and reduced any chance for one last boomlet.
I believe the Boomers will want to retire, but not have enough money to do so, because their homes are too big, their cars too expensive, and they just spend too much, unlike their parents, the Greatest Generation. I believe they will start to slow their purchasing of discretionary items, Boomer women will buy less clothes in anticipation of building healthier bank balances and portfolios. Since 70% of the economy consists of consumer spending, the reduction (not elimination) of spending by the bulk of the consumers will have a damaging effect on the economy. The Boomers, when they retire, will be replaced by the less productive “Echo Boom” generation (children of Boomers) who will need work experience to equal the productivity of the retiring Boomers. The combination of fewer purchases by consumers together with a less productive work force with the potential for rising inflation and resulting higher inflation interest rates will make it harder for companies to increase their earnings. The result could be a compression of price earnings multiples and hence, a lower stock market.
No less an authority than Grantham, Mayo, Van Otterloo & Co., a company which proposes allocation percentages for portfolios predict the growth rates in U.S. high quality stocks over the next 7 years will be 5.7% almost one half of the 78 year historical average of 10.5%.
Adding to the problem of reduced growth of the stock market, consider the problem of how the government will pay for the Boomer Social Security needs, the Boomer Medicare needs, the pensions of retired government workers and the free or subsidized medical care of retired government workers. Former U.S. Comptroller General and General Accounting Officer, David Walker has recently stated at the Foundation for Accounting Education “We have been living beyond our means for far too long.” “We need to recognize reality and then we need to push the reset button on the federal government.”
I do not believe that the Boomers will vote to deny themselves the benefits they believe they are entitled to. I believe there will be political problems in the government allocating a finite amount of money either to old Boomers or investing in the younger generations. I believe the likely result may be for the government to raise taxes to pay the promised benefits. A rise in taxes has the tendency to contract the economy because wealth is transferred from the productive private sector to the less productive government sector.
My dire prediction is not forever, but it may be for a generation. The “Baby Bust” generation and the “Echo Boom” generations will outlast this downturn and eventually the markets and economy should turn up. However, for the Boomers, the time frame is important because of their age, it is doubtful they or their portfolios can outlast the problem period.
A proposed solution to the problem is for a person to consider using a combination of these three strategies:
1. Purchase financial products that will seek to guarantee your principal. This is important in order to eliminate the sequence of return risk if one is dependent upon selling positions in the portfolio in order to generate cash to live on.
2. Purchase equities that provide a steady stream of cash. The cash is in lieu of, the probably below historical average, capital gains. The consideration of the tax treatment of capital gains versus ordinary income, while important, should be secondary to the fact of a real flow of cash. Regular cash flow is important in order to avoid the sequence of return risk, if one is dependent upon selling positions in the portfolio in order to generate cash to live on.
3. Use a disciplined strategy to take short swing profits for non cash paying investments instead of using a buy and hold philosophy; buying when an investment is undervalued and selling when overvalued.
If you want to discuss this further and as to how you might craft a personal strategy to survive this scenario, please call us.
Remember, We’re Here For You!!
Fundamental Investing Strategies for the Long term. Weathering market downturns. MFS Investment Management 10/08
GMO: Stocks Will Lag Historical Average for Next 7 years by Gary Smith www.seekingalpha.com
Former Comptroller General Walker calls United States Government ‘Unsustainable’ by Melissa Lajara The Trusted Professional Vol. 11 No. 21