Originally published February 10, 2009
It probably seems as if there is no end to the bad news you hear on TV or read in the papers, so I wanted to send this update for a few reasons. First, I want to revisit the approach we are taking as that will help to set the tone for the rest of my note. While this is something we have discussed (on more than one occasion for some of you), I realize that the basics may be forgotten as soon as you leave the office or hang up the phone. For some, at times like this you may simply not remember these things. Next, I want to provide some perspective on the current environment. Finally, as part of our ongoing due diligence, we recently had a call with a number of senior portfolio managers at one of the fund companies we deal with, and I would like to summarize a few of the highlights of that call and then tie everything together. Overall, the goal of this note is to address concerns you might have, give you some perspective and allow you to take a deep breath and go on about your life – something that the popular media really would prefer to avoid.
For some of you, this will simply be a review. For others, it is a timely reminder of why we do what we do. As you may recall, your portfolio has been divided into 3 “buckets”:
Bucket 1 is designed to address your spending needs for the next 12 months. Since these are funds we know you’ll need soon, this bucket is primarily invested in cash, CDs and/or money market accounts. It is not subject to any market risk or fluctuation.
Bucket 2 is designed to address your spending needs for years 2-5 (or longer, depending on your particular circumstances). Like bucket 1, these are funds that we know you’ll need within a reasonable time horizon, so we generally do not want to expose these funds to much risk. Typically, these funds are invested in a combination of money market funds, CDs, bonds, conservative funds or other lower volatility investments.
Bucket 3 is designed for longer term growth. Since it is designed for longer term growth, this is the portion of your portfolio that will likely have the most significant exposure to stocks. Of course, this exposure is diversified among a number of different industries, geographies (US and foreign) and company sizes (large and small). As you may recall, the exposure to stocks is important because of their ability to help us deal with the ravages of inflation over time. If you are entering retirement, this bucket might have to help provide for a 30-year retirement and the impacts of inflation over that time period. If you are still accumulating for retirement, this bucket should be designed to grow until your retirement and then provide for a retirement that can be 30 years or longer (life spans are increasing). So, the time horizon for Bucket 3 is very long in most cases.
In addition to being an effective planning tool, the buckets are also designed to help us and you address the emotional reactions that all of us have to the market. During times like this when the markets are falling, our “fear” response kicks in and tells us we have to sell — we have to protect ourselves. However, if we think about things rationally, which is difficult (but easier if you have someone counseling you), we begin to realize a few things:
- Buckets 1 and 2 are my “insurance policy” for at least the next 5 years, so I don’t have to make a knee-jerk reaction,
- Most of my stock investments are in Bucket 3, and I don’t even need Bucket 3 for 5 or more year,
- Usually, I like things that go on sale. Also, I was always told “buy low and sell high”. Stocks seem pretty low, so why would I want to sell when they might be on sale? When that TV (or shoes, car, etc) went on sale, I jumped on it – I didn’t sell all my other TVs (or shoes or cars);
- I know that the stock market has had difficult times in the past, but it has always recovered. Moreover, there has never been a time where it hasn’t reached new highs eventually.
- Even if the stock market (the Dow) doesn’t get above it old high (around 14,000) any time soon, a move to even 10,000 is over a 20% increase, and a move to 12,000 is about a 50% increase. So, we don’t even need to make new highs to benefit from these levels.
There are plenty more things your “rational” mind (or advisor) might tell you, but I think you may be getting the picture. While none of us can guess when the market will improve, we have time on our side because of Buckets 1 and 2. Importantly, there has NEVER been a time in history when the markets didn’t eventually improve. We’ll come back to this, but first let’s review where we are and how we got here.
According to government statistics, we entered a recession in late 2007, which means that we have been in a recession for some 13 months or so. The average recession in modern times has lasted about 11 months, with the longest being about 16 months. That doesn’t mean that we can expect this recession to be over in a few months, but it may suggest that we are closer to the end of this recession than the beginning.
While markets were generally weak from October 2007 through August 2008, something changed in September/October 2008 (and it wasn’t the election). We experienced the first financial crisis in a considerable amount of time. Note that I did not say “economic”crisis. Without going into excruciating detail, the most immediate root of the crisis can be traced back to securities created during the real estate boom and accounting rules imposed by the government. Suffice to say that these two issues resulted in a situation where banks were worried about lending to one another. That fear of lending to one another caused the entire system to seize — companies began experiencing very real difficulties in financing their businesses. There were fears articulated by some that the entire financial system would collapse.
You may remember the “bailout” (it would take another lengthy note to explain why this wasn’t really a bailout — we can save that for some time in the future). Well, you may also remember the failure of our government to approve the “bailout” for a week or so. This delay resulted in the stock market experiencing tremendous losses as there was true panic selling. At the same time, companies that needed money were being forced to begin paying very high interest rates. Since interest rates and bond prices move in opposite directions, this resulted in the prices of outstanding bonds to come down. It is very important to realize that none of these things were happening as a direct result of the quality of the companies — these were happening to companies across the board. So in essence, we had a situation where the proverbial baby was getting thrown out with the bathwater, and there was truly nowhere to hide. It is important to understand that this was still primarily a financial crisis.
Unfortunately, this started a spiral…people continued to panic so they began redeeming their mutual fund investments, hedge fund investments, etc. The professional managers saw opportunity and wanted to buy, but they had to sell to raise cash to meet the redemption requests. Given the nature of the panic, these managers were often forced to sell investments in very good companies because that is where the most trading volume was. Hopefully, you can see where this is heading — this forced selling caused additional price declines in some of the very best companies. Once again — this was not a reflection of the quality of the underlying companies.
So, where does that lead us to today?
The government has and continues to throw quite a bit of money at this problem (the total amount is in the trillions of dollars). This response all but guarantees that we will not enter another “Great Depression”. The stock market is at valuation levels not seen in decades, which suggests attractive returns may be in store for investors with a long-term time horizon. Non-government bonds are paying yields that are excessive given pricing on government bonds, which may provide savvy investors with the ability to get paid while they wait for more normal conditions to return. Finally, there is more money in money market funds and the like (as compared to investments in equity funds) than at any point in history, which means that there is plenty of pent-up demand once the masses feel that “things look better”.
On the last point, there are plenty of people that are waiting for “things to get better” before they do anything. While I don’t want to be Pollyannaish, the stock market has historically been a predictor of events, not a follower. In other words, it is likely that the stock market will improve dramatically before any of us feels like “things are better”. To that end, a well-allocated portfolio and a well-designed plan will require some exposure to stocks (as well as bonds and other assets), so that you will be in a position to participate when the market improves – regardless of whether or not “things” seem better.
Conversation with Portfolio Managers
|As part of our ongoing due diligence process, we recently had a telephone conference with a number of the portfolio managers at one of the fund companies that we deal with. Since this is not a “sales piece”, we’ll leave the names omitted; however, we did feel as if some of the information was worth sharing to help provide you with some perspective on what the managers are thinking (note: the questions and answers have been paraphrased/condensed).
Q: When will this end?
Q: It seems as if there has been no place to hide.
Q: Are there opportunities?
A: You do not often get opportunities to buy high quality companies at current valuations. Forced selling has given us that opportunity.
Q: Confidence is low – why should people stay invested?
A: Unfortunately, there has been no place to hide. We can’t say when the economy or the market will respond [to the stimulus packages]. You need to be cautious, but invested for the rebound. Based on usual measures of valuation, one would predict decent upside. While there is quite a bit of near-term uncertainty, we are focusing on opportunities, which are plentiful.
Q: What have you changed in your investment process?
A: At the end of the bull market, we were taking some flak for not being risky enough. We think our process, which emphasizes fundamental research and a long-term approach, has been reaffirmed by these markets. There are a lot of long-term opportunities.
Wrapping It Up
So, where does that leave us? While we cannot predict whether or not we have seen the lows for this cycle, there are a few things we can say:
- Valuations are currently as attractive as they have been in decades, suggesting positive results for investors with a long-term time horizon.
- Based on historical precedent, it is likely that we are closer to the end of the recession than the beginning of it.
- The stock market is a forecasting machine and will likely show marked improvements before “good news” starts to appear.
- Our portfolio managers are finding “a lot of long-term” opportunities.
- While we don’t know whether the “market” will give us lemons or lemonade over the short term (i.e., the next year or so), buckets 1 and 2 give afford us with the ability to ignore the short-term moves in the markets so that we can be positioned to take advantage of the recovery when it arrives…this is why we plan!
As always, we are here for you. Please do not hesitate to call or email if you have any questions. Also, please feel free to forward this to friends or family members who might benefit from some of the information or perspectives.