October 2008 |
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Many years ago the late global investor, Sir John Templeton (founder of the Templeton Mutual Funds) identified the four most dangerous words in investing as "this time it's different". His point in making that statement was that investors tend to rationalize and suffer from their investment decisions near market tops and bottoms by believing that this time it is different and that the bull or bear market will continue despite the historical evidence to the contrary. We decided six months ago that it is different this time and that it was not prudent to be thinking in such conventional ways. It was not time to buy stocks but rather to hunker down and protect portfolios against that severe financial storm that was heading our way. Different investment strategies were required for these different times.
Investors have been in shock and awe over the past few weeks as they watched the stocks of Fannie Mae and Freddie Mac, a venerable Wall Street institution like Lehman Brothers, regional banks like IndyMac and Washington Mutual and a massive insurance company like AIG virtually disappear overnight. A number of smaller banks throughout the country have ceased to exist as bad lending practices and inadequate capital finally caught up to them. It is widely expected that there will be more.
For the first time in a very long time people questioned the safety of the deposits in their local banks even when they have been told that those deposits are insured by the FDIC. Individuals with more than $100,000 have been moving money out.
If that wasn't bad enough, the safety of money market funds was in doubt when one of the oldest funds in the U.S. announced they could only payout 97 cents for every dollar put in. That caused investors to seek out money market funds that only invested in U.S. government securities. The government had to quickly step in and offer insurance to money market funds to try to stop the outflow.
The lack of confidence in the U.S. and global financial systems has gotten so bad that banks stopped lending money overnight to each other because of fear that the borrowing bank may not exist in the morning. The various central banks like the Federal Reserve have had to provide that liquidity to keep the banks operating.
Impatient investors finally got the financial rescue (some say bailout) plan from Congress that is supposed to help the U.S. credit system begin to function normally again. The $700 billion price tag climbed to $810 billion when certain tax breaks and spending provisions were included. The ultimate cost will probably go higher over time as our government continues to throw money at a problem that we think will take time to resolve it. There are no quick fixes.
While we never forecasted the extinction of large financial institutions or runs on money market funds, we were very concerned about the health of the banking industry and the detrimental effect this vital but ailing industry would have on the economy. How can this economy grow when its life-blood (credit) is declining? It can't.
The consumer, whose spending represents 70% of this economy, is being beaten and bruised with the combination of higher energy and food prices along with declining home prices and stagnant real wage growth. Now many of them get to look at their September 401k or IRA statements and see the damage done to their retirement savings from this bear market. We suspect that most people will be focusing more on saving money than spending it in the future. Again, this is not conducive to economic growth.
So we have taken exception to conventional thinking as espoused by Templeton and most professionals in the investment management business. This time is different...very different and conventional thinking has caused many respected investment professionals to lose a lot of money for their clients. They kept buying stocks because they thought the bottom has got to be near. As they know now, it wasn't.
Even with this rescue plan this economy is in for some hard times ahead, in our opinion. That realization is only beginning to be discounted by the stock market.
The conventional "investing for the long-term" strategy entails maintaining long-term equity allocation target levels and not trying to "time the market". When the market goes down you buy more stocks to get your equity allocation back up to where it is suppose to be. To avoid emotional pain in bear markets as a result of financial pain, conventional investors are advised to "not look at their statements".
We think conventional investing can be a dangerous strategy to adhere to in times like these. For people near or in retirement it can bring about a lifestyle-changing depletion of wealth especially for people living off their portfolios. For others it can cause them to finally panic right at the market bottom and sell all their stocks at the worse possible moment.
We decided the best strategy for our clients was to try to get out of the way of the coming economic squall. As we sold stocks we let the cash build up in our clients' portfolios. In addition, we hedged the majority of the stocks in the portfolios to provide some downside protection. These actions significantly reduced the volatility of the portfolios and helped our clients (and us) sleep better at night.
Having avoided large losses and accumulated a lot of cash, our clients' portfolios are in a good position to make money when the market cycle turns. We don't have to make up for big losses in the past. Thankfully, this allows us to be patient and wait for the right moment.