November 26, 2008
Dear Valued Client,
Since our last special market update letter to you on October 10th, economic data have worsened and the stock market has continued to decline. As advisors, we counsel our clients to do the right thing, so it is very upsetting to see our clients' portfolios depreciate as much as they have this past year. There has been no place to hide this year except in cash and cash equivalents. Equities across the board are down 40% or more. It did not matter what industry, what size company, or whether you were invested in the U.S. or abroad. Here are some examples of major indices' returns as of November 25, 2008: S&P 500 Index -40%, Russell 2000 Index -41%, MSCI EAFE Index -46%, and the MSCI Emerging Markets Index -56%. Alternative investments such as real estate and commodities did not fare much better. The S&P/Case-Shiller residential home price index has dropped every month this year and is down 17% over the last year. Publicly traded real estate investment trusts declined 39%, as measured by the MSCI US REIT Index. The Dow Jones AIG Commodity Index declined 25%. Most fixed income securities are also down, which is unusual in a weak stock market environment. Investment grade corporate bonds, as measured by the iBoxx Liquid Investment Grade Index, declined more than 9%, while high quality municipal bonds, as measured by the S&P National Municipal Bond Index, are down nearly 4%.
The question on everyone's mind is what should be done with his/her portfolio now? Before that question is answered, I feel a brief overview of the situation is warranted.
Cause of Crisis
The reasons for this crisis can be attributed to a number of factors pervasive in both the housing and credit markets, which developed over an extended period. The inability of homeowners to make their mortgage payments, poor judgment by borrowers and lenders, speculation and overbuilding during the boom period, risky mortgage products, high personal debt levels, increased leverage, complex financial innovations that distributed and perhaps concealed default risks, central bank policies, and government regulation (or lack thereof) have all contributed to today's problems. In its November 15, 2008 "Declaration of the Summit on Financial Markets and the World Economy," leaders of the G20 echoed this statement. Unfortunately, the domino effect of the crisis has been to throw the entire global economy into recession.
Legislative and regulatory responses
Various actions have been taken since the crisis became apparent in August 2007. This included emergency government assistance regarding investment bank Bear Stearns, mortgage companies Fannie Mae and Freddie Mac, insurer AIG, and most recently, Citigroup, one of this country's largest commercial banks. The U.S. central bank, the Federal Reserve, lowered the target for the Federal funds rate from 5.25% to 1% and the discount rate from 5.75% to 1.25%, undertook open market operations to ensure member banks remained liquid, used the Term Auction Facility (TAF) to provide short-term loans (liquidity) to banks, and expanded the collateral it will lend against to include commercial paper in its attempt to help address continued liquidity concerns. Central banks in other countries implemented similar policies. Just this week, the Fed took two new steps to unfreeze the credit market by committing a staggering $800 billion to purchase various types of mortgage and consumer debt, such as student loans and credit card debt.
In September 2008, the U.S. federal government proposed a plan to purchase large amounts of troubled mortgage-related securities from financial institutions at an estimated cost of $700 billion. An amended version of the plan was approved by Congress and the Emergency Economic Stabilization Act of 2008 was immediately signed into law by President Bush in October 2008. The main part of the Act is the bailout plan, known as the Troubled Asset Relief Program (TARP). The TARP has actually morphed over the last few weeks to become a bank equity infusion program and continues to evolve. For instance, Treasury Secretary Paulson recently stated that he is now considering using TARP funds to finance stock purchases in non-bank financial firms, back consumer debt such as car loans, student loans, and credit cards, and subsidies to mitigate mortgage foreclosures. A secondary part of the Act, but important to consumers, is the temporary increase in FDIC coverage up to $250,000 per depositor. In October 2008, the FDIC created the Temporary Liquidity Guarantee Program to further strengthen confidence and encourage liquidity in the banking system by guaranteeing certain debt of banks providing full coverage of non-interest bearing accounts regardless of dollar amount.
It will certainly take some time for these measures to improve the financial markets and the economy. However, it is fair to say that matters would surely be worse if not for these measures. The duration and depth of this recession is unknown, but talk of a depression seems off base. For one thing, unemployment during the Great Depression reached a whopping 25%, while the most pessimistic views for this recession have unemployment reaching about 10%. Additionally, the monetary authorities at the time of the Great Depression did not fully appreciate the scale of the problem, which contrasts starkly with today's "all hands on deck" mentality. Thirdly, the government in the Depression-era was overly concerned about the budget and did not pump enough liquidity into the system. Today, the pace of liquidity injections is truly unparalleled. Finally, the approach by today's central banks has been a coordinated worldwide effort, as opposed to the piecemeal approach undertaken in the early 1930s.
It is also important to note that on November 4th, the United States experienced a significant political shift when Democratic nominee Barack Obama handily defeated Republican nominee John McCain. The legislative branches also made large strides in favor of the Democrats. By the time President-Elect Obama officially takes the helm in January 2009, the country will be in the midst of the current economic malaise and will inherit a federal budget deficit in excess of $500 billion. With these conditions, President-Elect Obama may find governing to be much different from campaigning, requiring him to reach across the aisle in order to gain support on a number of legislative issues. Just as this victory came from his views of change, the financial markets and the U.S. economy also hope to see triumph come from a time of great change. With unprecedented conditions being aided by extraordinary governmental involvement, the markets and the economy are set up to embrace a time of adaptability, recovery, innovation, and growth.
What to do now
It is tempting to sell stocks and bonds and just hold cash to avoid the current market volatility. As mentioned in the past, we feel that the asset allocation decision is the most important step to managing risk - how much to invest in equities and how much to invest in bonds. We do not believe in timing the market, so we try to keep the portfolio fairly close to the target allocation in all market conditions. While we do not anticipate strong corporate or economic data in the near future, the market does tend to rally six months before an actual economic recovery and it is possible that the market can begin a rally any time from this point on. We are already seeing some signs that the credit markets are improving. For instance, LIBOR, an interbank rate, has fallen steadily since October 10th, and municipal and investment grade corporate bonds have rallied amid this early sign of normalization. Moreover, the recent Fed action of announcing plans to purchase large amounts of mortgage debt immediately reduced the rates on new mortgages, which should help the housing market. We continue to feel that it is prudent to remain invested at all times to ensure participation in the market upswing. Courtesy of our friends at Janus Funds, I have attached 2 charts that illustrate how investor psychology and being out of the market for short periods of time can substantially harm long-term investment results.
The second step to managing risk is to build a broadly diversified portfolio. We invest in companies across various industries, companies of different sizes, and companies in the U.S. and abroad. For fixed income exposure, we buy investment grade bonds from companies with various credit qualities and maturity dates. The same rationale applies whether purchasing individual securities or their mutual fund and exchange-traded fund counterparts. As always, we place trades if we think that they will improve the portfolio. Throughout the rest of 2008, you will likely see extra trading activity. We are not making strategic changes to the investment plan we have been using in client accounts. We are not timing the market either. These trades will be a combination of tax loss harvesting in taxable accounts, as well as a rotation into securities we feel may be better positioned in the current environment. Some trades may be done as a temporary move, as in the case of tax loss selling, while others may be placed with a longer-term perspective. Note that capital losses can be used to offset an unlimited amount of capital gains, as well as up to $3,000 of ordinary income per tax year. Tax-losses can be carried forward indefinitely.
We continue to extensively monitor the current situations and are staying up to date on all developments. Generally, we are not recommending a change in asset allocation. Of course, we are available to discuss such action, as well as a change in overall investment strategy, at any time.
Additionally, we suggest that clients continue to save for their retirement or their children's college education. This as an opportunity to buy at low levels. Perhaps even more importantly, clients that are retired and using their portfolio for ongoing income to support their lifestyle should consider whether their portfolio withdrawals are sustainable considering current market conditions. Please call us if you would like our opinion as to whether a downward adjustment to your portfolio withdrawals is prudent. Even if we indicated that your portfolio could support a particular level of withdrawals in the past, this should be revisited due to the severity of the current market drop. We have already pointed out to some clients individually that they need to adjust their lifestyle (at least temporarily until market conditions improve) and will continue to reach out to our clients in this regard over the next few months.
As always, please feel free to contact us to schedule an in-depth market or portfolio review
Condor Capital Management