An Update On The Financial World

What a month it’s been so far! I’ve heard from several of you, and I’m surprised I haven’t received more calls. It is certainly understandable that the recent news and financial activities have you quite concerned.

This is the ugly side of our system of capitalism – where we have loosely regulated components (investment banks aren’t as tightly regulated as commercial banks, obviously). Over the past few years, many companies have taken advantage of relaxed standards to make a lot, make that a boatload, of money. For example, ten years ago, no one would have thought you could have no money down, no assets, no job, and still buy a house. And, there is little doubt that many consumers were willing participants in this ruse – the blame goes to both sides. But the financial institutions should have been held to a higher standard – after all, the leaders of those organizations have been walking away with millions in salaries and bonuses, leaving the homeowners and shareholders (and uninvolved taxpayers!) to clean up the mess. While that may sound like I’m calling for additional governmental intervention, it seems that some preventative intervention would have been preferable to the “after the fact” $700+ billion intervention we’ve been forced to employ.

So, how we arrived at this point, and how, perhaps we might prevent it in the future is frankly, an extremely complicated issue that will be debated for decades, I’m sure. What’s most important in my opinion at this stage, is for we citizen-investors to review the landscape and make good choices about what to do next, given the environment that has presented itself.

Let’s start by reviewing the facts about our current situation, and what those facts mean going forward…

The Credit Markets Are In A Crisis In order for our large companies to operate effectively, nearly all of them operate within the Credit Market, borrowing cash on very limited terms (usually less than 9 months). These loans are called Commercial Paper, and Commercial Paper has traditionally been the investment of choice for money market funds, since these loans are very liquid and quite secure – meaning they can be turned into cash quite quickly. When the overall marketplace became concerned over the validity of corporate balance sheets and therefore the corporations’ ability to meet these obligations, people began pulling their money out of the money market funds. When money leaves money market funds in large amounts, the fund must redeem their Commercial Paper – and when they’re not buying new Commercial Paper, the corporations who depend on those loans are caught in a bind without operating cash. So when you hear talk about the “rescue” or “bailout”, this is part of the reason why – corporate America is having a hard time paying its day-to-day bills without having to make dramatic moves (like selling parts of the business to raise cash, as insurer AIG is doing). The good news is that, although this is a very real problem, it is temporary, as the markets in our capitalism system have a tendency to work out kinks like this. How long will it take? Probably less than a year, but it may take longer. What are the impacts for you? Likely slightly better rates for money market funds, but also likely stiffer requirements from banks for longer-term loans like mortgages.

Investment Banks Are Broken Some of the largest investment banks (Lehman, Bear Stearns, Merrill, etc.) were heavily involved in the process of handling the Collateralized Mortgage Obligations (CMOs) that became the central derivative of the subprime mortgage crisis. These CMOs are packages of hundreds of mortgages, used as investments by all kinds of funds, investors, and companies. The problem is that 1) the underlying loans were being made on very risky terms, such as zero-down on inflated valuations of homes; and 2) the ratings agencies (Standard and Poors and Moody’s among others) were not being realistic about the quality of the underlying investments. So, in other words, these CMOs were being touted as “safe” investments, when in fact they were extremely risky. Add to that set of circumstances the fact that many of these investment banks were leveraging (borrowing more money) to own the CMOs, and you’ve got a recipe for a real crisis when the real estate market took a dive and homeowners began to default on their mortgages, since they now held a mortgage for more than their home was worth. The good news here is that, with the “meltdown” that occurred in the debt market, new regulation and much tighter restrictions will keep this from happening again, at least as long as memory serves us. Plus, the “rescue” provides a way for some of the folks directly impacted by this (those with overblown mortgages) to gain some traction on their financial situation without losing their homes. In the meantime, even though the rescue package was characterized as a “bailout” – we taxpayers will not foot the complete bill. The remaining banks (those not up to their ears in the problem to begin with) will be purchasing the mortgage packages under much more stringent terms, effectively paying back a portion (but probably not all) of the “bailout” money, which is good for the Treasury (and we taxpayers) in the long run.

Diversification Doesn’t Remove ALL Risk In a situation like we’ve seen over the past several weeks, where emotion and greed are ruling the day and we witness a worldwide financial meltdown, there is no safe harbor. In other words, if all investments are falling as we saw recently, just face it, unless you’re only invested in CDs, your account is going to reduce in value. The good news is that this is only a temporary situation. Historically, this kind of activity has lasted from three to six months. After that, those asset classes that have become the most mis-priced through the crisis typically come back much more strongly than others – but all asset classes bounce back. At these market low positions, it might make good sense to re-balance your portfolio – that is, buy low now that you can. Of course, if you have money that has been on the sidelines in cash that you were intending to have in the market, now is an excellent time to buy in. (Hint: Warren Buffett is doing just that!)

The Short Term Market Is Driven By Fear and Greed After we saw the monumental drop off in market values last week – what happened? Only the largest single-day point gain ever for both the S&P 500 and the DJIA. But did you see the screaming headlines about how great this was? Of course not! Good news doesn’t sell newspapers or TV advertising. Unfortunately, our markets will always be driven by emotion, but the good news here is that you have me to rely on – and in those times when things are sounding awful on CNBC or whatever is your medium of choice, relax, and switch it off, knowing that I’m here to do the worrying for you… That’s part of my job, so switch over the baseball playoffs or tune in the debates. Don’t let the fear and greed mongers dissuade you from your appropriate long-term view of things.

The Market Outlook – Historic Perspective So, with the above context, let’s have a look at our current market outlook with some perspective on what happened in the stock market in past, seemingly similar situations. For context, let’s use the bear market environments of 1973-1974 and 2000-2002. These two, for those that haven’t read up on them, were a couple of dillies, as bear markets go. In the 1973-1974 downturn, the S&P 500 lost 43%, and in 2000-2002, it dropped 47% (this includes dividends, the actual price drops were larger). In addition to the precipitous drops in valuation, these two bear markets lingered far longer than the average – 12 months after the 1973-1974 market had crossed the 20% drop point (making it an official bear market), the market had dropped another 27%. For the 2000-2002 market, a year after its official bear declaration, stocks had lost an additional 1.2%.

These were the only two markets over the past fifty years in which the S&P 500 was lower 12 months after reaching a 20% decline. The very good news here is that neither of these markets bears much resemblance to our present marketplace. Presently we have a rumor of inflation picking up – but nothing like what we saw in the 70′s with the double-digit inflation and wheezing economy that we suffered through in that decade following the bear in 1973-1974.

The more important factor is stock valuation – when the 1973-1974 bear market began, the S&P 500 was selling for 40 times the earnings of the underlying companies, and 35 times trailing earnings when the 2000-2002 bear market began. This kind of sky-high valuation was evident for the 1929 and 1987 precipitous crashes as well. But when this present bear market began, the S&P 500 was only selling for 19 times trailing earnings – not a low level, but certainly not comparable to those of the classic “crashes”.

The bear market that our present situation most closely resembles is the one that occurred in 1990, which culminated in another financial crisis – that of the collapse of thousands of savings and loans. So what happened following that crisis? From 12/31/1990 to 12/31/1991, the S&P 500 increased 26%. Sounds like a pretty good outlook, don’t you think? I’m not for a second suggesting that we’ll see such a runup over the next 12 months, but history has shown that just such a thing is quite possible. But also remember that history should only be used as a guide – not as the answer.

The Bottom Line So, boiled down, my recommendations are as follows:

• Hold tight to your position. There is no good reason to sell your investments at this point, no matter how shaky you are. You definitely do not want to be on the sidelines in a cash position when the market begins to pick back up. Considering only the past 28 years (1980 to present), if you were fully invested in the market the entire time, your return would have been 3018% overall – but if you’d missed the best 50 days during that time period, your aggregate return would have only been 430%. On a $10,000 beginning investment, that’s a difference of over a quarter-million dollars.
• Rebalance if your account needs it. Evaluate your future plans, and if they call for a restructuring of your portfolio and/or a rebalance, now is the best time to do it. Give me a call and I’ll work with you to accomplish this.
• Ignore all the “noise”. Shut off CNN, give yourself a break from it all. Take a walk, or watch a baseball game or a movie. (remember, I’ll do the worrying for you!)
• Pass this newsletter along to your friends, families and colleagues, if you think it might help them to cope.

That’s all for this month – next month we’ll get back to some more uplifting topics, like IRAs and stuff like that! Until then… take care.

I can learn from you, you can learn from me - please leave your comments and links!

Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author