Personal Chief Financial Officer
Market in Perspective
December 31, 2007
Dear Reader:
After enjoying the holiday season with family and friends and as the New Year begins, it is a wonderful time to reflect on and give thanks for the abundance in our lives. I hope we all take time during this busy holiday season to do just that.
As for the market, it has been a year that tests ones’ fortitude. In August we saw the Dow and S & P 500 hit all time highs, only to see most of the gains erode as the bears took control for much of the latter part of this year. Even so, the International markets have, as measured by EAFE (Europe, Asia and Far East), generated double digit gains year to date.
Speculation in housing that created the “bubble” which was fueled by egregious lending practices pushed prices to unsustainable levels, ultimately creating this sub-prime credit crisis. As this saga unfolded the equity markets were slow to react to the potential threat on equity valuations. After all, it was isolated to the residential market and mortgage lending and not the equity market, right?
Unfortunately, mortgage loan defaults do impact equity valuations of the lender, particularly when the value of the security underlying that loan has declined significantly below loan value. Additionally, what about the greater equity valuation risk of the consumers’ ability to spend? Sad to say there are many examples of this “inefficiency” in the equity markets short term.
The reality is, short term, the equity markets frequently get it wrong both ways. They got it wrong when they drove the NASDAQ to over 5,000 during the dot com “bubble”. They got it wrong when they drove the S & P 500 to a low of 800 following 9/11. That is why it is so important in times like these to remind ourselves of how the markets work. In the short term, markets don’t necessarily compensate for risk and valuations are driven by fear and greed. In the long term markets do work, returns compensate for risk and prices reflect intrinsic value.
I am not proposing this market naivety is easy to exploit. In fact, there is compelling empirical evidence to suggest otherwise. I am suggesting that the markets long term move upward (generally at double digit rates) and short term, move around that underlying direction based on the psychology and resultant behavior of the moment.
There surely are, over time, certain fundamental imbalances in valuations which can be exploited. But, those moments tend to be rare and at the extreme, the late 1990’s and just prior to the Iraq War being examples. Other less extreme moments in time are much more difficult if not impossible to exploit.
Below is a graphic that illustrates how important it is to “Stay the Course”, as Peter Lynch (prior investment manager, the Fidelity Magellan Fund), often commented. A $1,000 investment in the S & P 500 January of 1970 would have grown to $51,316 by December 2006, thus rewarding investors who maintain a long-term outlook.
But inconsistent short-term performance may test one’s commitment to a long-term strategy. On paper, market timing offers a seductive prospect. By predicting market direction ahead of time, a trader might capture only the best-performing days and avoid the worst.
This graphic also shows the other side of that story. Large gains may come in quick, unpredictable surges. A trader who misinterprets events may leave the market at the wrong time. Missing only a small fraction of days—especially the best days—can defeat a timer’s strategy. To illustrate, if an investor missed the best 15 days during the period from January 1970 to December 2006, an investment of $ 1,000 would have only grown to $25,059, still dramatically better than one-Month T-Bills ($ 8,613), but less than half the $51,315 of a fully invested portfolio.
It is this author’s opinion the impact of the sub prime crisis on the broader market will wane short term. What will drive the markets going forward will be trends in macro growth and fundamentals. This is equivalent to “seeing the forest for the trees”. Regarding macro trends, two authors with views of the world I happen to share are Thomas L. Friedman and Harry Dent, Jr. Friedman, in his best seller, “the World is Flat”. A Brief History of the Twenty-First Century, makes a compelling case for the embrace of capitalism by China, Russia and other countries previously isolated from the capital markets, along with the advent of the internet technology driving global growth long term.
Friedman asks “when you read the history of the world twenty years from now, and come to the chapter "Y2K to March 2004," what will they say was the most crucial development? The attacks on the World Trade Center on 9/11 and the Iraq war? Or the convergence of technology and events that allowed India, China, and so many other countries to become part of the global supply chain for services and manufacturing, creating an explosion of wealth in the middle classes of the world's two biggest nations, giving them a huge new stake in the success of globalization?”
Harry Dent, Jr. in his classic book, “The Great Boom Ahead”, referenced the power of consumerism as he writes “the 80 million or so boomers—those born between 1946 and 1964—are hitting their peak earning, spending, and investing years, and that’s what’s driving the economy’s incredible performance and the stock market’s spectacular returns.”
Assuming for the moment that we buy their view of the world, what about the fundamentals? As Friedman also concludes, technology has not only provided efficiencies in its own right, but has provided access to a vast new labor pool, allowing corporations to continue to drive down expenses, thus accelerating earnings on the products and services they deliver.
Is there evidence of this growth and efficiency? The answer is a resounding “Yes”. Earnings have been screaming both in the US and abroad. The question is, are they sustainable? You don’t have to agree with every prediction, but rather the authors’ basic tenets, to envision the incredible market potential going forward. As the graphic below suggests, MCSI World Index of prices compared to earnings (P/E) is at their lowest level in 12 plus years, a notably strong fundamental.
So what does all this mean to the disciplined investor?
- Disregard the noise of the short term. The housing market and related credit crisis will be resolved near term. These events only incite the emotion of fear and greed, which for the undisciplined investor tends to produce bad investment decisions.
- Position your portfolio to take advantage of the long term by investing in asset classes that will fairly compensate for risk.
- Globalize your portfolio to benefit from the disproportionate growth internationally.
- Mitigate the risk of your portfolio through diversification to assure a volatility you can tolerate. Returns fundamentally come from assuming risk. But, if you select a risk level you cannot tolerate, you will likely succumb to the emotion of the market.
- There is ample empirical evidence to suggest that 90% to 96% of returns are generated by the asset allocation decision. This leaves little room for significant long term improvement in return by timing or finding the consistently outstanding manager. Resist timing, except in the most extreme markets, and then only with competent professional advice. Avoid high fees, particularly front and back loaded funds, because fees do matter.
- Most importantly, have faith in the markets long term. As the concluding graphic suggests, when you get above the trees, you can clearly see the power of the markets.
Sincerely,
Michael F. Rolph
Via Financial Insight, Inc.
Registered Investment Advisor
Market in Perspective
March 17, 2008
Dear Client:
The events surrounding Bear Stearns the past few days have had and will continue to have a valuation impact on the equity market short term. Bear Stearns had widely been known for its investment strategies in sub-prime mortgage back securities. That “niche” played to its advantage when housing was escalating at unprecedented levels and mortgage rates were at fifty year lows. Unfortunately, the egregious lending practices in the sub-prime mortgage market along, with falling home prices as the housing bubble burst, left many home owners with loans they could not afford long term and loan values far in excess of home values. The resultant loan defaults and foreclosures contributed to the failure of two Bear Stearns hedge funds last summer. That, along with substantial other investments in sub-prime mortgage backed securities put such financial strain on Bear Stearns that it culminated in a liquidity crisis which compounded as investors effectively created a “run on the bank”.
The Federal Reserve, along with J.P. Morgan negotiated a 28 day loan guarantee to provide stability for the firm. Over this past weekend J. P. Morgan entered into an agreement to acquire Bear Stearns for $2 a share. Just six days earlier the stock had traded at $70. The market has known Bear Stearns’ critical financial condition for some time. The market had not anticipated, however, that the only solution was a “fire sale” of $2 a share. Due to the likely impact this event would have on the market, the Federal Reserve announced Sunday evening that is was cutting the rediscount rate by ¼% from 3.5% to 3.25% immediately, and Monday creating another lending facility for big investment banks to secure short-term loans.
Federal Reserve Chairman Ben Bernanke stated Sunday evening that "these steps will provide financial institutions with greater assurance of access to funds". This event is likely to add even more volatility to an already volatile market. It is very important at times like these that as investors we weather the storm. The market has experienced events like this throughout its history and has always moved forward. It is certainly painful short term, but it is crucial to remain disciplined through this period. Your long term financial security will be achieved if you “stay the course”.
Please give me a call at your earliest convenience to discuss this and your portfolio further.
Respectfully yours,
Michael F. Rolph , CEO
Via Financial Insight, Inc.
Registered Investment Advisor