Monday, October 27, 2008

How Bad Can It Get?

It’s time to get our heads out from under the covers and face our worst fears. The financial crisis is world-wide, and the U.S. is actually better off than most countries. Iceland is bankrupt, and others (including Russia) are teetering. What happens when a crisis turns into a complete collapse?

Keep in mind that the worst possible outcomes are short-term. We’ll take a look at those and then look at the reality of the long-term.

Short-term Possibilities:

Scenario #1: Complete Financial Collapse. Likelihood = 1% - 2%. This could rival the Great Depression scenes we see in old movies with bread lines, tent towns of homeless, etc. You’re not able to use your credit cards, or write checks. In the worst case, where faith in US dollar evaporates, bartering or using gold becomes the basis of commerce.

This extreme outcome could be produced in our current economy if one or two extremely destructive exogenous events occur in the next year or so. These traumatic events could be anything from a huge California earthquake, Al Qaeda usurping power in Saudi Arabia and strangling the world’s oil supply, or severe weather changes brought on by global warming, etc.

We have suggested that clients who are genuinely concerned about this worst-case scenario keep 1-2% of their portfolio in gold bullion.

Scenario #2: World-wide Deflation. Likelihood = 5-20%. Countries try to protect their economies using tariffs, which sets off retaliation in other countries so global commerce dries up. Shortages become a way of life. Widespread deprivation kindles violence, terrorism escalates, and a large scale war may loom.

Even in this case, the dollar would likely be the world’s safe haven. Decreasing prices enable those who have cash or U.S. Treasury bonds to survive and prosper.

Scenario #3: Recession Reaction. Likelihood – 15-35%. Panic sets off contraction in consumer spending which cascades through the economy. Classic recession response, including lay-offs, unemployment of 10-15% in US, higher in other countries. The Euro may be destabilized by conflicts in monetary policies of member nations. Cutbacks in inventories closes factories; bankruptcies increase. Portfolio Panic Reaction leads many people to take foolish risks.

We work closely with clients to manage their endogenous risks, rebalance portfolios accordingly, make sure that adequate liquidity is maintained.

Scenario #4: Volatility Eruption. Likelihood = 25-40%. We are likely experiencing this phase now. Market prices in securities, commodities, housing, etc. take huge swings in waves of panic trading. Investors retreat to the sidelines, so trading volumes vacillate. This is how the market finds price balance, by testing the extremes. This could be a relatively short phase followed by onset of recession which could be severe, or gradually recover as markets begin to bounce back.

This is most difficult time for investors. In today’s economies this scenario usually stirs government intervention in the markets. This brings the danger that the money supply is increased faster than productivity gains which can trigger spiraling inflation. Having a long-term fixed rate mortgage is the best protection against inflation. Survival in this phase requires clients to turn off the TV.

Scenario #5: Bounce Back. Likelihood = 15-35%. If governments are successful in shoring up confidence in their economies, and adequate liquidity is available in capital markets, stable commerce will again emerge. Housing prices will drop to the point where entrepreneurs can buy up excess inventory and rent out homes with a positive cash flow. New business formations provide most new employment opportunities.

The stock market is likely to start rebounding a year or so before this phase kicks in. Clients guided by Functional Asset Allocation, which we preach, will prosper in this stage since they will not have sold off their stock holdings. Those who have continued dollar-cost-averaging, (e.g. through their 401-k’s, etc.) will enjoy rapid accumulation in their portfolios.

Long-term Outlook. Likelihood – 98-99%. As this downturn is relatively severe, it may take another 2-3 years to substantially recover. Then we will enjoy approximately 5.5 years (on average) of prosperity, which we will soon take for granted. On the next downturn, we will be again surprised. We will go through though another down-cycle as we have for the past century. Again we will think that ‘it is different this time.’ A year or so into that downturn we will again anguish about “How Bad Can It Get?” Then I will send out this blog again, as I did seven years ago in Nov. 2001…

Sleep well tonight! Bert

© Bert Whitehead, M.B.A., J.D. 2008

Monday, October 13, 2008

What Are Your Options Now?

Last month we could take some solace comparing the current bear market to past recessions. Last week, though, was the worst week ever for stocks, dropping 22% over eight trading days. The market is down 36% YTD and the Dow is back where it was in 1998. Even though this recent drop is due to irrational panic, is it time to switch gears?

Before outlining your options, it is still important to keep some historical and global perspective. So far there have been steeper market declines during the 1972-1974 recession and during the 2000-2002 dot-com bust. We are not on the brink of another Great Depression, when the market lost 93% from 1929-1932. Unlike the past, this market cycle is global and the markets in Japan, Britain, Germany, Australia, Hong Kong, India, China and France are all down well over 40%.

Here are your basic options, followed by our commentary:

1) Buy more stocks all at once

2) Buy more little by little (dollar-cost-average)

3) Hold everything to see what happens

4) Hold market position but review and reallocate investments

5) Sell some/all stocks for now and keep in cash, or buy bonds

6) Sell everything and put it in gold or under the mattress.

1) If you are a Gambler, you could take extra cash, or take out a home-equity loan (now offered at 3.99% through Schwab), and put it in the market as fast as you can. This is basically ‘market-timing’ which is always a mistake in the long run, but gives you bragging rights if you are correct (otherwise don’t tell anyone). If you are driven to do this, only do it with a small amount of money (5% or less of your portfolio) and don’t sell your bond ladder to get the cash.

2) Taking extra cash, or using your current 401k contributions, to dollar-cost-average into the market is actually the best option. If you are young enough this is a once-in-a-lifetime opportunity to provide for your retirement so you won’t even need to worry about Social Security (which you may not get anyway).

3) If you are retired, or need some cash flow from your portfolio, holding on to what you have provides peace of mind (assuming you have a balanced portfolio with a 15 year bond ladder with Stripped Treasuries). It is tragic to see how many people are letting money ruin their lives now by watching the news all the time, talking to everybody about how awful it is, mired in angst about whether they should buy or what they should sell. In the long view this will have as much impact on your life as last year’s Super Bowl.

4) Hold but review and reallocate as needed is a great idea. Of course you pay us to help you with this strategy. so we are biased toward this option. We have let you know when major shifts are called for (e.g. sell muni bonds) and can help you execute these changes. We are now reviewing our current portfolio holdings to see if there are better money managers in various asset classes, and will advise you as appropriate. If you are feeling very anxious, it may be a subtle psychological clue that you should have a lower risk portfolio due to endogenous changes in your life (e.g. employment, health, business/real estate risk). If this fits you, please call us to see if your portfolio should be reallocated.

5) Sell! Put it in the bank or buy bonds. This is folly because you are letting your emotions dictate your investments. This is one of the stupid things some smart people are doing with their money. Not only do you have to decide when to sell, but also when do get back in to the market. So you live out the next couple of years on the edge of your seat watching the market. When it goes up, you jump back in, but then get whipsawed as it drops again. So you sell and take your loss. On the next uptick, you lie awake every night wondering if you should buy this time. Get a life!

6) Sell everything and buy gold or put it under your mattress. This is one of the stupid things that stupid people do with money. Sure, keep some cash or gold within reach (not more than 2% of your portfolio) to hedge against financial Armageddon if that is comforting, but it is not an investment strategy.

We hope this outline of your basic investment options will strike a chord with you, and confirm that you are on the right course for your particular situation. If it is unsettling, please email us so we can set up a time to discuss further.

PS The Cambridge strategy of using the 15 year Treasury bond ladder is impacting the industry. See this Oct. issue of Money Magazine:

© Bert Whitehead 2008

Bert Whitehead, MBA, JD

Tuesday, October 7, 2008

Time to Act!(?)

If you haven’t been stewing about the market, don’t bother to read this. If you have been losing sleep over the market’s ups and downs, we hope this will put it in perspective. We had a conversation this morning with over 75 members of the Alliance of Cambridge Advisors (ACA) across the country to discuss the situation and appropriate action clients could take.

As of this morning the Dow was down about 25% YTD, and the European Markets are down over 30% YTD. The impact of the bailout won’t be felt for at least a month, and we are likely to see significant market volatility at least until the end of the year.

To put this in historical perspective, the Dow dropped 25% in one day in 1987. In the last recession, from 2000-2002, the market was off 45% at the bottom in 2002. A number of clients jumped out of the market in 2002 because they couldn’t stand the thought of losing half of their portfolio.

Alas, once burned, twice shy = so they were hesitant to put money back in the market when it started to recover, worrying it would drop again. During 2003, the market soared over 30%, and by the time they got back in during 2004 they were never able to make up for the loss they experienced from jumping out.

This market presents both dangers and opportunities for investors. Below we review actions you might consider depending on your stage in the ACA Life Cycle, as well as specific advice if this market is now impacting your cash flow. We have included all of the stages, not just yours, because many clients like to share this information with their friends and family.

1) Foundation - ages 20-30: This is a great time to buy your starter home. You have to shop for foreclosures and short sales though, or you might buy a house you could buy for half the money next year. If more than 10% of the home sales in your area are foreclosures, they are driving the market price, so hold back, no matter how tempting it is to jump in. In the meantime, pay off your credit cards and accumulate cash. Keep contributing to your 401k, since you can borrow this money for a down payment if you have to.

2) Early Accumulation - ages 30-40: Since by now your net worth should be 1 to 3 times your annual income, and you have a home, save-save-save. Hold off on home upgrades and renovations until you have built up a cash reserve of at least 20% of your mortgage balance. Split your 401k contributions 50/50 between cash/stable value funds and equity mutual funds.

3) Rapid Accumulation - ages 40-55: Your net worth is now 3-10 times your annual income so invest aggressively in your equity mutual funds to bring them to at least 60% of your portfolio. This is a great time to buy stocks using Dollar-Cost-Averaging (i.e. buying some every month). Doing this now will guarantee you a great retirement, and you will look back in 10 years and be amazed at how low the prices were. However if you are in danger of losing your job, see the section below on “Cash Flow Problems.”

4) Financial Independence - ages 55-70: At this point you are still working but supplementing your income with investment earnings. This is a dangerous stage right now. You want to make sure you don’t deplete your investment portfolio!
Either work more to increase your income, or cut your living costs.

5) Conservation - ages 70-85: You are probably now retired and should have your ACA Bond Ladder complete. It is critical to make sure you continue to live within your means. Excess spending means your portfolio will be depleted to quickly. Keeping to your spending plan will assure we will be able to replace the rungs you are using from your ladder when the economy turns around.

6) Distribution - ages 85+: Many clients in this stage are distributing their largess. We suggest holding off on additional gifts to children or charities for 6-12 months. You want to gift your largess, but you don’t know what that will be until this financial crisis ends.

For a more complete discussion of these life stages, we would suggest re-reading chapter 7 of “Why Smart People Do Stupid Things With Money” by Bert Whitehead, MBA, JD, who founded ACA.

Cash Flow Problems? Special consideration should be given in situations where a client is laid off or their business is losing money. You should contact us before taking any action. However, here are the sources of cash we suggest in order:
a) Cash: conserve it, and if you have depleted your cash to below 4 months living expense, consider borrowing money on your home equity line of credit (banks only lend you money if you don’t need it, so don’t wait until then).
b) Bonds: sell bonds which are not in a qualified (i.e. pension) account.
c) Stocks/Mutual Funds: sell equities which are not in a qualified account. At this point it is likely you will have a very low taxable income this year. If the stocks are at a gain, you may not have to pay capital gains tax if you are in a 15% bracket. If there’s a loss, you can use $3000 each year after offsetting capital gains and carry forward the loss to future years.
d) If you are anticipating a negative taxable income, we may want to use the opportunity to convert IRA’s to Roths.
e) If things get this bad, you may have to consider cashing in Savings Bonds.
f) If you end up having to live on your credit cards, we should be doing bankruptcy planning with you.

The economic situation could worsen substantially, particularly if there are compounding exogenous events like terrorists setting off a Middle Eastern war which interrupts the world oil supply, or a severe California earthquake, or a global health plague. These however are very remote. There is nothing you can do about these possibilities.

It is more likely that your endogenous situation could change due to a disability, layoff, divorce, etc. In these cases we should rebalance your portfolio accordingly, so give us a call to set up an appointment.

Finally, if you find yourself often anxious about the world financial situation, do yourself a favor and stop watching TV news or listening to the radio. The media has been hyping this issue to increase ratings, and of could all the politicians are bellowing about it to get votes. Most of them don’t really know what to do about it and just rant. Stop listening!

Warren Buffet is a calm, collected buyer in this market; Jim Cramer is jumping up and telling people to sell now! Warren Buffet is one of the richest men in the world; Jim Cramer earns a living with his antics. Who do you want to emulate?

Bert Whitehead, MBA, JD

Monday, October 6, 2008

Getting Out of Egypt

The Red Sea hasn’t parted, but at least the bail-out gives us some boats. Our problem now is to realize that the leadership skills needed to get out of Egypt aren’t the same ones needed to get to the Promised Land.

It is expected that the congressional action will have a calming influence on the markets. The next few weeks will be telling. Markets are still likely to show some volatility, so just remember that roller-coaster rides are always scary, but only dangerous if you decide to jump out (especially when going downhill…).

We are continuing to monitor the situation and will keep you informed. The greatest danger in this situation is that it could be aggravated by other events. Major financial catastrophes usually are due to a ‘perfect storm’ of exogenous events. For example, the Great Depression is variously thought to have been caused by the Smoot-Hawley Tariff act (which caused global retaliation and crippled our exports), or the run-up in the stock market due to low margin requirements, or the government not stepping in to save the banking crisis. In my opinion, the Depression was due to all three happening at once, and then compounded by the severe drought of the 30’s.

Serious exogenous threats would surely aggravate the situation today, like a major Calif. earthquake, Mideastern war, terrorist disruption of oil supplies, etc. However these are improbable possibilities which we can’t do anything about, except complain and worry.

The real threats in this environment are endogenous threats which you may encounter, like losing your job, or emerging health issues, or problems in relationships or with children. These endogenous events can be exacerbated by the current financial situation. I believe that these are times when a professional fee-only financial advisor offers the most value and can provide you with peace of mind. If you are losing sleep due to this situation, please let us know. We can help you figure out a plan to find the Promised Land.

Bert Whitehead, MBA, JD