Monday, April 14, 2008

Economic Predicament (April 2008)

If It's Not One Thing, It’s . . .

. . . three or four things to make a real economic mess. What has caused the economic predicament we face today? Politicians are all pointing fingers, blaming the "Sub Prime Mortgage Fiasco," or the bursting of the housing bubble, or the falling dollar. It may be instructive to understand how these economic scenarios blow up from time to time.

The 'Great Depression' was variously blamed on Hoover/Rockefeller for not maintaining liquidity in the financial markets when runs started at banks. Others pin the fault on the Congress for the Smoot Hawley Tariff act, which raised our tariffs to protect American jobs, but set off a wave of retaliatory tariffs by other countries that decimated our exports. Often the stock market bubble of the 20's, where stocks were bought with only 10% margin, is fingered as the problem. The truth is, I think, that none of these events by themselves caused the Great Depression, but rather a 'perfect storm' where all these events happened in the same time period. Of course the record 'Grapes of Wrath' drought in the Midwest and plains states in the early 30's exacerbated and prolonged the depression.

This is true of other recessions too. In the 70's, the stock market also ended a record run-up at the end of the 60's, plus the Vietnam War was a huge financial drain. Inflation started rising rapidly, and was likely accelerated by Nixon's Wage and Price controls in the early 70's. Those factors were then aggravated by the increase in oil prices by the oil cartels, as well as the strategy of the Federal Reserve to cut interest rates to head off a recession. The result was 'stagflation' and the death of Savings and Loan companies, salvaged by the RTC.

There were mild recessions too. The late 80's had a brush with the junk bond collapse, compounded somewhat by the stock run-up in the Reagan years. But there were not enough negative whirlwinds to create a major recession. Housing hit some bumps in the early 90's, but again the national economics wasn't impacted by other forces, and in fact the increase in globalization and computerization propped up prosperity.

We were hit very hard in 2000-2002, when Greenspan finally broke the back of stock market’s 'irrational exuberance' which was then soon followed by 9/11. The era came to an end, impoverishing many nouveau-riche millionaires and decimating portfolios. It was the effect of these events happening together that produced the severe economic downturn, which in turn created huge unemployment.

Today we can see the bond market, which had become enamored of 'collateralized debt obligations' which were foisted on the investing public. This created another liquidity crises, and the stock market dropped as companies and individuals found they had committed to more debt than they could handle. The housing market, buoyed by speculators collapsed and now almost every region has a surfeit of excess housing inventory.

Will it get better? Yes, but maybe not right away . . . if there are other set-backs, we could face worse times. For example, if there is a string of
Municipal bond defaults, due to the overwhelming unfunded pension liabilities. Or even a severe earthquake along the California coast, or the overthrow of the Saudi Kingdom or other Middle Eastern political shift which interrupts the world’s oil supply. The economy can withstand one or two of these setbacks and recover quickly as it did in the 80's and 90's. However, if there are three or four of these storms which occur in the same period of time, we could see our economic situation seriously worsen.

The problem is that it is impossible to figure out the timing. It is a mathematical certainty that municipalities are not going to be able to pay the pensions they have promised to the baby boomers and beyond. Scientists agree that a major earthquake in California is inevitable. But no one knows when.

For each of us personally, we can protect ourselves from these outcomes by keeping a diversified portfolio. Treasury bonds are the stalwart buffer against deflation. If we encounter rising inflation and associated high interest rates, a long-term mortgage is our best protection. We will eventually see the dawn of prosperity again, and maintaining a diversified stock portfolio is what allows prudent investors to participate in long term growth.

So, even if it's not one thing, but three or four bad things that make a perfect storm, it's not a good idea to jump ship.

Bert Whitehead, MBA, JD

Wednesday, April 2, 2008

Is US Banking System a House of Cards? (March 2008)

Is US Banking System a House of Cards?

Bear Stearns, one of the largest wirehouses (i.e. stock brokers) in the country tanked this past weekend. That means their stock ended up being worth a little more than a penny on a dollar, dropping from ~ $170 to $2 per share. Shareholders, 1/3 of whom were employees, basically lost everything as JP Morgan bought up the pieces for peanuts.

This raises some questions inquiring minds want to know:

1) Is the US Financial structure about to fold like a house of cards? No. None of Bear Stearns clients lost any money in their brokerage or money market accounts (unless, of course, they owned Bear Stearns stock). Customers’ accounts were transferred intact to JP Morgan. Federal regulations require that clients’ accounts be segregated from firm assets, and are protected by creditors. Details of additional insurance coverage were reviewed in my last email. I personally spoke to Schwab’s compliance attorneys and am satisfied that our clients accounts are well protected. It is large financial institutions that incur the losses with these failures; retail customers such as our clients have never lost any money through the failure of large brokerages.

2) Where should I be investing now? Interest rates have been falling, real estate went bust in most locales, the stock market trends down (although it was up 400 points on Tuesday), gold appears to be in a speculative bubble. Cash looks pretty good right now, even as money market rates are just over 3%. I think dollar-cost-averaging into the stock market will pay off long term. Avoid making any illiquid investments (e.g. real estate, business ventures, etc.).

3) Are the days of a comfortable retirement gone for good? No = the key is balance. A portfolio properly balanced with bonds & cash, real estate, and a diversified stock portfolio will endure. You are protected against deflation, inflation, and still poised to participate in times of prosperity.

4) How long will this last? I’m not a market timer. I am concerned about clients surviving the downside. Things could get worse economically if the municipal bonds market collapses, and there are indications it may. So balance is more important than ever, and trying to guess which way to jump not only produces insomnia, but has been shown to be an almost certain road to lower investment returns. Over the past 20 years, as the market has risen 12%+ per year on average, the average investor has only earned 8% on their stock portfolios. The lower returns are contributed to by higher costs and higher taxes, but most of all are due to clients jumping in an out of the markets. The real costs are in the angst and anxiety of focusing on ‘the market’ rather than ‘the future’ = that’s why you have Stripped Treasury Bond Ladders!

Remember, if you decide to get out of a dropping market, you have to make two decisions right: when to get out, and then when to get back in. Clients who just stay put don’t have to agonize about either, and ten years from now will be farther ahead. Please call us if you have any questions or want to discuss your situation.

Bert Whitehead, MBA,JD

Could Chicken Little Be Right? (March 2008)

To: Cambridge Connection Clients
Could Chicken Little Be Right?
Being a long-term investor is like being on a roller-coaster: The ride up is exhilarating, but the ride down is scary! Here are the answers to some of the questions you may be thinking:
1. Is my portfolio safe? Yes, because you have a substantial amount of your portfolio in US Treasuries. They are very strong, and increasing in value, because there is a world-wide flight to safety. Treasuries are the ‘high ground’ in the investment world…actually more like the top of Mt. Everest.
2. What should I do about the falling dollar? Your portfolio includes a significant allocation of foreign stocks, which are not hedged. All other things being equal, the value of these increases when the dollar falls. This protects you some degree against the falling dollar, but not against a world-wide recession.
3. Almost all my money is at Schwab: is it safe? Your accounts at Schwab are protected by SIPC insurance of $500,000, plus additional insurance on $150,000,000 ($600,000,000 in aggregate) provided by Lloyds of London. They are not government guaranteed, but the only way you could lose anything is if a) Schwab become insolvent, and b) your securities were missing, and c) your accounts exceed the insured amounts. This is highly unlikely = you have a better chance of winning the Big Lottery.
4. What is the most important thing I should do right now? Don’t panic. This is a normal market cycle. The worst thing to do is to jump out. The stock market is volatile, and we will be advising some clients to start ‘Dollar Cost Averaging’ into the market since prices are so low. But of course we don’t know how low they could go.
5. Should I buy gold now? Many of our clients do own gold, but it’s not the right investment for all clients. Give your Cambridge Advisor a call if you would like to consider it.
Rest assured that we are watching this situation continually. We are concerned about the safety of municipal bonds, but we moved those out of client’s account a couple of years ago. Call us if you have any questions.
PS Schwab has lowered the minimum grant for Donor Advised Funds to $100 from $250. The minimum to set up an account has also been lowered to $5,000 from $10,000.

Bert Whitehead, MBA,JD

Got Treasuries? (January 2008)

To: Wealth Management Clients

Subject: Got Treasuries?

Just a note on the current volatility of the world markets (which means stocks across the globe are getting hammered). We generally don’t comment on market moves, as we are not market timers. We do know, however, that many clients may be concerned about their portfolios, and looking for guidance. Here are a few points to consider:

• Your portfolio is protected by your Treasury Bond Ladder. Virtually all of our WM clients have a significant portion of their portfolio in Stripped Treasuries. Many clients doubted the wisdom of buying Treasuries last year, or 3 years ago, or 10 years ago because ‘rates are too low!’ I have a saying: ‘Safety Trumps Yield.’ Your Stripped Treasuries are now keeping your portfolio buoyant. Your yield is locked in while current yields are falling further as there is a world-wide flight to safety in the financial markets.
• No, it is not a good time to bail out of stocks. Your bond ladder assures you 15 years of cash flow guaranteed by the US Treasury. History, documented in many studies, has repeatedly shown that jumping out of stocks in a bear market results in long-term portfolio loss. Stocks are a long-term investment; ask yourself: where will the market be 5 or 10 years from now? Plus, if you get out now, you have the problem of deciding when to get back in. As dramatic as this downturn is, the upturn will be just as sudden and dramatic. You are better staying put with your treasuries than losing sleep over when to get out, and then when to get back in.
• How long will this bear market last? Historically, down markets recover in a couple of years after hitting the nadir. This one could be longer, however, as the specter of municipal bond defaults due to unfunded pension liabilities haunts the market. Many muni bonds which were AAA insured were considered safe. But now the insurance companies that ‘guaranteed’ the bonds are being downgraded as they have lost so much in the subprime debacle. Many municipalities, no longer rated AAA, are not able to raise taxes enough to cover the looming avalanche of baby-boomers pension payouts. Since these pensions are not federally insured, defaults in the muni markets could provide a double whammy to the financial markets. This could delay recovery for as long as 5 years. Which is why your bond ladders are built out for 15 years…

Rest well: we’ve got your back covered!
Bert Whitehead, MBA, JD