Quarterly Newsletter – January 2009

2008 was a disaster in the markets. We are told this over and over – there has never been a year so bad since 1931 – and very likely more disaster lies ahead.

But perhaps it wasn’t a disaster. The real-estate boom had to end and, as booms often do, it ended badly. Now we know we have to pull up our boots and make a living. We must save more and stop borrowing to keep an unsustainable, debt-financed, consumption lifestyle going. We have to face our retirement funding problem. But the weaker dollar and thus more vibrant American manufacturing economy that can follow may well make that funding problem and Medicare easier to deal with. Sensible tax and entitlement reform will be required, but these would not be out of the political reach of an Obama administration that had previously dealt with the recession.

And remember the $150 a barrel oil of last year? The consumption boom seemed to be pointing to ever higher oil prices. High priced oil leads to floods of money going into some not very nice countries, such as Saudi Arabia, Russia, and Iran. The current recession has reduced oil prices by 70%. Now Russia and Iran face economic problems and thus reduced international influence. In both countries the pressure for political reform is rising, as it may also be in China. These countries may learn that allowing an unhappy electorate to vote is better and more useful than having unhappy mobs riot. Another possible good outcome from the crisis.

The scheme of Bernie Madoff had to come to an end – Ponzi schemes always blow up. Now it has. Reality has replaced fantasy. Those returns of his were never real – just as inflated housing prices never were sustainable. The 50-65% drop in the value of world stock markets and in many house prices, while not fun for their current owners, is a real boon for and a wonderful gift to younger people and to people of reduced means. Real (inflation adjusted) wages have gone up at a 15% annual rate since September due to the fall in rents, house prices, consumer prices and energy. Many young or less well off people previously priced out of the housing market by the bubble can now afford houses, and their retirement savings will go twice as far in the stock market. The real estate bubble, like the tech bubble before it, was an unsustainable chimera – a fantasy. Far from being a disaster, the end of the fantasy can make possible a sustained financial future for this country. The world of January 2008 has vanished. That is a good thing.

What we face is a crisis of confidence, both short and long term. Can our system rise to the challenges? The citizens of the country (and the world) don’t really know. We sort of knew real estate was in a silly bubble but we did not imagine banks could be so badly managed. It gnaws at us that our long term national finances are not in good shape. We are worried that it might all just crumble like the banks did. All one hears nowadays is that we might literally be headed to a decade of stagnation a la Japan or even to a replay of Smoot Hawley and the depression.

How should one respond to such a crisis? Good government policies give confidence. So do good investment policies. Such a discussion should start with an acknowledgment of certain facts about markets. First, there are three primary risks investors face – volatility, inflation and outliving their money. The investment conundrum is that the solutions to each of these can affect the other. For instance, a decision to increase the cash in one’s allocation decreases volatility but at the same time it increases the risk of inflation eroding the purchasing power of your portfolio. Second, risk and return are related. As the riskiness of stocks increases so do expected returns. In poker (and economics!) there is a theory of sunk cost. Past bets should not influence new bets. Thus you should always be looking at the current information to make decisions. Imagine you just inherited the current value of your portfolio in cash (as opposed to having a larger one 12 months ago). Stock prices look cheap now. Expected returns are higher for equities now than they were. Wouldn’t it be likely you would allocate a fair piece of your portfolio to stocks, depending on your time horizon and tolerances? Past losses are sunk costs. Ignore them. The current low prices of both stocks and bonds have a lot of very bad news already priced in. Equities lead into the recession and they will lead on the way out. The market can recover well before the economy does.

Our method and advice should continue to provide you with reasons for confidence. We were rebalancing like crazy during October and November of last year – one of the very few advisors who stuck to a discipline of buying stocks as they fell. We were not buying because we thought we knew what would happen but rather because we believe markets work in the long term. In the long term, patient and steady risk taking will be rewarded. This was true from November 20, 2008 (the approximate bottom, so far,) through the end of the year. Every stock category we own was up at least 20% during that time. REITs were up 49%. And you own more shares of those than you would have owned had we not bought more as they fell. Those returns are a sunk gain, returns that will never be available for people who ran to cash as the markets fell.

2009 will probably be another year of volatility in the markets. Stocks will likely be both down a lot and up a lot as optimism replaces pessimism and vice versa. But to imagine that this is all just terrible, that we would all have been a lot better off if 2008 had just never happened, we believe to be quite wrong. Wise policies can make a big difference. It is by no means obvious that bonds or cash (pessimism) will do better than equities (optimism) in 2009. It is just impossible to predict – or so we think. Patience and steady rebalancing are the way to deal both with market volatility and with volatile emotions.

Jim & Dean