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Investing in the Financial Markets for the ‘Right’ Reason

Investing in the Financial Markets for the ‘Right’ Reason

Many of you have contacted me over the past couple of weeks with questions and concerns regarding the current investment climate. As your advisor, one of my roles is to play ‘psychologist’ in that I listen to your concerns and try to help determine strategies to incorporate them. Many of you whom I’ve worked with for quite some time understand that I never tell you what is right/wrong or good/bad. Those are value judgments that you must make for yourself. Rather, we discuss a myriad of strategies and discuss the pros/cons of each.

Well, I’m using this opportunity to contradict everything I have ever told you. Indeed, there is something that is ‘wrong’ and ‘bad’ and that is an extremist shift to a heavy cash and fixed income weighting in light of recent market volatility. Conservative strategies are great for my grandmother and even she’s bullish on the markets!

Ok, seriously now…

There truly never is a right or wrong. I imagine my above comment is my opportunity to blow off some steam. However, there are emotional decisions and there are rational ones and that is something we should all consider. I am an investor like each and every one of you so I fully understand the pain felt when markets decline – particularly when there doesn’t seem to be any rhyme or reason and it appears that there’s no end in sight. However, it’s important to differentiate between short-term, ‘feel good’ decisionmaking and long-term financial success.

First and foremost, we must ask ourselves why we are invested in the financial markets. Are we seeking long-term growth of capital? If so, we are investors and must keep our focus on long-term, risk-adjusted performance. If this is not our goal then we should give serious thought to why we are invested. The financial markets may not be the right vehicle to meet our needs. We need to remember that investing is a means to an end – not an end in itself.

The goal of asset allocation / modern portfolio theory is to ensure that the individual components of a portfolio complement each other. Stocks, bonds, real estate, precious metals, energy, etc. all have a unique risk/return profile. Growth investments will act differently than value investments. No one part of a portfolio is risk-free. Some assets will increase in value while others decrease. Not all assets will increase at the same time. This is by design!

An underlying belief in asset allocation / modern portfolio theory is the necessary ingredient to long-term, risk-adjusted financial success. Anything else amounts to market timing and we as gamblers – let’s be honest and call market-timing what it is – have a lousy history in terms of calling market tops and bottoms.

We sell and buy too late. Markets go down and then we look to preserve what’s left. Markets go up and then we look to get in on the action. We’re always too late.

Why then do we seek to move towards cash and fixed income at this time? Is it a short-term, emotional response to market volatility or do we believe that the future of the economy is dark?

Let’s take a recent look at the price of financial assets. The financial markets boomed during the mid to late ‘90s. Prices were sky high but the economic fundamentals didn’t justify them. The dichotomy had to come to a logical end meaning prices had to come down or the economy had to improve. Hindsight is 20/20 as they say but we clearly see that the economy cooled and financial asset prices tumbled.

Today our situation is no different. Economic data suggests an improving economy yet financial asset prices are well below where they should be. Again, the dichotomy must come to a logical end. Financial asset prices must increase or the economy must slow. The data suggests the economy is improving with strong GDP figures, a strong housing sector, increased government spending, strong (although weakening slightly) consumer confidence and low business inventory levels. Therefore, the only way to resolve the dichotomy is to have the prices of financial assets rise.

Further, consider that there is something along the lines of $7,000,000,000,000 of cash ‘on the sidelines’.

That’s trillion with a T! Where is this money going to go? Will this money flow overseas? Sure, some money will find its way to foreign markets both in the form of new investment and currency repatriation. The recent fall in the dollar (although the trend has reversed itself over the last few days) is tied to the latter.

Will this money flow into real estate and gold? Sure, this shift has occurred to an extent as these have been a couple of the best performing asset classes over the recent past. However, have these assets performed well due to solid fundamentals or due to investor flight out of other asset classes? The latter deserves a greater weighting given the softening of certain real estate sectors and the de-linking of gold as a store of value. Committing new money to real estate and gold is likely to make these fairly valued to slightly over valued asset classes downright overpriced. What will happen to prices when investors flee to move back into stocks?

Will money flow into corporate bonds? This market is quite small and investors are jittery given recent accounting ‘scandals’ although we should keep in mind that a few ‘cooked books’ shouldn’t justify the indictment of all of corporate America.

How about government debt? Consider that about 50% of all US government debt obligations are held by foreign investors. They won’t sell their holdings as they have no safer store of value. This leaves a relatively small portion of the market for US investors who have already bid up bond prices in a ‘flight to quality’.

Interest rates (which move inversely to bond prices) are at multi-year lows which is in direct contrast to the direction of interest rates as justified by the recovering economy. Interest rates tend to rise as the economy grows stronger. Rates must rise over time meaning that investors will be forced to flee fixed income investments. Committing new money to a bond market that is artificially overpriced is like trying to cram into a packed elevator. What will happen to bond prices when investors move back into stocks?

Indeed, bond investments of any type are a dangerous bet at current prices. Consider the following from the July 26, 2002, edition of The Wall Street Journal:

…experts caution against overreacting. For starters, there’s the issue of timing. Bonds delivered strong returns over the past few years as interest rates dropped; bond prices move in the opposite direction as interest rates. But many financial professionals note that interest rates now are at extremely low levels. Whenever rates do start to rise, outstanding bonds will decline in value and bond funds may end up with periods of negative total returns. Indeed, investors don’t have to go back too far for the last time this happened. When interest rates rose in 1999, the average long-term government bond fund lost 5.7%. Says Don Cassidy, senior research analyst at Lipper, Inc., “It’s a scary time, but doing what will make you feel comfortable may not be to your financial advantage.”

The only markets of sufficient size to absorb the bulk of this $7,000,000,000,000 of cash are the US equity markets. This is one of the most positive long-term arguments that can be made in favor of equity investments.

Ok, so what is my point? Have I truly lost it? (That’s rhetorical – please don’t answer!!!) My point is that it’s important to maintain a balanced portfolio. Moving into a heavy cash and fixed income weighting is dangerous no matter how good it might feel in the short term. Diversification allows us to enjoy the upside while limiting losses on the downside. It won’t always provide the maximum return but it won’t decimate our portfolios when markets move against us. Asset allocation truly allows us to sleep at night – anything else is market timing no matter how much we rationalize it. Remember, a rose by any other name…

To paraphrase the elder President Bush: ‘stay the course’!

As you know, our resources are available to serve you in a multitude of ways. We are currently in the process of updating our quarterly economic commentary which you will receive in the mail when complete. I encourage you to review this information and call me if you wish to discuss it.

Further, our next economic and investment conference call is scheduled for August 23rd at 12:00pm EDT.

You will receive details about the call in the next couple of weeks. In the interim and as always, please call or write to me if I may be of assistance.

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