Letter to Our Clients - May 2010

May 2010

 

Dear Clients and Friends:

A. The Year So Far

Well, it had been a quiet year in the stock and bond markets up through the end of April. A Goldilocks Market: not too hot, not too cold, but for 4 months, just about right. I could not think of anything original to say during this period, which is why it has been so long since my last letter.

As I write this, the last week of May, all the gain for 2010 has been wiped out and most indexes are in slightly negative territory. This only slightly negative situation masks the brief but dramatic 1000 point drop of the market a few weeks ago. The media of course are loving this, as headlines scream about investors fleeing the market. However, all that has really happened is that, for the first time since March 9, 2009, the market (briefly) dropped 10% from its recent high. This is called a “correction” in technical terms, and can be a good thing by blocking irrational exuberance, to use Alan Greenspan’s words.

There are many theories about why the dramatic drop has occurred. The most common explanation is that the huge debt loads of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) will halt the global recovery, and perhaps even plunge us back to the levels of late 2008 and early 2009.

This is certainly possible, but I believe we are seeing that the major causes of market swings (both down and up) seem to come from events or causes that were generally not anticipated. In retrospect the bursting of the real estate bubble should have been predicted, and of course some people were warning about it for years. Nevertheless it took the failure of Lehman Brothers to create the panic of 2008. By March 2009 there was no good economic news to be found anywhere, and yet the stock and bond markets exploded upward.

There is a more recent example of the futility of predicting trends. For months we have been hearing that 1) the dollar will sink compared to other currencies, 2) inflation will increase dramatically,

3) interest rates will rise and cut off economic recovery, 4) nobody will want to buy US Treasury bonds because of our debt levels, and 5) the US stock markets will languish compared to overseas markets. So far in 2010 the dollar has risen against most currencies, inflation is at the lowest levels since the early 1960’s, mortgage rates are back below 5%, and the purchase of US Treasury bonds by foreign countries has spiked again, I believe to record levels. Oh, and the US stock markets are doing better than almost all foreign markets. This situation may not last, and we may yet lose our global competitiveness. Still, I believe investors take enormous and unnecessary risk if they make their financial decisions based upon the pessimism or optimism of their political beliefs, or upon the expectation they can anticipate the directions of economies or financial markets.

B. Managing Market Volatility

The 1000 point drop a few weeks ago, which occurred in a matter of minutes, exposed the fact that the technology and sophistication of major financial institutions have eclipsed the ability of the exchanges and regulators to maintain orderly markets. This is being cited as a reason why small investors are unwilling to come back into the stock market.

This could work to your advantage. In “the old days” investors might have felt comfortable buying Investment A and selling Investment B because of what they had read or heard about the pricing advantage of one and the declining fortunes of the other. Of course, insiders always had an advantage. Then the internet, and regulations following the 2000-2002 bear market, took away some of the information advantage of insiders. However, when everyone has access to (almost) all the information, it is difficult to know what is relevant. Decision-making does not necessarily improve, and insiders still have advantage.

It may be different now. Investment information is no longer what is driving the markets – instead, it is trading information. The regular occurrence of rapid price movements seems to make it futile to think that an individual investor on Main Street can compete with an institutional investor on Wall Street.

And yet...If one ignores the daily, weekly, monthly trading activity, and instead stays focused on long-term fundamentals, then the factors keeping “timing investors” from participating in the stock market will work to the benefit of investors with patience, discipline, and a long-term strategy. Why? When consumers want goods and services, individuals and companies will find a way to provide those goods and services at a profit. Financial markets will reward those companies that do well and punish those that do not. Profitable companies survive and remain the core positions in stock and bond market indexes. Investing in those markets, then, will provide opportunities for individuals who can prudently divide their investible assets among growth and income opportunities, while always maintaining appropriate cash reserves.

Financial professionals call this “asset allocation.” Most investors never earn the returns the indexes offer, because most investors are always buying when they feel comfortable and selling when they are worried. They often are moving funds in and out of different asset classes at just the wrong times. It is also interesting how many financial professionals think they can call the trends and time the markets, and so lead their clients into or out of asset classes at the wrong times.

To combat this behavior, a fellow financial professional suggested that “asset allocation” is not sufficient for investment success. Instead, a successful investor should practice “asset dedication.” I liked this thought so well I wanted to share it with you.

CONCLUSION

For several months I felt there was nothing to write about. Now there is more to discuss, but I am out of space. Next time I plan to talk about “secular bull and bear markets.” Until then, I wish you good health, prosperity, happiness, and wonderful Summer weather. Thanks again for the opportunity to work with you.

Best wishes,

Robert K. Haley, JD, CFP®, AIF®
President