Winter 2009 Quarterly NewsletterBy Meredith Stoudt
Posted on April 8th, 2009
Winter 2009 Quarterly Newsletter
(view as pdf)
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PAST ECONOMIC COMMENTARY
By Clint Edgington
At such times, it is important to focus on things that we can actually control, and identify and accept the variables that we cannot control.
While many economists attempt to forecast what the future holds, we know the precise future is not predictable. However, an examination of the past can give us great insight into ourselves, how we’ve reacted in the past, and how we may react in the future.
A Brief Reflection
The current recession that we’ve been experiencing since December 2007 ended the previous period of expansion that began in late 2001. As you may recall, our markets and economy began to nosedive in early 2000 due to the heady economic expansion in the mid/ late nineties, primarily due to overinvestment in fiber optics, internet related stocks and virtually anything involving technology. The severe market decline and slight economic recession was deepened by the tragedy of September 11, 2001. The cloud of fear darkened when the accounting skeletons (Enron, etc.) began creeping out of the closet, only to be joined by Wall Street analysts pumping up their investment banking clients, rather than providing truthful analysis to Main Street.
This market downturn is structurally different. Instead of a ‘hangover’ from overinvestment, we have begun to experience a powerful cycle of deleveraging. Our economy and society had become quite leveraged in the late 1990’s, exacerbated by Greenspan’s low interest rate environment which spurred a real estate bubble fueled by cheap and questionable debt. While many pundits have blamed specific securities, the securities were simply the tools used, not the underlying problem.
The first disruptions began in early 2007, but picked up significant steam midway through 2007. The spring of 2007 saw a few large mortgage companies and other behind-the-scenes companies that invested heavily in subprime mortgages have their first problems, however; it had not yet become a front-page issue.
In July of 2007 I began working on my first consulting engagement in this new environment. A group of mutual funds that had invested heavily in collateralized mortgage obligations and other asset backed securities and began experiencing a liquidity crunch These funds (and others like it) were facing a two sided battle: Paying its investors back that were redeeming their shares, and funding those payments by selling increasingly illiquid securities, thus flooding the market and decreasing their price. Decreased asset prices translated directly to lower fund values, spurring additional redemptions from investors. The banks and broker-dealers that promoted or were affiliated with these funds tried to release the pressure by buying some of the assets from them, however the broker-dealers and banks had problems of their own as many held these assets on their books and were under the same pressures. The “Catch-22” of selling illiquid assets that further depressed their value created an environment of fear, and stimulated rumors on “who would go out of business and when.”
The first major broker-dealer to succumb was Bear Stearns, forced to be purchased by JPMorgan in an eleventh-hour deal subsidized by the government. This was the first time many of us began to think of government bailouts as a possible solution. Unfortunately, this has now become normalcy. Market participants got caught up in the age-old mentality of, “This time it will be different.” “This time we are in a new economy” was the cry of the late 1990’s market, only to be brought back down to earth by simple reasonableness. After that, the new mantra became, “Our sophisticated risk metrics thought they were eliminating their risk by buying insurance against these assets from hedge funds, only to realize that they were all buying insurance from the same volatile, and unregulated, hedge funds, thus making the insurance worthless. While you can transfer and redistribute risk, many firms now painfully realize that you cannot eliminate risk.
This deleveraging began affecting the “real economy” first through difficult credit markets, which then translated to economic contraction. Deleveraging cycles typically take longer to play out than other types of negative economic cycles. The average post-WWII recession lasts approximately ten months, and we will be entering our fourteenth in February. While I am not as pessimistic as many pundits, it is interesting to compare this to particular previous downturns. The period from 1929-1933 and Japan’s “lost decade” are especially good examples of deleveraging cycles.
When will this stop? Did the U.S. market already hit it low in November? Nobody knows. As Warren Buffet said:
I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
One thing we must accept is that there is a lot of stimulus in the economic pipeline. From multibillion dollar bailouts to ultra-low interest rates, if you’ve ever believed in the phrase, “Don’t fight the Fed,” now would be the time to adhere to that as you’ll be fighting the Fed, President Bush, President- Elect Obama, Treasury Secretary Paulson, and the Troubled Asset Relief Program (TARP). Keep in mind two additional things: first, this stimulus takes time to filter through the economy; second, that historically, those in control of fiscal and monetary policy tend to overshoot to stimulate the economy.
What is the answer to all of the uncertainty?
1. Focus on what you can control.
Adhere to a written investment plan modeled to withstand market downturns and profit from up-turns. Is your asset allocation still pertinent to your plan? Has volatility made rebalancing necessary?
Adjust your risk tolerance in the future. Look at how your portfolio is acting—write down your feelings now, and remember your feelings two years ago. Your risk tolerance changes for many reasons—temper the changes in your risk tolerance due to market gains and losses.
Focus on your cash flow. A small silver lining in this economy is that the price of almost everything has go down, from luxury cars to fuel. Create some short-term reserves from this additional cash flow.
Estate planning. This is a prime year to revisit an estate plan that is already drafted, as many critical variables expire or change this year. In addition, a lower value on most assets makes now a prime time for gifting and succession strategies.
2. Identify and understand variables you can’t control.
Ignore the pundits and fortune tellers. Turn off the noise! Market forecasts, economic forecasts, and research analysts’ predictions on stock prices have a miserable record. Statistically, there must be someone who will accurately predict the market bottom (or whether we have already hit it), but it’s not possible to tell who. The irony of the major Broker Dealers continuing to provide market predictions as they struggled for their very survival due to their errors is surely not lost on any of us.
Clint Edgington has researched, written about, and testified about the historical markets for the past decade.
BEAT ON THE STREET: Protect Yourself From Ponzi Schemes
By Mark Fissel
Current Events on Wall Street
Bernard Madoff’s Ponzi scheme has left everyone in the investment community appalled by the brazen act as well as the lack of regulatory oversight. The former chairman of the NASDAQ market’s elaborate Ponzi scheme swindled many sophisticated investors and institutions to the tune of fifty billion dollars. The lack of regulatory oversight is evidenced from the SEC Chairman Christopher Cox’s rebuke of his own agency, as well as many examinations that did not uncover the fraud.
Beyond an analytical review of investments, we at Beacon Hill Investment Advisory ask ourselves a few very simple questions:
1. Where are the actual assets?
Madoff was acting as a custodian for the assets, meaning that his firm was not only doing the investing, they were literally holding the investments. This creates the potential for abuse. At Beacon Hill we do not act as custodian of our clients’ assets. While we have performed due diligence to be able to recommend a Custodian, we are happy to work with whatever custodian our client chooses.
2. Do I understand the basics of the investment and the investment strategy?
Madoff sold his strategy as a leveraged hedge fund making a play around option expiration dates through the use of S&P puts, with his downside collared, thus limiting downside. This approach is not new; however, limiting the downside inherently limits the upside. Jon Najarian, co-founder of OptionMonster. com, said of Madoff, “I met with the man and didn’t think…he wanted to show me his strategy.” Najarian added that no one could figure out how Madoff’s strategy worked.2 In effect, it was too good to be true.
Institutional hubris is a theme that we see replayed throughout history. The corporate culture of most institutions does not encourage analysts to admit that they “just don’t get it.” If we do not understand an investment or the strategy, we do not embrace it.
Mark Fissel has conducted extensive due diligence for custodians that Beacon Hill recommends to clients.
SEEN IN THE PRESS
Beacon Hill is committed to contributing to the general knowledge base of our community. A few of our most recent press contributions can be seen below.
“Ohioans taken in by Ponzi schemes,” by Steve Wartenberg
Columbus Dispatch 12/21/08 (Clint Edgington)
“Practice triage in your spending…” by Gregory Karp,
Chicago Tribune 11/30/08 (Clint Edgington)
“Market Fears, Stay the Course,” by Clint Edgington,
Columbus Dispatch 10/5/08
|Clint Edgington, CFA
Beacon Hill Investment Adivsory
|Mark Fissel, RFC
Beacon Hill Investment Adivsory