April 2010: Investing in Today's Uncertain Environment

Open Client Meeting Review:  April 2010

Update on the Financial Crisis & Investing in Today’s Uncertain Environment

Update on the Financial Crisis

The Problem: The financial crisis resulted from a confluence of factors—factors fueled by 50 years of credit (debt) expansion.

In three words, the problem is “too much debt.” And, simply stated, the cure for the ills arising from too much debt is a reduction of debt.

Same Song, Different Band: Professors Carmen Reinhart and Kenneth Rogoff have examined credit crises and sovereign defaults (think Greece). In their recent paper, From Financial Crisis to Debt Crisis (http://www.economics.harvard.edu/faculty/rogoff/files/RR-Financial%20crash_February_241.pdf), and their popular book, This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009), the authors challenge the popular notion that each crisis is unique. In each instance, the sequential phases of a credit crisis, like the one that erupted in 2008, are similar and their outcomes do not vary. Although a long and painful process, resolution of the debt problem will be an eventual reduction of debt.

Reducing Debt: Excessive, unmanageable amounts of debt can be reduced in four ways. Listed from least painful to most painful, they are:

1. Pay down the debt (but if borrowers can’t make the payments, they’re unable to pay back principal),

2. Restructure debt (through reduction or partial-forgiveness of principal, and/or modification to payment terms),

3. Default and foreclosure (lenders take over the assets that secured the loans), or

4. Inflation and currency debasement (debt is repaid in cheaper, inflated dollars).

Transfers Are Not Reductions: Transferring the burden from specific individuals and businesses to our nation’s taxpayers does not remedy the problem of too much debt. Government debt that replaces private debt simply shifts the burden from individual debtors and businesses to taxpayers at large. Since the current crisis began, private debt (that is, consumer and business debt) has declined while government debt has continued to grow. So, in total, there has been no overall debt reduction in the U.S. — that is, no relief of the problem.  Like individuals and businesses, governments are not exempt from the problems and ills that arise from excessive amounts of debt.

Pretend and Extend:  Denial is not a solution.  Pretending that bad loans are good loans and postponing the resolution of problem loans by postponing the day of reckoning does little to resolve the problem.  It simply allows the problem to linger (think Japan).

Investing in Today’s Uncertain Environment

Complacency Is Dangerous:  As we pass the first anniversary of the stock market’s recovery, and the stock market continues its stunning ascent, it’s important to consciously avert being seduced by the growing complacency we see replacing lessons from the financial crisis.  Complacency is not an investor’s friend.

Crystal Ball: As investors, we should not assume we know exactly how the future will unfold and how it will impact the investment world.  No one can predict the future with certainty (although many will ask you to believe otherwise).  Any number of scenarios could play out in the coming months and years.

Human Nature: The challenges to the world’s economies are great and it would be a mistake to assume that today’s problems are not formidable.  And, it would also be a mistake to underestimate the resilience and determination of our economy and of people, both here and throughout the world, striving for better lives for themselves, their children, and their grandchildren.  The will of the individual is a powerful force.

At the onset of the financial crisis we witnessed a condition of a negative feedback loop.  Negative events (lending frozen, plunging stock market, job losses) gave rise to a negative outlook that manifested in more negative events that created a more negative outlook and so forth.  Recently, we have observed the early stages of a positive feedback loop.  Positive events (e.g., rising stock market, easing of job losses, rebounding manufacturing) have begun to foster a more positive outlook (improved business conditions, abatement of job losses) which in turn will result in more positive events (consumers are loosening up their purse strings, businesses are planning to hire) thereby creating a more positive outlook and so forth.  Just as few could envision the severity of the financial crisis and worldwide economic downturn, few can envision a reversal and renewal of worldwide economies.  As we say in the investment world, “You just never know…”

Multiple Possible Outcomes: Asset Allocation Advisors contemplates many varied scenarios and outcomes, but we do not rely upon just one outcome. We position client portfolios for many different possibilities. We don’t need to be precisely “right” or guess correctly about what will happen, when it will happen, and how it will impact the investment world. Instead, we use a balanced strategy that is flexible, has a long history of proven resilience, and is adaptive to many possible scenarios. As prudent investors, we are willing to sacrifice being 100% right in exchange for not being 100% wrong.  We don’t need to be 100% right, but we do need to not be 100% wrong.

What Should I Do As An Investor? Our investment objective is two-fold: profits and protection of capital. Our investment strategy embraces balance, diversification, moderation, and patience.

We favor balanced mutual funds that allow their managers a great deal of flexibility and latitude utilizing all types of investments, foreign and domestic, including stocks, bonds, convertible bonds, preferred stocks, cash and even precious metals.  Our finding is that “go anywhere” managers can avail themselves to a broad range of opportunities to find and capture profits.  They can also take defensive stances when warranted.  Think of it this way; it wouldn’t make sense to put restrictions on a great chef and, similarly, it doesn’t make sense to restrict talented fund managers.

Consider this — the Standard & Poor’s 500 stock market index incurred a slight loss for the ten years ending December 31, 2009.  However, as the saying goes, “the market may have gone nowhere, but it did so in an interesting way.”  The overall stock market may have ended the decade close to where it started the decade, but not all stocks ended the decade unchanged, and certainly none of them were flat throughout the entire ten years.  There were innumerable opportunities to capture profits that decade as individual stocks rose and/or fell during the ten year span.

Furthermore, stocks are not the only game in town.  Our selected managers also look for profits from other types of investments, like corporate bonds, government bonds (foreign and U.S.), convertible bonds, preferred stocks, and commodities. Change creates opportunity.

Client portfolios are constructed using a mix of mutual funds carefully selected for their managers’ abilities and records of success in achieving our two-fold objective. In addition, consideration is given to how our mutual fund selections behave in aggregate. We favor managers that apply their philosophies in unique ways with results that are not always in sync with each other.  As we like to say, “You need something zigging when something else is zagging.” While each fund manager uses a balanced approach and they are all geared toward the same end goal, their differing strategies provide yet another form of diversification.

Although past performance cannot guarantee future performance, we believe that identifying and using exceptional managers favors superior results over the long-term. We are pleased that our strategy has provided above average results, compared to an index of similar balanced mutual funds, for the trailing three and five year periods—the most volatile period in decades.

Past, Present, Future: The past two years were highly unusual in their extremes: 2008 was a year most investments experienced unusually large declines, and 2009 was a year of unusually large increases. We caution investors from becoming complacent. The coming years will present many challenges, some familiar and some entirely new. Change creates investment opportunities and perils. It’s always been that way. Flexibility, careful investment selection, and adherence to time-tested fundamentals of prudent investing— balance, diversification, moderation, and patience — makes sense and embraces standards of sound, effective investing. We believe this approach offers the best investment path for investors in today’s uncertain times.

We appreciate you and your continued business, and thank you for referring your friends to Asset Allocation Advisors. As always, please feel free to call us with your questions and comments.  We welcome your input. ***

Greg Schultz & Bruce Grenke
© 2010 Asset Allocation Advisors, Inc.