April 2009: Where Are We Today? (Mileposts on the road to recovery)
Since its March 9th low, the U.S. stock market (as measured by the Standard and Poor's 500 Index) has rebounded nearly 25%, but remains 6% under its December 31, 2008 closing level and 45% below its October 2007 record high. Stock market psychology around the world has noticeably improved, but the distressing economic news continues and promises to remain so near term in the months ahead. The current painful recession will persist until: 1) the banking system is purged of its toxic balance sheet assets and resumes normal lending activities; 2) housing prices stabilize, and 3)cconsumer spending begins to recover.
As mentioned in our most recent e-mail, the authorities are attempting to avoid further deflation in the housing market while at the same time keeping the lid on inflation expectations. Economists and portfolio strategists are beginning to project a slow rebound in the U.S. economy in the 4th quarter of this year or in the 1st quarter of 2010. Emerging is a general feeling (the media's constant dreary drumbeat notwithstanding) that the worst of the credit market crisis has been dealt with. However, if the projected Federal budget deficits are not considerably moderated in the next few months, heightened inflationary expectations will replace deflation as a primary investor concern. Unchecked deficit spending narrows the government's fiscal policy options and in the long term jeopardizes the U.S. dollar's value, primarily vs. the yen and euro. Despite the current troublesome economic background, equity markets appear to be nearing bottom, and perhaps investor exuberance, reflected over this past decade in rising price/earnings ratios (see JP Morgan "Market Insights Series" chart attached), has finally been washed out in today's diminished stock market valuations. With this in mind, portfolio rebalancing seems called for. As such, we will be redeploying excess cash reserves back to equities in phases over the next six months.
In this process, we will be adding a new asset class position in publically-traded commercial real estate securities through the Morgan Stanley Global Real Estate Investment Trust Fund (REIT). Down 68% from its February 2007 peak, the Dow Jones Equity All REIT Index (which tracks 113 publicly-traded stocks) lost 32% during the 3 months ended March 31st. REIT declines in the latest quarter were uniform across most real estate sectors (e.g., hotels -38%, malls -37%, retail -39%). Size did not matter either . . . large publically-traded REITs declined about as much as smaller capitalization REITs. Since last summer, publically-traded REIT stock price volatility has escalated. However, if the stronger players can maintain their dividend yields (average 4-5%), at today's prices this asset class should produce strongsrelative returns longer-term. Further, when and if inflation concerns begin to ratchet up, a position in real estate through global property ownership should benefit portfolios as well as provide foreign currency exposure (i.e., a way to hedge against gradual U.S. dollar purchasing power erosion).
Recovery Math (Why the rebalancing discipline is so important)
A question on many investors' minds today is likely to be . . . if the equity markets have bottomed, what are the prospects for recouping portfolio values lost since the stock market record highs of October 2007? The answer is, of course, "it depends." Before tackling the specifics, however, first a "recovery math" refresher. If a stock purchased at $100 per share declines 50%, how much must its price appreciate to return to original cost? The answer, perhaps some will be surprised to recall, is 100%, or $50. Applying this recovery math to the entire U.S. stock market-if the October 2007 S&P 500 Index peak was 1,565 and today's index reading is 825, then the lost ground to be recovered amounts to 740 index points, or 90% on today's current index base. If one would hope to regain the October 2007 peak index value during the next five years, then an annualized return of 13.7% would be required for the S&P 500.
How often have equity market returns equaled or exceeded the above requisite annual compounded recovery rate? During the past 83 years, since 1926, the S&P 500 Index has returned 9.6% compounded each year.* At this rate it would take roughly 7 years for the market to regain its October 2007 level. This seems a daunting task given the global economic outlook. However, there have been periods when stock market returns have exceeded the 80-year average rate (see attached chart "Average Annual Returns for the Decades" from Aequitas Investment Advisors). But today the equity markets start at extremely depressed levels. To this point, deflationary fears, investor pessimism and dwindling confidence (as reflected in depressed price/earnings ratios) have combined to form a low base of diminished expectations. When confidence in the markets' prospects improves, often P/E ratios expand. From such equity market circumstances as we face today, surprisingly satisfactory results often develop.
Realistically, however, given the credit market and economic issues we face, as well as the prospect that an ever more intrusive government promises to alter the way the financial services sector and the markets operate in the future, expectations should probably be tempered. Time will be required to repair and reset equity investor behavior. Stock prices will recover, but a return to past peak levels may take more time than expected. As for your own portfolios, past disciplined rebalancing, reallocating over-weighted equity fund sale proceeds to fixed income, and remaining fully invested has served to temper portfolio losses (compared to an all-equity allocation). As always, patience, disciplined rebalancing, and attention to risk management are essential in achieving a better risk-adjusted result.
The Politics Behind Financial Markets Regulation (The story behind the headlines)
Current conventional wisdom has it that in reaction to the housing and synthetic paper credit market meltdown of the past year, the U.S. banking and financial services industry will be much more closely regulated in the future. This will no doubt turn out to be so. However, watching the House Subcommittee on Capital Markets hearings and fact-finding process underway today (which is intended to lead to comprehensive Congressional reform legislation), one is hard pressed to conclude much wisdom of any kind will arise out of this process. During the past 15 years, many publically-traded financial instruments throughout the world's investment markets have become so arcane as to almost defy a rules-based regulatory approach. With the advent of electronic trading networks (i.e., subscription transaction channels outside the public auction markets which facilitate direct trades between two or more parties), the task of regulators attempting to improve transparency for all players has been made all the more difficult. Beyond this, the extension of such regulatory reform to include the opaque activity of hedge funds, private equity financial transactions and illiquid risk-transfer vehicles such as securitized home mortgage pools, would almost seem an insurmountable challenge.
As if the prospect of a complete legislative overhaul of the regulatory environment were not enough, behind the curtain an important bureaucratic power struggle is underway. Having been found wanting and seemingly always behind the curve, the Securities and Exchange Commission (SEC), our Registered Investment Advisor (RIA) watchdog, finds itself struggling to maintain its relevance. Chronically under-staffed and sandwiched between Congressional politics and a highly sophisticated, dynamic capital marketplace, the SEC has sought to extend its reach through a supplemental Self-Regulatory Organization (SRO) approach. In the broker-dealer world this has spawned an activist body called FINRA (Financial Industry Regulatory Authority). FINRA, representing the "sell side" of Wall Street, is well financed by high-powered broker-dealers and, as is usually the case when such groups begin to take themselves seriously, tend to extend their reach and perpetuate their existence. In this instance FINRA seems intent on expanding its role beyond the securities dealer and brokerage business into the investment management (RIA or "buy side") world.
The reader might well ask why should this concern me? The issue behind this power struggle is that currently the sell side, in its dealings with the public, is legally held to a lower level of responsibility in the performance of its duties than is the buy side (i.e., RIA). A Registered Investment Advisor, like TFC, must, at all times, place the client's interest first. In other words, RIA's have a fiduciary responsibility to their clients. Brokers, even if foregoing commissions and charging only a fee for their services, are not held to the same standard of objectivity. So, to cut to the chase, if FINRA were to assume regulatory oversight for firms like TFC, the alignment of purpose between the RIA and its clients could, practically speaking, be less assured.
In mounting its takeover campaign, FINRA has recently testified before the House Financial Services Committee on Financial Institutions proposing that the RIA fiduciary responsibility principle be watered down by a legally vague measure to be defined as "a universal standard of care." The intent is so obvious as to be laughable, and to propose such a benchmark in the wake of the Madoff revelations begs credulity. With this background in mind, clients (brokers use the term "customer") might find the spin which will no doubt unfold in the weeks ahead a bit more understandable. If FINRA succeeds in adding RIA's to its extended SRO oversight and subverts the fiduciary responsibility paradigm, individual investors will have lost a useful protection and yet another performance guideline by which to measure the stewardship of those managing their personal financial affairs. The SEC now seems to be better informed about the potential consequences of such a FINRA takeover, but intense sell-side lobbying goes on unabated and until the final legislation is on the President's desk, this threat to investor protection remains.
We would be happy to answer any questions you might have and welcome your comments and suggestions.
Sincerely,
James L. Joslin
Chairman & CEO
* Morningstar, Ibbotson: Stocks, Bonds, Bills and Inflation, 2008
