November 14, 2008

What I Have Learned

I founded Frye Financial Center in 1979 and began writing our financial newsletter in 1982. As the years progressed, my writings evolved from the strictly informational (e.g., “the Dow is up 5% year to date”) to the more personal and philosophical. Readers let me know that they were enjoying the more folksy style and were looking forward to reading my columns and seeing how I would weave current events into my personal observations.

And then the ‘Financial Tsunami’ hit; a global panic took hold and I felt my correspondence to you   had to change to reflect the times. My communiqués of late have dealt with the meltdown, sub-prime mortgages, CDO’s, the market “bottoming out” process, the Tarp Plan, etc. and navigating through this financial storm.

If your sole purpose in reading this e-mail is to find my remedy to your reduced portfolio value, you should re-read my last few letters and read only to the bottom of the next paragraph of this one.

I haven’t changed my outlook or core beliefs. Our economy, because of unchecked greed in the financial/real estate sector, and gross mismanagement on the part of government leadership, has hit the skids. I expect the current market volatility to continue through the first quarter of 2009 when the policies of the new administration and the stimulus plan of the current one begin to gain traction. Recovery should begin in the latter part of 2009 when I expect confidence to begin to return to the marketplace. In the very short run, most, if not all the economic news will remain on the negative side. On the positive side, I think we are near the bottom of this market crash.  Rather then get yourselves in a panic while we wait for this lame duck administration and Congressional session to end, I would suggest that you turn off CNBC, don’t obsess over your monthly statements and enjoy a good book. If you have any liquidity (and you still have a job,) stocks and many tax-free municipal bonds are presenting some good opportunities for long-term investors and should be considered.

ON A MORE PERSONAL NOTE

For those readers still with me, I am going to describe what goes on in my head at 3:00 in the morning. Before I do that though, I need to explain that during normal business hours, and for a couple of hours after that, I have very little time to think. My team and I spend the day analyzing up to the minute data, reviewing and rebalancing portfolios, and talking to very concerned clients. This leaves little time to contemplate what is happening from a global, macro-economic standpoint, and little time to place the current crisis into any type of historical context ----that all comes later in the night--- at 3:00 am when all is quiet and I have woken up from my first of 2 short segments of sleep and can study the markets on my home computer.

THE GLOBAL CRISES

Alan Greenspan has labeled this crisis a “once in a 100 year event,” and, for the most part, I agree with him. Let’s first simply compare the current market meltdown to the more recent crash of 2000-2002 to illustrate how much worse this one is. While the crash of 2000-2002 seemed painful then, it was primarily a crash in technology sector stocks. Those of you who had well diversified portfolios back then, barely felt a ripple. Those with heavily concentrated positions in Tech and Internet stocks were hurt badly in that portion of their portfolios, but their bond investments held up, their real estate values held up, and their business values held-up. The term ‘upside-down’ had not yet entered the financial lexicon.

At the end of the day, diversification worked, valuable lessons were learned about the risk inherent   in concentrated positions and life continued.

Let’s fast forward to today and examine the contrast. This meltdown is being viewed as a once in a hundred year event, because all asset classes have plunged together---tech stocks, value stocks, big stocks, small stocks, short bonds, long bonds, tax-free bonds, residential real estate, commercial real estate, oil, gold, other commodities, businesses, art…everything!

For those of you beating yourselves up and plagued by the recurrent (every 15 minutes) thought,  “I should have sold then”, or “I had this bad feeling and wanted to go to cash,” I want you all to consider the following. But for the government bailout of Banks and Financial companies, enormous deposits of cash were about to be wiped out. Other then FDIC insured deposits ($100,000 then) there were massive amounts of uninsured cash about to disappear into the ether. It was only when our major institutions such as Wachovia, Washington Mutual, Merrill Lynch, etc. were about to collapse, that Uncle Sam came in and saved the day.

GLOBAL PANIC

Thirty years in the financial industry and many years of graduate study didn’t completely prepare me for the current crises. I was warning all of you about rising real estate prices for years, and I may have been the only financial advisor telling you that oil prices would crash. However, I never realized or predicted that a global panic would cause every asset class to crash down together with one great, earth-shattering thud.

When the entire world loses confidence at the same time in the economic system and leadership, and there is a resultant global run to the cashier’s window to sell, virtually every asset losses value---good stocks, good bonds, bad stocks bad bonds—it doesn’t really matter. When panic hits, and/or cash needs to be raised quickly, the public sells what they can and they sell their most liquid assets—stocks and bonds.

HIGHLY IMPROBABLE EVENTS—HURRICANE KATRINA

Our government and officials in Louisiana knew that the levies in New Orleans were subject to breach, but they explained that it would take a 1 in a 100-year event for that to happen---a major hurricane entering the gulf and the bayous in a precise, directional path.  Rather than plan for such an event and in so doing prevent thousands of lives from potentially being lost, and billions in infrastructure and property being destroyed, they played the percentages, and didn’t plan at all. And the rest, as they say, is history.

The Bottom line is that highly improbable events, over the long term, will eventually occur. Or as a professor of mine once said in an actuarial mathematics course, “if you lock a chimpanzee in a room with a typewriter, over an indefinitely long period, he will with 100% certainty, eventually type out the Declaration of Independence.”                     

THIS IS WHAT I HAVE LEARNED

So let’s go back to our financial markets and the current once in a hundred year tsunami. Given the remoteness of this occurring again, mathematically, it would make sense to ignore the possibility. And that, perhaps, is the big mistake we all made; even though the probability of a particular outcome is remote, if the damage that can accompany that outcome has the potential to be unbearably severe, can it be ignored?

In the Katrina situation, if the worst possible outcome was only property damage, then a possible argument might have been made for ignoring the unlikely potential hurricane. Given the loss of life and the magnitude of the devastation, it is clear officials made a huge error in ignoring the possibility.

The answer then, for future investors and financial planners, is that no matter how good times are, you always need to know that a highly improbable tsunami can blow through at some point and turn things upside down. Therefore, one has to always be prepared. I am not advocating saving your used pieces of tinfoil, as my grandmother who lived through the great depression always did.  The best way to safeguard against financial ruin, or to at least soften the blow somewhat, is to keep your portfolio’s allocation consistent with your time horizon, to always be cognizant of your liquidity and to minimize the debt you take on. This crisis, as every other, bears out the wisdom of that advice.  

Our entire nation is going through this sobering, painful process together, and in fact, our own 401k plan at this company is in the same boat as yours. I firmly believe and history proves that getting out of the market is as risky to your long-term investments as being in it can be for your short-term investments. The best opportunity to recoup losses and to have the potentially best long-term result lies in sticking with a disciplined approach and the risk adjusted plans you have in place.

The storm is still hovering over us, and the extent of the havoc that will ultimately be wrought cannot be known. I am positive, however, that better days are ahead and I am totally committed to being there for all of you as we find our way out of this economic down turn.

Austin A. Frye, MBA, JD, CFP®

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*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  Stock investing involves risk including loss of principal.

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