Stock Volitility Need Not Drive Investors Away

Stock Volatility Need Not Drive Investors Away

A headline which appeared on Bloomberg’s website yesterday “Stock Volatility to Leave Lasting Scars on Investors’ Psyche” highlights a concern that a growing number of investors are leaving stocks for good. Last week the S&P experienced an unprecedented four-day span of volatility in which the large-cap index fell and rose by at least 4% each day. In a panic, investors pulled $23.5 billion from US equity funds, the most since the financial crisis began in October 2008, according to the Investment Company Institute.  

Add the still-fresh memories of losses suffered following the Internet bubble of 2000, the 57% collapse in the S&P 500 Index from October 2007 to March 2009, and the one-day plunge in May 2010 that erased $862 billion in value from US shares in minutes and you have strong emotional reasons for avoiding stocks altogether. Laura Keeley of Bloomberg makes the case that many investors won’t return. 

She points out that the $12.2 trillion mutual fund industry has historically been able to count on investors coming back to stocks following significant selloffs such as “Black Monday” in October 1987, the Asian currency crisis in 1997, and Russia’s debt default in 1998. She notes that in the year following the 2000-2002 bear market; US equity funds attracted $130 billion in new funds, according to the Investment Company Institute. 

But the latest spate of power dives seems to have caused more than merely the loss of fund assets. Confidence and the willingness to take risk are evaporating. Keeley highlights ICI data showing that domestic stocks lost $98 billion in 33 straight weeks of withdrawals last year following the 20-minute market plunge in May. They’ve had redemptions of $74 billion so far this year. The latest withdrawal streak began in 2007 and didn’t end even as stocks surged from their March 2009 lows, according to Keeley.  

We often hear burned investors proclaim that ‘cash is king.’ Keeley says that “cash holdings are at the highest levels since the record in March 2009, according to an Aug. 16 survey by Bank of America Merrill Lynch. Investors from 18 to 30 years old have the highest cash position of any age group at 30% of their portfolio, MFS Investment Management said in an Aug. 8 report. Almost three in five investors cite fear about volatility or needing money someday as a reason they hold high or increasing levels of cash.” 

William Finnegan of MFS said “investors are in cash for a reason and, regardless of time horizon, conventional investing wisdom no longer applies. The Great Recession of 2008 has had a profound and longer-lasting impact on investors’ confidence than expected.”

With all due respect to Mr. Finnegan and the mutual fund industry, the Great Recession is less to blame for driving investors away from stocks than the fund industry themselves are; along with financial advisors who sell them without regard to their appropriateness relative to goals and resources. In short, too many investors are poorly advised. They are under-diversified and they take far more risk than is required to meet their important goals.  As a consequence, the volatility they experience is far greater than the broad stock market itself, and considerably more volatile than efficient portfolios designed with US Treasuries to hedge against stock market risk.   

Our Balanced Model is roughly 40% US Treasuries (7-10 year) and 60% stocks. Its volatility was only about a third that of the S&P 500’s. Our most conservative Risk Averse model (30% stocks and 70% Treasuries) was actually up .2% following the 4-day roller coaster ride.

 

It stands to reason that the less volatile one’s portfolio is, the more likely he or she is to remain calm and avoid emotional mistakes. During our planning sessions we encourage our clients to enjoy their lives more and worry less about the daily, weekly and monthly market gyrations. Through our patented Wealthcare process we can show them with assurance, the statistical probability of meeting all of their important goals.  

While experiencing lower volatility than the stock markets and stock funds, our clients focus more importantly on their goals. When they ask us if they are OK, we understand that they are concerned about much more than losing money. Deep down, they need assurance that they are still on track to meet the challenges and goals ahead. They want and deserve more than an educated guess from us. That’s why we continually stress test their plans for proper funding to withstand the worst of markets. When we tell our clients they are ‘OK,’ we are confident in our assessment of their situation.  

Following the 20% drop in stocks these last few weeks, we found that only 9% of our clients’ plans fell into an under-funded status. In each case, only modest adjustments were required to bring them back into our comfort zone. In each case the remedies were readily accepted by our clients because we had already discussed them according to priority. They changes ranged from eliminating the pre-payment of a mortgage for a couple of years, to delaying retirement by a year (they enjoyed their work) to increasing stock allocations modestly. The calls and adjustments were completed within a couple hours.  

During all of last week we had only two incoming calls from clients concerned about the stock market and their plans. They and the clients we called went away more comfortable and confident in their plans and their investments, despite the media noise to the contrary.  

The investment services industry bears much of the blame for the mess in which many investors find themselves. Clearly, if there were more fiduciaries and fewer salesmen in the industry, individual investors would be far better served and in much better shape. According to Wikipedia a fiduciary relationship exists when one person, in a position of vulnerability, justifiably reposes confidence, good faith, reliance and trust in another whose aid, advice or protection is sought in some matter. A client, according to Merriam-Webster is “one that is under the protection of another.”

How much better it is be protected as a client than it is to be sold as a customer.

The Rollercoaster of Uncertainty

Since the slide in equity prices that began July 22^nd, US stocks have lost some $2.8 trillion dollars in value and roughly $4 trillion worldwide. Following yesterday’s rally, the MSCI Total US Market Index is down 13.5% and the blue chip Down Jones index is down 12.1%. Investors slugged it out this week as news gyrated on earnings, interest rates from the Fed, jobs data, and European bond woes. The Dow experienced an unprecedented four-day ride points-wise; down 634, up 429, down 519, and up 423.

 Monday’s woes were focused on European debt woes; specifically Spain and Italy. The ECB bought bonds of these countries for the first time since creating its debt-purchase program 15 months ago according to the WSJ. Italy's 10-year bond yield fell to around 5.3% from just over 6%. Spain's fell even further, to 5.15%. But the news did little to slow the declines of stock in Europe and around the globe. According to the WSJ, “Italy and Spain, the region's third- and fourth-largest economies, have a combined gross domestic product of nearly €2.7 trillion, almost 30% of the euro zone total. Royal Bank of Scotland economists estimate the ECB and Europe's bailout fund will eventually have to own €850 billion of Spanish and Italian bonds to safeguard those countries.” Estimates are that they bought somewhere between €3.5 billion to €5 billion ($5 to $7.14 billion), a mere drop in the bucket, but enough so far to stem the tide. 

The Fed was center stage on Tuesday as they replaced their customary timeframe for maintaining interest rates at near zero from an “extended period” to a crystal clear two more years, through mid-2013. Their use of the word “anticipates,” makes the statement less than a pledge, but it is the first time in recent history the Fed has come right out and given a specific time period. They referenced deterioration in labor market conditions and noted that temporary factors (Japan and weather) appear to account for only some of the recent weakness in economic activity. Three of the twelve governors dissented on the new language as they fear inflation. The markets initially reacted negatively to the Fed’s deteriorating view of the economy but turned 616 points to finish up 429 for the day.

Europe was back under the lights on Wednesday as investors worried that the ECB might be unable to contain its debt crisis and that the economy was faltering. Investors were also worried that Europe’s financial problems would spill into the US. All 10 groups of the S&P 500 Index fell at least 2%. Bank of America and Citigroup each dropped more than 10% as the costs to protect the government debt of Greece, Italy, Spain and France rose. The S&P 500 fell 4.4% percent to close at 1,120.76 and the Dow declined 519.83 points. 

Yesterday in rhythmic fashion, the Dow surged 423 points on news of an unexpected drop in jobless claims and better-than-expected corporate earnings gave a glimmer of hope that the economy isn’t slowing as fast as earlier feared on the US debt downgrade and as Europe’s debt crisis widens.  

It was also announced yesterday that more executives at S&P 500 companies are buying their stock than any time since the depths of the credit crisis in 2009 after valuations plunged 25% below their five-decade average. Some 66% of insiders at 50 companies bought shares between Aug. 3 and Aug. 9, the most since the five days ended March 9, 2009, when the S&P 500 reached a 12- year low, according to data compiled by Bloomberg.  

With the meteoric fall in US Treasury rates these last few days, mortgage rates have benefitted as well. The Wall Street Journal reports that the 30-year fixed-rate mortgage averaged 4.32% for the week ended Thursday is down from 4.39% the previous week and last year's rate of 4.44%. Rates on 15-year fixed-rate mortgages averaged 3.5%, which is down from last week's 3.54% and last year's 3.92%. Five-year Treasury-indexed hybrid adjustable-rate mortgages averaged 3.13%, are down from 3.18% last week and 3.56% a year ago. One-year Treasury-indexed ARM rates averaged 2.89%, are down from 3.02% in the prior week and 3.53% in the prior year.

Is this another 2008? 

There were numerous headlines and references this week suggesting the possibility that we might be on the precipice of another 2008. They suggested that the circumstances were eerily similar. Francesco Guerrera of the WSJ made some excellent observations of why this time is significantly different from the 2008 financial crisis that resulted in and from the collapse of Lehman Brothers.  

Guerrera says there are three fundamental differences between the financial crisis of three years ago and today.  

1. “The older one spread from the bottom up. It began among over-optimistic home buyers, rose through the Wall Street securitization machine, with more than a little help from credit-rating firms, and ended up infecting the global economy. It was the financial sector's breakdown that caused the recession. 

The current predicament, by contrast, is a top-down affair. Governments around the world, unable to stimulate their economies and get their houses in order, have gradually lost the trust of the business and financial communities. That, in turn, has caused a sharp reduction in private sector spending and investing, causing a vicious circle that leads to high unemployment and sluggish growth. Markets and banks, in this case, are victims, not perpetrators.” 

2. “Financial companies and households had feasted on cheap credit in the run-up to 2007-2008. When the bubble burst, the resulting crash diet of deleveraging caused a massive recessionary shock. 

This time around, the problem is the opposite. The economic doldrums are prompting companies and individuals to stash their cash away and steer clear of debt, resulting in anemic consumption and investment growth.”

3. “The final distinction is a direct consequence of the first two. Given its genesis, the 2008 financial catastrophe had a simple, if painful, solution: Governments had to step in to provide liquidity in droves through low interest rates, bank bailouts and injections of cash into the economy. The policy didn't come cheap as governments world-wide poured around $1 trillion into the system. Nor was it fair to the tax-paying citizens who had to pick up the tab for other people's sins. But it eventually succeeded in avoiding a global Depression. 

Today, such a response isn't on the menu. The present strains aren't caused by a lack of liquidity—U.S. companies, for one, are sitting on record cash piles—or too much leverage. Both corporate and personal balance sheets are no longer bloated with debt. The real issue is a chronic lack of confidence by financial actors in one another and their governments' ability to kick-start economic growth. The peculiar nature of this crisis means that reaching for the weapons used in the last one just won't work. Even if the central banks were inclined that way, pumping more money into an economy already flush with cash would provide little solace.”

The conclusion is that more money pumped into an economy already awash in too much cash is not going to induce businesses to invest or hire or investors to invest. Short term stimulus measures such as temporary tax breaks and intra-mediate term infrastructure projects have failed to start the engine.  

Uncertainty

The issue facing the country at this crucial point is summed up in one word UNCERTAINTY.  Mr. Guerrera hit the nail on the head when he said, “The real issue is a chronic lack of confidence by financial actors in one another and their governments' ability to kick-start economic growth.”  

The upcoming battle of Congress’s ‘Super Committee’ promises to pit Keynesian’s social liberalism (big government) against Milton Friedman’s free market economics. But with a wobbling economy suffering unemployment of 9.1% and confidence dropping, the debate is anything but hypothetical.  

Keynesian policies of huge government spending to start the economy simply have not worked. While the government injections of TARP were necessary to avert a complete financial meltdown in 2009, the stimulus measures that followed have been ineffective, expensive, and hugely additive to the national debt. Piling more people into the wagon and forcing fewer to pull it simply is not a recipe for success.  

The fiercest arguments will be the right ones; entitlements and taxes. We all hope that that some meaningful reform emerges in both areas, but it is absolutely clear from Republicans that nothing resembling tax increases will be acceptable in the House and perhaps the Senate. Believe it or not, this is less about politics and more about sound commonsense economics than ever.  

Higher taxes slow investment and hiring – period. That’s not what you want to do in a recession or near recession. Frequently cited are the examples of tax increases resulting in economic growth during Reagan’s and Clinton’s presidencies. What is not mentioned is that the economies in both circumstances were coiled springs ready to explode and tax increases were certainly not the trigger. Clinton benefitted hugely by his Vice President’s invention of the Internet.

Under President Regan the American economy went from a GDP growth of -0.3% in 1980 to 4.1% in 1988. Unemployment fell from 7.1% in 1980 to 5.5% in 1988. Oil prices per barrel dropped from $60 to $20, stagflation was ended by Fed chair Paul Volker, regulations were reduced, and America’s confidence skyrocketed. These are not the things of tax increase.  

According to Wikipedia, “With the Tax Reform Act of 1986, Reagan and Congress sought to broaden the tax base, eliminate many deductions, and reduce rates. In 1983, Democrats Bill Bradley and Dick Gephardt had offered a proposal to clean up/broaden the tax base; in 1984 Reagan had the Treasury Department produce its own plan. The eventual bipartisan 1986 act aimed to be revenue-neutral: while it reduced the top marginal rate, it also partially “cleaned up” the tax base by curbing tax loopholes, preferences, and exceptions, thus raising the effective tax on activities previously specially favored by the code.”

The ‘Super Committee’ would do well to read some history, particularly those of bi-partisan success stories of Regan and other. What would really be nice is if they would take an honest look at what happens to US economies when taxes and regulations are cut. The remedies are not complicated, but they require more political sacrifice of one party than the other. Will it happen? It has before.