January 17, 2009
After what has transpired over the past year in the stock market, where does one begin this year-end letter? This time period will be studied by finance and economics courses for years to come. It is beyond the scope of this letter to cover every detail that has emerged over the past three months. However, I did my best in summarizing some of the highlights below; however, it is my belief that we should be concentrating not on the past, but the future: What do we do now?
I believe the root cause of this stock market catastrophe is the collapse of the housing market. Essentially, the low interest rates that we saw several years ago induced a lot of borrowing by builders and homeowners. Builders built as many homes and condos as they could in the hopes that consumers would be buying. The government looked the other way while Fannie Mae and Freddie Mac lent money to people who just a few years ago would not have qualified for a mortgage. Many figured and counted on real estate prices staying the same or going up. After all there is only limited land available, right?
As interest rates increased over the past few years, three, five and seven-year adjustable rate mortgages (ARMs) started to come due. There turned out to be many mortgage holders that could not afford the higher interest rates. They defaulted; the bank ended up with the property. The bank then turned to sell the property and retrieve as much cash as possible. This is not a bad scenario by itself until you realize thousands of other houses were being foreclosed upon. All of a sudden you had a lot of housing inventory on the market. Instead of a home price staying the same or going up, you had real estate prices going down.
As earlier discussed, during the early part of this decade many people purchased homes. The mortgages on these homes were subsequently sold to investment banks that bundled these mortgages and sold them to investors (institutions, countries, towns, etc.). Some investment banks included “insurance” on these products in the form of “credit default swaps”. “If these bundled mortgages go bad, give us a call and we will send you a check for the original value of this bundled product.” As more and more investors fell back on the credit default swaps, they found that the investment banks that sold them did not have enough cash to cover the claims (credit default swaps are outside of government oversight. Proper government oversight would have forced them to carry more cash when selling these securities).
All of a sudden, cash was king. Investment bank balance sheets, which were mostly made up of securities tied to real estate, snow balled to bankruptcy levels. The forced security selling resulted in several “fire sales” of investment banks to bigger, more stable banks or investment holding companies. So far, Lehman Brothers has been the only investment bank to declare bankruptcy, but there have been several huge mergers and/or acquisitions at unbelievably cheap prices.
Hedge funds that were levered 30 to 1 also had some liquidation issues. As the stock market declined, more and more investors wanted to get out. Many believe that the “de-leveraging” that we have experienced over the past few months has much to do with hedge funds trying to come up with cash to meet investors’ redemptions.
All of this leads us to the S&P 500 setting volatility records during the fourth quarter of 2008. When will we reach the bottom? How many years will it take to recoup what we have lost? I have put together some suggestions for you to review:
We are in a once in a lifetime, or possibly century, opportunity right now to purchase stocks selling at gigantic discounts. If you went to your favorite department store and noticed that everything was at least 20-50% off, you would most likely be interested in buying a few things, right? The risk we are taking is that stocks could become cheaper in the short-term; as I like to point out on the historical equity chart in my office – the long-term slope is positive.
- If you are unable to sleep at night due to worries about your nest egg: By all means, let’s consider taking 10- 20% of your equities off of the table. We could then sit with that money on the side for a little while until you feel comfortable again. I want to avoid liquidating the entire portfolio at this time. With CDs and money markets paying 1-3% per year right now, it would take a lot of years to break-even.
- If you are within one to three years of retirement: The stock market may take three or four years to make it back to the same level we had a few months ago. We will have to adjust our financial expectations to account for this change. Obviously the longer you can go without tapping into your IRA and/or taxable account, the better.
- If you are five or more years away from retirement: This is a superb buying opportunity. Remember the investment mantra: Buy Low; Sell High! You do not want to be adding to your portfolio in a high market. It is best to be buying into a low stock market
Many of you noticed I made some changes to your composite portfolio in the past few weeks. These changes were made to insure that you would be paying the least amount of capital gains taxes possible. In fact, most of you will see that the losses generated by these sales will help lower your overall tax liability for 2008 and for the foreseeable future. Your allocation as a result of these sales remains the same as it was prior to these changes. Please contact me should you have any questions.
These are very difficult times for everyone – especially those in retirement or close to it. While I do not have a crystal ball telling me what lies ahead, I do know that with history as a guide there is no quicker way of earning back our money that was lost than to keep our portfolios invested according to the allocations we have discussed in the past. Hang in there – we will work our way through these circumstances and, hopefully, be stronger as a result!
Enclosed you will find your Portfolio Performance Summaries, Portfolio Holdings Statement as of December 31, and a quarterly Account Management Fee Statement. Please call us should you desire the most recent copy of our Form ADV, Part II. In addition, please notify us should your investment objectives or personal financial situation change.
Sincerely,
William A. Bullock
P.S. The 2008 tax information will be mailed in a separate mailing no later than mid-February. Also, I have included a piece that was mailed to me by Selected American Shares – a fund many of you own. I thought you might find it interesting