|
September 17, 2008 Dear Client: Crises of the security markets are unnerving, painful and confusing. Unfortunately they are also common. In 1973 and 1974, the S&P 500 index declined 48%, following the OPEC oil crisis and subsequent wage and price controls. The Savings and Loan crisis of the late 1980s led to a $50 billion bailout of S&Ls and huge budget deficits in the early 1990s. Asian markets declined sharply in July 1997, in response to currency controls placed by the Thai government. The failure of Long Term Capital Management in 1998 required a bailout of $3.5 billion orchestrated by the Federal Reserve Board, pulling U.S. stocks down by 19%. These crises have a commonality: a disruption to the risk/return equilibrium. In the 1980s, federal regulation of S&Ls (or perhaps the lack of regulation) encouraged S&Ls to make risky loans that were effectively backed by the government, helping to create a housing price bubble that required a federal bailout (sound familiar?). The resolution of Long Term Capital's crisis may have been the starting point for the latest disequilibrium: implicit government backing could have increased investment return per unit of risk. To regain equilibrium, either risk increases, return decreases, or both. We don't yet know the cause of the current crisis. We probably won't for years, if ever. We do know, however, that the result is a seizure of credit markets. Short-term credit is the lubricant required for functional markets. Lending has halted because lenders do not know the value of assets. They are afraid that the collateral backing loans is worth less than the value of the loans. At some point, the fundamental value of assets will be ascertained and institutions will resume lending. Until then there will be wide swings as the market attempts to price the assets. Some highly leveraged institutions will not survive. But some institutions will buy assets at very low prices, and emerge with stronger balance sheets. To visualize this process, think of mortgage-backed bonds. Some of the bonds may be backed by non-risky assets, such as old mortgages on properties with loan-to-value ratios below 50%. Others may be backed by newer mortgages on homes with negative equity. In the current market, the distinction between the two bonds is unclear, and non-risky securities are being discounted along with risky ones. Clearly the values assigned to assets one year ago were too high relative to their concomitant risk. Whether prices have adjusted too far down, or not far enough, remains to be seen. Under conditions like these, prices tend to swing widely until a new equilibrium of risk and reward is reached. It is important to maintain your long-term perspective. From their high on October 9, 2007 through yesterday U.S. large-cap stocks have declined about 21%, U.S. small-cap stocks have lost 15%, and foreign markets have lost 31%. A diversified equity-oriented portfolio would have experienced less extreme losses. For example, a portfolio with 30% U.S. large cap equities, 15% U.S. small cap equities, 30% foreign equities and 25% bonds would have lost 16% top to bottom. The same mix would have returned 7% annualized over the last five years. We'll provide more information in our third quarter statements. Meanwhile, we expect markets to continue to be volatile. Finally, if you have in a bank large cash holdings that exceed FDIC insurance coverage limits, we recommend that you purchase CDs or treasury bonds, or have us purchase CDs for you through your brokerage account. Fidelity and Schwab are not investment banks, and do not pursue their own trading strategies. Their businesses are diversified, and both are financially strong. In addition to their own financial stability, both are members of SIPC, a corporation mandated by Congress in 1970 to provide coverage for brokerage customers. The nature of the coverage for brokerage firms is different from FDIC insurance: FDIC insurance protects depositors from the failure of a member bank. Banks have depositors and brokerage firms have investors. Investments are volatile; SIPC does not protect investors from pricing declines. Its role is to protect investors from a brokerage firm's misconduct, in which securities are lost, stolen or unaccounted for. In those cases SIPC replaces missing securities. If you have any questions about the security of your cash holdings, please contact us to discuss your options.
Regards, |