History as a Guide

If you hold equity investments and have watched the headlines the last several weeks, you are probably second guessing something you are currently doing with your investments. Should you be? Allow me to make a few observations from what I know and from what I currently see in our economy. From there, the answer may be clearer.

Are we in a bear market?

A bear market is a period of stock declines of greater than 20% from their high. Broad market indexes are darn close. Let’s just say it: we’re in one. The important thing is understanding what that means. We have had seven bear markets since World War II. Therefore you should know that this is not a new experience. You should also take note that bear markets usually last for 6 to 18 months. If we consider the high of this market to be October 2007, we are now 5 months in. Although I don’t think this will be a 6 month bear, I don’t think it will be 18 months either. In three of the post WWII bears, declines were -36%, -48%, and -49%. The other four were -21%, -22%, – 27%, and -20%. No one knows which type of decline this may be.

Is this time different?

You may be thinking: “Thanks for sharing with me the news about the post WWII bear markets, but I don’t care. I didn’t have money then!” You really want to know if this time is different. The answer to that is yes…and no.

This time is different in the way some financial institutions packaged and sold debt investments. They sold them to institutions who in turn packaged them differently and resold them to others. The packages were full of risky debt, such as interest only mortgages and mortgages sold to people with no money down or no income verification. “WHAT?!” you say. That’s right. Would you give $500,000 to someone who told you they had the means to pay it back, but couldn’t prove it? What might happen if someone took a $500,000 loan on a $500,000 home, then the value dropped to $450,000 and the payment on the loan doubled? Well, we are seeing that scenario play out. The lenders and borrowers are getting hammered, but it is affecting the rest of us too!

What isn’t different this time is the market’s progression: speculation occurs somewhere in the market, a bubble is created, the bubble bursts, and other areas of the economy are affected. This bubble was real estate and credit. The last one was technology (remember?). The next one will be something else. One lesson to learn is when one segment of the market starts taking off above realistic expectations of basic economic fundamentals, do not chase it with everything you have (a lesson to “house flippers” for sure).

What is the Federal Reserve’s role?

The Fed’s goal isn’t to influence stock prices. Its role is to keep the financial system stable in the long term, while short term problems are worked out. This is not a perfect science. Nor is the reaction by investors to it.

Usually a result of a financial crisis is that someone fails, a few companies fail. Though it isn’t good for the employees and shareholders of that fi rm, it is a natural part of a market economy and is part of the stability restoration process. Recently Bear Stearns was bought by JP Morgan Chase for $2 per share, a decline of 93% value. Was this a failure? Some say yes. Others say no, it didn’t “go under.” Jim Hohman, a founding partner of my firm, gave this perspective earlier in the morning: “On the other side of that bad news is the good news that JP Morgan believes within 4 years this will add $1.0 billion to their bottom line. That’s good, right?”

But one failure won’t do it. This won’t be over until at least one more financial institution goes out of business. To calm your worries, they won’t all fail – just some that employed bad business practices and didn’t have enough good things going to make up for it.

What should I do right now?

Small investors can make big mistakes in times like these. This is where the temptation to sell at lows can start to creep into your thoughts. This would not be a good time to do that because you guarantee yourself a loss. Remember, at the other end of your sell is someone buying – and they are buying at a 20% discount!

When regular people hear that a bear market is around, the market is usually nearing its bottom. It would be too late to sell. Professional investors rarely get the timing of buying and selling right. If they can’t do it, I am not confident that amateurs can pull it off any better.

If you are a current client of mine, I can assure you that you do NOT have any money in the stock market that is planned for use in at least 3 years (for most of you it is 5+ years). Therefore, the daily volatility is not so relevant to your portfolio. You have cash and a diversified portfolio of bonds that create some stability in the short term.

If you invest on a regular basis in a 401k or other plan, these are the days systematic buying was made for. You are “buying on sale”.

Veteran investors know this: don’t fixate on the short run; stick to your established diversification strategy; and invest based on when you need the money, not on what media and “experts” predict.