Reflecting on the “R” Word

“How do you think things will go this year?” The question was posed the other day by a client, a bright, urban professional with a family, a successful career, and better-than average grasp of financial matters. It’s a question all financial advisors get frequently, so my response should have been more polished, but I muttered something like: “I believe we are in the end stages of a positive run that is quite long. I think we will have positive growth this year and by mid 2008 we will be in a recession.”

“You think we’ll have a recession?” he almost shouted, with some incredulity and maybe a little shock. I restated my point, taking only slight note of his apparent surprise, “Do I think we will have three consecutive quarters of negative GDP? Yes, I do. We always do.”

Having to articulate something as basic as that—and having it come as a shock to others— forced me to think about the implications and about the importance of explaining fundamentals—to clients…and myself.

At some point in our financial studies we all learned about the economic cycle: growth, peak, decline, and trough. Cycles vary in length, of course, but they follow the pattern. And during these economic cycles, the stock market has its up and downs. It’s the natural course of a market-driven economy. We will—eventually—have another decline and trough, and that will be followed by growth and peak. We’ve seen the historical graphs, reviewed the numbers since, say 1926. We take this pattern for granted. At least I do, and so can generally well-informed others.

Why does this matter now? Well, first realize we are five and four years, respectively, beyond the recession of 2001 and the “once in a generation” market decline of 2002. By once in a generation I mean a drop in the broad market of greater than 40%. Some still feel the pain of their losses in the last down market. In the ensuing five years, the U.S. equity market has performed very favorably for investors; international equity markets, even better. But again, the psychological pain is still there. On the other hand, if one understood the general nature of the markets and stayed invested, the last five years have been very good. Anyway, just because the market or a sector goes negative doesn’t mean one must accept a negative return—unless you’re in index funds.

Second, experience tells us that the most successful money managers over time understand that an investment is neither good or bad by itself, but only at a specific price. When the market declines and the prices of stocks drop, opportunities to buy increase. Simply put, we can buy at sale prices! It’s indirectly the rationale underlying dollar-cost-averaging strategies and dividend reinvestment. We might even relish declines in value—just as we love sales at Circuit City, Dick’s Sporting Goods, and Target. Behavioral psychological says this is a tough one to master in our investing, but we need to try.

Finally, if we experienced declines in our portfolios, did we lessen the effect by diversification across asset classes and investing styles? Did we balance with bonds—corporate and government, domestic and international— so we had cash when stocks were on sale? Did we diversify equities—with domestic and international, large and small, value and growth? Did we add alternative investments that don’t follow the general movement of the broad stock and/or bond markets? If not, are we diversified now?

I’m not predicting a monumental decline in market values. That’s not my job. But I can still venture that at some point (maybe mid 2008, maybe sooner, maybe later) we will have a recession and—not necessarily simultaneously—a negative-performance year, or two or three, in the U.S. stock market. I remind myself to say this to clients, and urge them not to fear it—just to understand it. In understanding they will retain comfort and find opportunity. More than likely, by following the thoughts stated above we can outperform the market.