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In Crisis Lies Opportunity
By admin

Over the past several weeks the financial markets have been in crisis. Even those of us who have been advising investors for decades have never witnessed global financial events of such significance.

Wall Street, with its bloated investment banks, no longer exists. In a matter of weeks, the ripple effects have impacted stocks, bonds, commodities, real estate, and now, Main Street. Even the perception of safe investments was affected as money market funds narrowly escaped being swept up in the panic.

More than 90% of mutual funds – tock funds and bond funds alike- have lost money this year, according to Morningstar, Inc. Investors are stunned and angry, and are desperate for answers: How much worse will it get? Will our financial plan survive the carnage? Will we experience another Great Depression?

Let's deal with the last question first: Another depression is unlikely. The Fed's potential role and influence in the wake of the 1929 stock market crash was poorly understood. Widespread suffering in the Great Depression was exacerbated by the federal government's failure to inject cash into the economy until years later. Today, the government stands ready to provide capital to stimulate the economy. Over $3.4 trillion sit in money market funds and corporate tills are flush with cash-non-financial companies in the U.S. have nearly $1 trillion in cash on their books. Depressions don't start when there is a build-up of excess cash waiting to be put to work. As that cash flows into the economy, conditions will improve.

Some may say that this recession will be long and deep. Dire warnings and predictions certainly do attract attention. Do not allow your fear to get the better of you. No one knows how long or how deep this will be.

What about your investment plan? During financial panics, price disconnects from value and the people who are rushing to the exits will accept any price for their shares. But after the panic subsides, pricing efficiency is restored and the value of shares is more accurately reflected in their price.

Diversifying among asset classes is an effective way of reducing portfolio volatility. Diversification does work over time, but not necessarily all the time. When it isn't working, when nearly every asset class is dropping in value, it is frustrating. We understand. But if you react to a downturn by selling out, you enter new territory: you become a "market timer." How will you manage this new responsibility? When will you know to change your portfolio again? How will you avoid the risk of selling low and buying high?

There is a middle ground. If you feel the need to increase the amount of cash in your portfolio, discuss this with your advisor. But try not to over-react; make small changes: "Sell to the sleeping point." Don't forget that markets historically recover. When they do, if you are on the sidelines you will miss out.

Where will the financial markets go from here? While we wish for greater certainty, the harsh reality is that the future is always uncertain. Wise investors know that trends change direction. Trend changes cannot be recognized in real time, only in hindsight, and therefore, the only reliable way to be positioned for the trend reversal is to be in position before it arrives. Among the wisest and most respected investors is Warren Buffett. Here is what "the Oracle of Omaha" has to say:

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So … I've been buying American stocks.

…[F]ear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month -or a year- from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.

We realize that many of you will face difficult choices. Those of you who are retired may have to reduce your distributions so as not to deplete your retirement accounts. Those who are approaching retirement may have to work longer than you expected. Endowment funds and institutions may need to review their budgets and spending plans. The fact that your accounts have dropped in value might have caused you to question or second-guess the soundness of your investment strategy. If so, please talk with your advisor.

This isn't the first time in my 28-year career that I have urged clients not to succumb to the pain of a bear market. Investors who bail out near the point of maximum pain rarely if ever get back into their investments at more favorable prices. By bailing out when prices are low, investors become locked into a buy-high, sell-low cycle; exactly the opposite of what they want. Stocks have always-repeat, always-recovered from their bear market lows and gone on to new highs. Why should this time be any different?

If my advice seems unrealistically optimistic, I'll concede that my positive outlook on the future is intentional. It isn't that I don't see the problems; it's that fear is a powerful emotion which can cause otherwise reasonable people to act impulsively. It is important to view the full picture. Jeremy J. Siegel, a Wharton School professor, provides this perspective:

…[T]here are some very encouraging signs. The bid by Wells Fargo for all of Wachovia's assets without a backstop from the Federal Reserve means that there is a price for these distressed securities that makes them attractive to lenders…

It is foolish to try to pick the bottom of either the stock or other financial markets in today's environment. In the short term, anything can happen, since emotion dominates economics. Yet at these levels it is virtually certain that stocks will be a rewarding investment for long-term investors. Stock prices relative to earnings have rarely been lower, not only in the U.S. but throughout the world. This liquidity crisis will be solved without precipitating a financial collapse. History has rewarded investors who had the fortitude to step forward in this environment.

In striving for balance and perspective amidst the gloomy news, remember: In crisis lies opportunity.

Your advisor and First Affirmative continue to be here for you. We remain committed to the mission of transformative investing, to helping you cope with these difficult times, and to achieving your financial goals.

R. Kevin O'Keefe, CIMA®, AIF®

Chief Investment Officer

Posted: October 10, 2008