Friday, May 07, 2010

Why We Don't Panic

Yesterday the Dow Jones Industrial Average dropped nearly 1,000 points intraday. The market ended the day down roughly 350 points. It is still unclear what directly caused the freefall. The New York Stock Exchange said this morning that they could not identify an error, but certainly something or somebody created an automatic and overwhelming response from computer generated trading.

Hopefully, this event will receive a tremendous amount of scrutiny from traders, regulators, and exchanges. Most of the downturn was corrected quickly. The market went down 700 points in 15 minutes then recovered 600 points in the following 20 minutes. The exchanges have decided to cancel many of the trades that occurred in that time frame. We had no orders present in the market when this occurred. When buying or selling, our orders are small and incremental and manually entered by us. We never have open or standing orders in the market that would fill automatically.

Regardless of the technical aspects of the sell-off, stocks began moving lower over the past week. The last several days have seen rising market volatility and a rally in U.S. Treasury Bonds, indicating a correction with a concurrent flight to safety. This comes as little surprise to us as markets will continue to confront the consequences of global over-indebtedness and economic imbalances. As written in this blog many times, deleveraging at all levels of society is a major theme for us in managing client portfolios today. The markets will ultimately deliver the verdict on how deleveraging takes its course, despite the efforts of interventionist government policies to manufacture a sustainable recovery. Currently, Europe is providing the best example of this circumstance and was a significant contributor to the momentum that got out of control yesterday.

“Show me a hero, and I will write you a tragedy.”

-F. Scott Fitzgerald

We have dual investment goals: generate wealth and protect capital. Our equity and bond holdings have performed very well since the market started recovering 14 months ago. Our bond holdings were mostly purchased in the midst of market panic in 2009 for very attractive yields-to-maturity. As stocks have recovered, we have shifted a significant portion of our equity holdings to conservative, high dividend paying companies that generate long-term wealth with consistently high returns on capital. These stocks achieve both investment goals simultaneously. Notably, however, we have also maintained a significant cash position, invested in the Schwab U.S. Treasury Money Market Fund.

Along with our bond holdings, this cash position contributes meaningfully to our goal of protecting capital. Even with a low yield, it provides a very important component of return. While it gives us flexibility to invest when opportunities appear, it gives us great comfort on days such as this. To be sure, while the market was down 9% yesterday afternoon, our cash position was down 0%. If a correction continues, that cash component will become more and more valuable both in its ability, not only to protect capital, but also for reinvestment at reasonable prices, upon which we intend to act.

Up to this point in the market recovery, we have been glad to let our bond and equity allocations do the heavy lifting of generating capital appreciation. Our cash position has not significantly hindered overall returns. Its relatively low yield has been inexpensive insurance to protect against a volatile backdrop no less severe than what was witnessed in the 1930s.

We are not trying to be heroes in this environment, chasing higher returns into a vortex of uncertainty. We have too much respect for the challenges of today to be cavalier in taking unnecessary risk with our clients’ capital. When confronted with low rates of return, investors often make the mistake of taking added risk. (A phenomenon we have witnessed repeatedly over the last 10 years.) Without compensation for that risk, losses occur suddenly and usually by surprise. Yesterday’s market action, reminiscent of late 2008, demonstrated clearly how a market shock might quickly undermine confidence when returns are low and risks are elevated. This environment is very different from the 25 years that preceded the collapse of the tech bubble.

Managing a portfolio that balances the goals of generating wealth and protecting capital will continue to serve our clients well as investors become more familiar with the changing character of markets.

If you have questions or comments, please contact us.

Peter J. Falker, CFA

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