Thursday, March 13, 2008

Newsletter Article

I contribute articles for newsletters and other local publications. Here's the latest for the Coral Gables Bar Association:

As I write this the U.S. stock market, as measured by the S&P 500, is down over 10% since the beginning of the year. The U.S. economy is widely believed to be either already in or entering a recession. Home prices are falling and foreclosures are rising. The municipal bond market has seen yields rise (prices fall) so much that long term tax free bonds are now yielding more than taxable Treasury bonds (see our blog for a more complete explanation of what is going on in the muni market: http://alhambrablog.blogspot.com/2008/03/municpal-bond-market.html). Consumer confidence is at an all time low.

Amidst all this doom and gloom the easy course is to give in and join the crowd. It is natural to be tempted to sell stocks and seek the safety of a money market or savings account. It is natural to want to avoid the pain of a bear market and wait for economic conditions to improve before doing any buying. Unfortunately, the easy, natural thing to do is not always the right thing to do.

Economic data tends to lag and the stock market tends to anticipate. Recessions do generally coincide with stock market downturns, but because of the lag time of economic statistics, they take a while to diagnose. On average the National Bureau of Economic Research announces a recession six months after it began. Furthermore, because the stock market anticipates, stocks often hit their bottom at the trough of the recession, not when it ends. If you wait until the end is announced, you could miss a large move in stock prices. In two of the last four recessions the entire stock market decline took place before the recession announcement. In the 1990 recession, which seems most like the current downturn, the recession and the market decline were over before the NBER even announced the recession.

Successful investing requires that one act as a contrarian. It is trite to say that investing requires one to buy low and sell high but that is what is meant by acting as a contrarian. How can you buy low if you don’t buy when the market is down? How can you sell high if you don’t sell when the market is up? It sounds simple, but does your natural instinct say buy right now?

So what should you be doing now? Well, that depends to some degree on your circumstances, but there are some common things that every investor should be at least considering right now. The most obvious and important task is to check your asset allocation. If you read my column from March of last year, Commodities as a Strategic Investment, and included some commodity exposure in your portfolio, you’re looking at a sizable gain by now. That means that commodities are probably a larger portion of your portfolio than you originally intended. Also, after the recent stock market decline, the portion of your portfolio dedicated to stocks has probably fallen. Consider taking some of the profit from the commodities (sell high) and using the proceeds to purchase stocks (buy low).

If you purchase individual stocks, you should review all your holdings. What seemed like a good idea a year ago may not seem as good now. If you own stocks that have declined in value, review them as if you were considering them for a new purchase. If you wouldn’t buy it now, you should consider taking the tax loss and moving on to something else. If the original rationale for buying the stock is still valid, consider buying more to lower your average cost. And if you’re stock picking doesn’t produce market beating results, consider using a low cost index fund as we do for most of our stock market exposure.

Finally, if you don’t have an asset allocation plan, it is time to get one. A well diversified portfolio allows you to weather the storms that are inevitable in markets. Consider that while the stock market has declined roughly 10% since the beginning of the year:

1. REITs are down 3-5% not including dividends. Yes, I mean Real Estate Investment Trusts. All real estate is not created equal.
2. The Goldman Sachs Commodity Index is up 17.6% and the DJ AIG Commodity index is up 19.1%.
3. Treasury bonds are up about 1.5% not including interest payments.
4. Foreign stocks (as measured by the EAFE index) are down 8.7%. Even Emerging Market stocks have outperformed the S&P 500, falling 9.5%.

We don’t know yet whether the current economic slowdown will develop into a full blown recession, but we do know there have been significant changes in our portfolios. Make changes now with an eye on the long term and always act as a contrarian. Buy low, sell high!

2 comments:

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