The Great Unwinding
Wednesday, October 29, 2008
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Posted by: Ben Valore-Caplan
October 29, 2008
Dear Friends,
As you know well, we are in the midst of a great economic crisis, what I call the Great Unwinding. The world is rapidly deleveraging an international monetary system that took years to build, one that required the complicacy of consumers, investors, bankers, regulators, credit rating agencies and governments, people of all stripes, shapes, parties and classes. To a certain degree, citizens throughout the developed world and much of the developing world had some skin in the game, with unlimited access to easy credit and high yields at levels that simply were not realistic or sustainable given human nature. Now, we are all paying for that excess and will pay for some years to come.
Attached, you will find an interesting overview of recent events produced by our partners at Fortigent. Read it. Our partners have done a fine job of focusing on what current events mean for investment portfolios. The first several pages focus on alternative or non-traditional asset classes, while the latter part focuses on macro-issues related to fixed income, cash and equities. Regardless of which asset classes you actually use, the whole perspective is important to understand since the financial markets are so intertwined.
In the play Macbeth, Shakespeare’s Banquo asked the witches of the heath, “If you can look into the seeds of time and see which grains will grow and which will not, speak then to me…” To some extent we all wish to know how this crisis will play out; however, I would suggest that we do not need to know the specifics as much as some might think. Predicting which day equities will “bottom,” or when normal liquidity will return to corporate bonds, or whether the Fed will cut 0.50% or 0.75% is far less important than determining how much to place in equities or corporate bonds, how to diversify those exposures, and whether or not to rebalance in the face of adversity.
A crisis such as this tests our resolve, our courage, our intellects and our understanding of our needs, fears, and objectives. While every investor is different, and while current events impact investors differently, there still remain universal truths. Respecting those truths is as important now as ever.
Truth: Know Your Objectives; Invest Accordingly
Marcus Annaeus Seneca pointed out that, “If you do not know what port you are steering for, no wind is favorable.” If your investment strategy made sense six months ago, if it accurately reflected your long-term growth objectives, spending needs, and risk tolerance, then we suggest investors would be best served by at least holding pat, and potentially rebalancing the portfolio back to the target allocation.
If this difficult market has you uncertain about why you take investment risk, then this is an excellent time to get clear on what you want to accomplish. It is easy to place primary emphasis on preservation of capital when things are most difficult; yet almost all investors require some return above Treasury Bills. Thus, almost all investors require investment risk. If you start with what you need to accomplish, the appropriate portfolio should emerge. Then, like most things in life, the appropriate discipline is required to stay the course when it is otherwise most difficult.
Truth: Asset Allocation Works over Time
In early 2000, word was that asset allocation was “dead.” That prediction proved premature. In this environment, many asset classes have been declining at the same time, though to different degrees. Thus, for some people, this increased correlation can create the impression that asset allocation no longer works. After all, if US equities, Non US equities, commodities, real estate, corporate debt and long/short hedge funds all decline together, then why diversify in the first place? Remember, an extreme liquidity crisis like this impacts all asset classes negatively, yet for different reasons and to different degrees. High quality stocks are being sold by hedge funds that have to cover margin calls and cover their shorts. Corporate debt has declined because the securities must be marked to market, yet the market is not trading. Commodity prices have rapidly declined as investors seek liquidity, as hedges deleverage and as some anticipate slower growth. Real estate prices have declined as investors and lenders reduce their risk appetite and keep their cash on the sidelines. But this high correlation is a short term phenomenon, as it is in almost all market extremes.
Look back over the past five years. Through Sept 30, The S&P500 returned 5.2% per year; the MSCI-EAFE 9.7%, the MSCI Emerging Market, 18.7%. The DJ Commodity Index returned 10.1% annually and the Lehman Aggregate 3.8%. Clearly, an eight-week period of high correlations does not discount the variability of returns (or volatility) across asset classes.
I have heard some try to predict which single company will come out of this market smelling like roses. I do not think that is the right question. Markets will generally improve; you want to have appropriate allocations to as many of those asset classes as meets your objectives.
Truth: Fundamentals Rule, Eventually
As structural changes are made in the financial services industry, confidence in the markets will get reestablished. As confidence is established, liquidity will return. As liquidity returns, risk appetite will reappear in sufficient quantity to move the markets. As risk appetite returns, fundamental valuations will matter again.
As fundamentals again drive investing, indexes will realign to reflect changing market capitalizations (although S&P and Russell reconstitute as of June 30). For active managers, the quantitative and qualitative factors they use should once again prove (or not) their worth.
Throughout this crisis, we have continued our fundamentals as well, maintaining a rigorous due diligence process around active and passive investment strategies. We have been meeting regularly with managers to review their perceptions, posture, and outlook. Now that we are independent, we have found that our investment universe truly has expanded, with many boutique managers approaching us who would not have considered working with our clients previously. Our research discipline is unchanged. We focus on understanding how passive strategies are constructed and how active managers craft their portfolios to add relative and absolute value. Times like this teach us a great deal about money managers. Those that are fundamentally sound will survive; those that are not will emerge diminished, if at all.
Truth: Respect Liquidity
Over the past year, cash has been the most difficult asset class from a research and due diligence standpoint. Several short-term bond funds using asset-backed securities took hits in the summer of 2007. Then the Auction Rate Market seized up in February. This spring and summer, money markets provided the greatest uncertainty as commercial paper, bank loans and even repurchase agreements revealed market risk previously discounted or misunderstood by the broader markets.
Even today, with FDIC thresholds raised and Fed guarantees attached to some money market holdings, significant liquidity risk remains. Thus ninety day T-bills now yield .75%, much higher than the 0.00% of a few weeks back, but significantly lower than the 2-3% they should yield given the rate of inflation.
In short, the price of high liquidity—and particularly safe high liquidity—has become quite expensive. Yet that is precisely because liquidity is so valuable. Thus, we strongly recommend having a clear understanding of near-term (6-9 month) liquidity needs, considering the possible source(s) of that liquidity (e.g. contributions, donations, current holdings, income, etc.), and consciously protecting the most liquid assets.
Truth: We Are Fortunate
I sense a great deal of stress and pessimism across the country. From almost all quarters, I hear concern about the election and its potential outcome compounded by sincere fear about the economy. Yet, for the most part, we are fortunate. Our election will disappoint many regardless of its outcome; yet any post-election battles will be held in the courts and Congress, not via violence in the streets. And though the global economy has been hit hard, we possess the tools necessary to heal this crisis and move forward.
The greatest challenge remains the impact of the markets on fundraising goals and business operations, retirement dates and net worth. It is in these areas that we must work togetherto ensure that your objectives and investment portfolio are aligned. This is a time for thoughtful patience, diligence and calm decision-making.
I believe that one outcome of this crisis will be a fundamental shift in how investment advice is bought and sold in the United States. As one of our clients noted yesterday, it is no accident that Syntrinsic was founded in the midst of such turmoil. We will continue to do our best to provide relevant insights during this period and we welcome your questions, comments and observations.
Sincerely,
Ben Valore-Caplan
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Former BT Atlanta Student & BT San Juan Capistrano Teacher
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