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Market Commentary 09/30/2013

Reflecting on a Five Year Anniversary

The debt ceiling, QE tapering and political stalemates have dominated recent headlines.  They’ve become such recurring themes that it’s hard to resist recycling them here.  However, we are now five years past one of the largest financial crises our country has ever faced and this is a good time to look back.  If we reflect on the causes of the crisis, the impact emotion had on investors’ returns and the actions taken since, we realize this was a defining moment we will be able to learn from for years.

There has been much finger pointing as to the single cause of the crisis but it was certainly far more complex than any single factor and, in essence, was a perfect storm.  It was fueled by massive levels of greed as well as the unintended consequences of good intentions.  History will paint a portrait of Americans living the good life…until it stopped.

We started hearing about cracks in the financial system as early as the summer of 2007.  At that time, it was difficult to foresee the huge ripple effect that crumbling financial institutions would have on the markets and the economy.  Leading up to that summer, personal spending was at all time highs and savings rates were hovering near zero.  Even with low savings, household net worth figures still looked good, augmented by booming home prices and a strong stock market.  Consumers were taking advantage of low interest rates, easy access to loans and increasing home values.  Banks were eager to lend and were lending liberally.

The traditional bank model of paying customers interest on deposits then lending those deposits at a marginally higher rate had largely been abandoned.  In this new world, banks didn’t hold their loans but instead packaged them up as investments.  It was more profitable to ‘sell’ a loan than to own it, making underwriting much less important.  Many investment banks and financial institutions had also found it very profitable to create and sell high-risk investments such as mortgage-backed derivatives.  On top of that, roughly half the mortgages in America were guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac.  This created even less reason to worry about the ability of homeowners to actually afford their mortgages.

The system began to deteriorate when it came to light that a large percentage of this packaged debt was not as creditworthy as investors were led to believe.  It was no longer good as collateral and lending between institutions froze up.  Levered products, such as mortgage-backed derivatives, magnified the losses.

Some of the most memorable events of the crisis occurred between September 10 and October 10, 2008.   The government permitted Lehman Brothers Holdings to fail, while The Federal Reserve Bank of NY authorized an $85 billion loan to save AIG.  Merrill Lynch and Co was acquired by Bank of America to avoid demise, and shares of the Reserve Primary Money Fund fell below $1, ‘breaking the buck’ for investors.  These events had a dramatic impact on the economy.  The US GDP dropped by 8.3% in the 4th quarter 2008 and home prices plummeted.  At the worst point, 26% of homes were worth less than what was owed.  The unemployment rate hit 10%, not taking into account the many underemployed workers or those that had stopped looking for work, making it the highest unemployment rate since 1982.  This period is referred to as the Great Recession.

In 2008 and early 2009, it was difficult to see the light at the end of the tunnel.  The worry and fear that many Americans faced was heightened by the barrage of media reports every time there was negative news.  Greed certainly was a large part of creating the bubble, but then fear took center stage.  Warren Buffet summarized this concept well in 2001 when he argued:

“Occasional outbreaks of those two super-contagious diseases, fear and
greed, will forever occur in the investment community. The timing of these
epidemics is equally unpredictable, both as to duration and degree.
Therefore we never try to anticipate the arrival or departure of either. We
simply attempt to be fearful when others are greedy and to be greedy only
when others are fearful.”

In the paper, “Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky and Keynes”, Hersh Shefrin and Meir Statman conclude that even with hindsight in our favor, financial crises are far too common to think we won’t experience them again in the future. They cite the crisis of 1974-75, which was almost as long and severe as the Great Recession of 2007-2009.  They discuss the twin Reagan-era recessions of the 1980s, which brought high unemployment and were followed by a sovereign debt crisis and a Savings and Loan crisis.  Shefrin and Statman also address the foreign currency crisis of the 1990s in regards to the action required to prevent the disposal of Long Term Capital Management from breaking the global financial system.

We know the world is uncertain and psychology plays a large part in creating booms and busts in the financial markets and economies.  The key is how we apply this knowledge, understanding that it will be different based on our own circumstances and objectives.  As financial advisors, our role is to create portfolios based on those very individual needs and objectives.  At times, we make tactical decisions about deploying capital but always keep the overall objective in mind.  When markets are volatile, our goal for each client is to have the portfolio positioned to meet income needs for a number of years while staying within the context of the client’s ability to sleep at night.

Some individuals have lost confidence in the investing process.  However, we believe five years after the financial crisis, our financial system is stronger than ever.  Our government has overhauled financial regulation in a scope that hasn’t been attempted since the Great Depression.  Regulation, oversight and enforcement are vital to markets and much of the recent regulation is positive.  Businesses have also become stronger and we welcome a renaissance in American manufacturing.

It’s important not to forget the lessons we learn from each of these crises, even though as humans we tend to have short memories.  As 2008 returns no longer appear on five year performance histories, we need to be reminded of the trade-off between risk and return.  Diversification remains a key tool both to being opportunistic and reducing portfolio risk.  History will repeat itself, though hopefully not for a long time.  We appreciate your confidence in our philosophy and look forward to addressing any questions or concerns you might have.

Thomas L. Menzel, CFP®                                             Shawn J. Jacobson, CFP®, ChFC, MBA      
Asset Manager                                                            Asset Manager


“After Market Rebound, Clients Remain Skeptical” Investment News, September 2013; “Five Years from the Brink” Bloomberg BusinessWeek, September 2013; “Buffett’s Crisis Lending Haul Reaches $10 billion” Wall Street Journal, October 7, 2013; “US Unemployment Rate Hits 10.2%, Highest in 26 Years” NY Times, November  6, 2009; “Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky, and Keynes” Hersh Shefrin and Meir Statman, Santa Clara University, November 2011.

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