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One way to measure the extent of the damage is to compare the $50 billion figure to measures of loss in the FBI's Uniform Crime Reports. In 2007, there were 9.8 million crimes against property in the U.S., which included about 2.2 million burglaries, 6.6 million larceny-thefts and 1.1 million car thefts. I think you'll agree that 9.8 million crimes represents a veritable army of miscreants. In spite of that, our total losses to property crimes in 2007 were a mere $17.6 billion. To be sure, it didn't feel "mere" if you suffered a burglary. The average loss was $1,991. Nor was it "mere" if you were one of the 6.6 million people who suffered a larceny-theft. In those, the average loss was $886. But when you add all the losses in 9.8 million common property crimes, it's just a fraction of the estimated $50 billion loss attributed to Bernard Madoff. Perhaps 2007 was an "off" year for theft? Well, there was a slight decline in the number of crimes, but not in the amount lost. In 2006, the report shows nearly 10 million crimes against property and losses of $17.6 billion. Similarly, the 2005 report shows nearly 10.2 million crimes against property and a total loss of $16.5 billion. Add the three years and you get $51.7 billion. Using that value, the losses Bernard Madoff may be responsible for equal all the losses caused by all the conventional thieves in America for nearly three full years.
Right now, it’s tempting to think that this bear market is so unusual that history’s lessons are of little use, and that the types of investments that are weakest now will keep dropping indefinitely. No two market environments are identical, of course, but there is plenty of precedent for the credit crisis of the last 18 months — and for its profound effects on the stock and bond markets. In fact, you can view the markets’ behavior since mid-2007 as a textbook illustration of a statistical pattern uncovered years ago by two finance professors, Lubos Pastor of the University of Chicago and Robert F. Stambaugh of the Wharton School of the University of Pennsylvania. They found that the financial markets are always vulnerable to what they called a liquidity shock — a sudden tightening of credit. Aside from the current crisis, two recent examples are the market conditions during the market crash of October 1987 and the wake of the near-collapse of Long-Term Capital Management in the fall of 1998. Some types of securities — high-yield, or junk, bonds, for example — are usually more vulnerable than others in such an event. The most immune from liquidity problems are those for which there is always robust demand, so they can be sold anytime without pushing down their prices. As has become abundantly clear over the last 18 months, Treasury securities are a good illustration. At the other extreme are those securities that, without an abundant supply of available credit, become difficult if not impossible to sell at any price. The professors’ research was the focus of this column in August 2001, and their study appeared in the June 2003 issue of The Journal of Political Economy. According to Google Scholar, no fewer than 623 academic articles and studies now cite their study. This research provides a good template for understanding the last 18 months, according to Lasse Pedersen, a finance professor at New York University who has conducted a half-dozen studies in recent years into the market’s reaction to liquidity crises. In the current crisis, Professor Pedersen said in an e-mail message, “securities with high liquidity risk have done very poorly,” just as we should have expected. A good example is convertible bonds, which previous research found to be particularly vulnerable to liquidity shock. “They have gotten killed,” he wrote. Though the large body of research into liquidity shocks may offer little comfort to investors who’ve lost so much in the last 18 months, it is an antidote to the argument that history has nothing to teach about the current crisis. The research has found that when liquidity shocks occur, they are so intense that the securities most vulnerable to them predictably provide higher longer-term returns. This happens, Professor Pastor said in an interview, because these securities must compensate investors for the risk of big losses during those shocks. This doesn’t mean that anyone can predict such shocks with certainty. Instead, according to Professor Pastor, there is a small but significant risk that one could happen at any time — and that investors are deluding themselves if they don’t take that risk into account. Investors who despair that this credit crisis may never end may therefore be guilty of the mirror opposite of a mistake made earlier in this decade, when liquidity was plentiful. Just as many investors forgot several years ago that another liquidity crisis was destined to happen someday, many may now be forgetting that liquidity shocks don’t last forever. Which securities will perform best after the current credit crisis, and which will fare worst? According to the research, once a liquidity crisis passes, other factors come to the fore, and securities that have risen in price, like Treasury bonds, are then likely to perform poorly. By contrast, the best performers will be those securities that have lost the most during past credit crises — not just during the current one. Convertible bonds and junk bonds are two obvious categories that should do particularly well, but others, including stocks, should also benefit. If you can tolerate short-term volatility, you should consider such securities for the long term, Professor Pastor said, even if you’re worried that the credit crisis has longer to run. That’s because it is impossible to predict the exact end of the bear market, and because these investments should provide high-enough returns over the long term to make the risk worth taking.
Here's the story. In the early 1980s, I was on the board of a small, multidivisional manufacturer with about $50 million annual revenue. The company manufactured and supplied rubber, plastic and metal parts for companies. One division made spark plug boots for Ford. Another made major castings for Xerox copiers and IBM keyboards. Jerry's division made machined parts for everything from cameras to snow blowers. Jerry was a machinist who started with a handful of machines. He grew it into a much larger shop. He could do just about anything with metal. Jerry wore a long shop coat, but even when he took it off, the deep scent of machine oil preceded him like a strong aftershave lotion. Jerry was also a collector. Only he didn't collect old cars or ancient lithographs. He collected automatic screw machines and other metalworking equipment. Behind his shop, a large Quonset hut was stuffed with his machinery, all bought at scrap metal prices. When he got a piece of equipment, often at a going-out-of-business sale, he took it to his Quonset hut and refurbished it at his leisure, the way other men restore old boats or cars. Then it just sat there. Jerry would wait for a turn in the market. When it came, he either put the machine to work in his own shop or sold it at a large profit. "The big companies give them away when the economy is off," he told me. "And small companies pay a premium for them when they have orders in hand." Value was all about the income you can produce with an added machine, he explained. Without orders, the machines were only worth their scrap value – and even that would be low when everyone else was scrapping, too. But with orders, a single busy machine could provide a living for a machinist, pay the rent and put money in Jerry's pocket. Or it could be sold at a fat premium. "The swings in value are always extreme," Jerry told me. "They're much more dramatic than the swings in income." As consumers, we seldom see this reality so clearly. Whatever the market value of our home, it still provides shelter. The same applies to our cars, appliances and other goodies – if they are being used, they have a value. We just don't know what it is in dollars and cents. Similarly, we're inclined to believe the old Mustang convertible or the aging Persian rug has value because someone will want to add it to his collection. Call it the Greater Collector Theory. Basically, it's difficult to get a visceral understanding of modest changes in income and extreme changes in value. Trust me, this does not apply only to automatic screw machine equipment. If it can't be put to use, you might have to pay someone to haul it away. You could learn that by spending five minutes in Jerry's Quonset hut. So what does the Pfrengle Principle have to do with you and me today? Lots. Right now we're transfixed by the disappearance of vast quantities of wealth. That's producing a second wave, a major "wealth effect," as we attempt to save real money now that home appreciation isn't doing all our saving for us. I have a suggestion: Next time you are impressed by a decline in value, check income. Note that it hasn't changed nearly as much as value. Note also that income may dip, but it also recovers. It's scary when you view the world by wealth. So remember: It all starts with income. Wealth and value are artifacts created by income.
For the last couple of decades, investors haven’t had to step up their savings because the stock market did the work for them. Since 1982, the Standard & Poor’s 500-stock index has recouped about 88 cents, on average, of every dollar lost in a bear market by the end of the first year of the subsequent bull market. By the end of the second year, that dollar would have been recovered, and then gone up an additional 18 cents. But it may not make sense to plan on that timetable now. That’s because 2008 was no ordinary year, and the current downturn may not follow the pattern of recent bear markets. In 2008 alone, the S&P500 has lost more — about 40% — than it usually does during an entire bear market, which historically lasts 16 months. And we don’t know when this bear market will end, or when the next bull will begin. Sure, it would be great if smart choices in asset allocation or purchases of stocks and funds could quickly get us back to break-even. But the math simply doesn’t add up. Say you were willing to be super-aggressive, especially now that stocks are trading at relatively cheap prices. And assume for the moment that this bear market has run its course. Even if you plan to be 100% in stocks, it may easily take another four years just to return to where you were at the start of this year. Why? Assume that you started 2008 with $100,000 invested in stocks, and, to keep the calculations simple, that you have about $60,000 left in your account now, roughly tracking the decline of the S&P. Let’s be optimistic for a moment. Historically, the first year of a new bull market comes with a surge — a 38% climb in the S&P, on average, since World War II. That would bring your portfolio back to just under $83,000. In the second year of a bull market, stocks tend to rise by around 11%. So your account would recover to about $92,000. In Year 3, prices historically rise 4%. That would take your nest egg to just under $96,000. Only in the fourth year, which takes you all the way to 2012, would you climb back above $100,000. Of course, all of this assumes that you’re fully invested in stocks, and uses the rosiest of scenarios: that the bear market is over and that stocks are on the verge of a multiyear rally. Is it wise to embrace those assumptions? Given the state of the economy, maybe not. It could take years for the market to fully recover from the excesses that created the recent bubble. Investors should keep in mind that “there’s often a difference between the end of a bear-market correction and the beginning of a new bull-market phase,” said Susan M. Byrne, chairwoman and chief investment officer at the Westwood Management Corporation. “After the bear market ended in 1974, it wasn’t until July of 1982 that I first started to think that we were really out of it.” What’s more, investors don’t seem to be in the mood to bet aggressively on stocks. According to Hewitt Associates, the employee benefits consulting firm, only 52% of 401(k) money is currently held in equities, down from 69% last year. Some of that shift occurred because stocks have fallen so much, but another reason is that retirement investors haven’t been “rebalancing” their accounts to get back to their original weighting in equities. “I think the inclination is going to be to hunker down, move out of equities and reduce contributions to the plan,” said Lori Lucas, defined-contribution practice leader at Callan Associates. So far, 401(k) investors haven’t altered their savings rate significantly. According to Hewitt, 401(k) participants contributed 7.8% of their pay, on average, to their retirement accounts this year. That’s down marginally from 8% in 2007. That is well shy of the 15% annual savings rate that financial planners often suggest as a safe target. “It’s going to be a real uphill battle to convince people they need to save more now,” Ms. Lucas said. For those who are still well within their working years, their savings rate is likely to be the biggest determinant of whether they can reach goals like financing a long retirement, said Ms. Fahlund of T. Rowe Price. That’s not to say that asset allocation and market returns aren’t important. But if you’re years from retiring, the rate at which you save matters now more than ever.
As of Dec. 12, the Standard & Poor's 500 index had lost $6.17 trillion since hitting record highs in Oct. 2007. That reduction in global stock wealth has outstripped the losses in the last bear market - the S&P 500 lost $5.76 trillion during the entire bear market of 2000-2002. Making matters worse, this one still has room to run. By Thanksgiving, many individual investors discovered they would have been better off sticking their savings under their mattress rather than the stock market for the past decade. On Nov. 20, the S&P crashed through the previous bear-market low of 776, made in October of 2002, to end its lowest close since April 1997. The S&P Broad-Market index, which blends more than 11,000 stocks from developed and emerging markets, has lost $17.7 trillion year to date. Most of the losses, or $16.1 trillion, were logged between May and December. "Until May, global markets were still expected to grow faster than the U.S., as China was seen growing more than 10%," said Howard Silverblatt, index analyst at S&P. That optimism evaporated as the credit crisis spread around the globe and the U.S. recession clipped the outlook for global growth. In November, the World Bank said China's economy is likely to expand at a 7.5% rate in 2009, its slowest pace since 1990. Once leaders in emerging markets, stocks in Russia have now plunged 72%, those in Turkey are off 68%, and those in India have fallen 67%. In October, Japan's Nikkei 225 hit a 26-year closing low; Iceland's exchange tumbled 81%, while Brazil's Bovespa index slumped 25%, its biggest one-month percentage loss in 10 years. The need to protect one's savings became so pressing that on Dec. 9, the government sold 4-week Treasury bills at a yield of 0%, meaning that bond investors were happy to just have the principal they'd lent back to them without a loss. The yields on other government bonds, considered the safest among all investment classes, also reached lows unseen since the government began keeping records in the 1950s. While investors opened their wallets to the U.S. government, they lent very little to anyone else. Commercial paper markets froze after the Lehman collapse, threatening to put out of business anything from big banks to small firms dependent on short-term loans. Borrowing costs for companies surged. Even banks became increasingly unwilling to lend to each other, as more took huge write-downs from bad assets. The London interbank offered rate, or Libor, soared to record highs near 7% after Congress first rejected a $700 billion bailout for financial firms. "Nothing compares with the crisis that we have faced," said Johnson of Johnson Illington Advisors. The U.S. stock rout already registers as the fourth-worst bear market since 1898, he said. "It's clearly historic."
They're wrong because they aren't considering the biggest factor that affects the amount of money you can safely withdraw from your retirement portfolio – market valuation levels. Retire when market valuation levels are high (levels are measured by the price-to-earnings ratio for a stock), and you'll be taking a big risk if you take more than 4% a year. Retire when market valuation levels are low, however, and you may be able to withdraw at 6% with limited risk. We can argue about what the exact price-to-earnings level of the current market is, but there's no doubt that it's down substantially. And below average. So if you were planning to make withdrawals at a 4% rate, you may now be able to make them at a 6% rate. In other words, even though you may have lost one-third of your nest egg, your retirement spending may suffer very little. Take 4% from a $300,000 nest egg and you've got $12,000 to spend. Take 6% from a $200,000 nest egg and you've got ... $12,000 to spend. You can understand how this works by checking the data from a research exercise I did using Morningstar Principia. The exercise is similar to one I did in 1995, when Peter Lynch suggested that people could be 100 percent invested in common stocks, withdraw 7% annually and never go broke. Using similar software, I showed that Mr. Lynch was wrong – you had a substantial chance of running out of money at such high withdrawal rates, even though stocks averaged returns of 10% to 11%. This time, the test is to compare two 25-year investing periods and see how many of a group of 14 well-known mutual funds survived the period at different withdrawal rates. In both periods, the funds were the same, a mixture of 14 load and no-load balanced and domestic large-blend equity funds that have very long histories. Here's the list: Alliance Bernstein Balanced A shares, American Funds American Balanced A shares, American Funds Investment Company of America A shares, Dodge and Cox Balanced, Dreyfus, Eaton Vance Balanced A shares, Fidelity, Fidelity Puritan, George Putnam of Boston A shares, MFS Massachusetts Investors Growth Stock A shares, Pioneer A shares, T. Rowe Price Balanced, Vanguard Wellington and Vanguard Windsor. In each period, the funds were set for initial withdrawal rates of 4.2% to 9%. Then the initial dollar withdrawal amount was increased each year by 4 percent to account for inflation. The program calculates the value of each fund at the end of each year. The results are shown in the accompanying table.
Start at a period of low valuation such as late 1983, and retirement improves substantially: All 14 funds survive 25 years of 6 percent withdrawals. You have to ratchet up the withdrawal rate to 9% before you whittle the surviving funds down to a single "last fund standing." That's quite a difference. Is this a lead pipe cinch – just raise your withdrawal rate to compensate for lower asset values? No, it's not. But the odds are in your favor.
With the exception of Treasury securities, virtually all asset classes have fallen in unison of late. These include even supposedly safe investments like high-quality corporate bonds; the average intermediate-term, investment-grade fixed-income fund has lost more than 6% of its value since the stock market peaked on Oct. 9, 2007. Many asset classes have performed even worse, falling by various double-digit percentages since the market peak. This group includes domestic blue-chip stocks, small-company shares, foreign equities, commodities, real estate investment trusts, high-yield bonds and emerging-market debt. Over the short term, diversification does not promise that your portfolio won’t decline. Rather, the strategy is intended to ensure that at least some of your investments hold their value at any given time. By this token, diversification hasn’t entirely failed in the current downturn. But investors needed to diversify some of their money into two specific assets — Treasury securities and cash — to call this strategy a success. Simply diversifying your types of stocks didn’t help. For example, between the October 2007 peak and the start of December this year, both the S&P500 index of domestic stocks and the Morgan Stanley Capital International EAFE index of foreign shares fell more than 40%. Nor did it help to own commodities, which some investors thought would soar regardless of the health of the United States economy. But as it became clear that the entire global economy was slowing — and as crude oil prices fell to less than $50 a barrel from around $140 — most of the major commodity indexes plummeted. Clearly, the most important step in diversifying your portfolio is to hold some of your money in stocks and some in bonds, said James Shambo, a financial planner in Colorado Springs. But only if you had put a large portion of your bond holdings into Treasury securities would your overall portfolio not have fallen so severely. Say you invested $100,000 in the S&P500 on Oct. 9, 2007, and held it there until the start of this month. Thanks to the bear market, you would be left with just $58,750. Had you diversified properly — say, by putting 40% of your money in the S&P 500; 25% in foreign stocks in the MSCI EAFE index; 25% in the broad bond market as represented by the Barclays Capital U.S. Aggregate Bond index; and 10% in cash instruments like Treasury bills, you would still be down, but your portfolio would be worth more than $72,825. As for your stocks, the only strategy that seemed to work — or at least incur smaller losses — was dollar-cost averaging, a way of diversifying by making purchases in regular increments. For example, if you invested $150,000 in a lump sum in the S&P500 at the start of October 2007, you would have had $90,400 left by the start of this month. But had you invested $10,000 a month, every month, starting last October, you would have had roughly $106,000 left in your account. Time is a crucial ingredient in all diversification strategies. “Pooh-poohing diversification will always work if you pick a short-enough time period to look at,” said Sam Stovall, chief investment strategist at S.& P. This is particularly true if you examine only periods of crisis. In a panic, there tends to be a “flight to quality.” This means frightened investors are likely to sell their risky assets to move into Treasury securities, which has happened in the current crisis. Of course, all the assets investors sell during panics will move in lock step. That would explain why, in most bear markets, “there is simply no place to hide in the stock market.” Stovall studied bear markets going back to 1946 and found that every sector in the S&P 500 lost ground by double-digit percentages during the average downturn. Only over time does diversification really show its worth. For example, over the 10 years through November, the S&P500 lost almost 1% a year, on average. But a diversified portfolio of 40% S&P 500 stocks, 25% foreign shares in the MSCI EAFE index, 25% in fixed-income securities found in the Barclays Capital U.S. Aggregate Bond Index, and 10% in Treasury bills gained nearly 2% annually, on average, according to T. Rowe Price. At least that was a gain. And the diversified portfolio was also 36% less volatile than the all-stock portfolio. Investors need to appreciate the limits of diversification, said Ned Notzon, chairman of the asset allocation committee of T. Rowe Price. “If someone is really concerned about the losses they suffered in the past year — if on Dec. 31, 2007, they thought they needed to preserve all their money as of Dec. 31, 2008 — then they really shouldn’t have been diversified to begin with,” Mr. Notzon said. Instead, those short-term investors should have kept their money in cash, or a combination of cash and short-term debt. Mr. Shambo adds that investors who are growing skeptical of diversification need to ask themselves an important question: What other choices do they have? “If the alternative is to concentrate your bets, where would you have concentrated during this sell-off?” he asked. The answer, of course, is Treasuries. But even if you were smart enough to put all your money in them before the stock market peaked in October 2007, you would now have a portfolio that is concentrated in the sole asset class that is trading at frothy prices in this bear market. OF course, if your intention is simply to hold Treasuries to maturity, you’ll have no problem. But if you want to sell those bonds — or a Treasury bond fund — once the economy starts to recover, you may be disappointed by the price you are offered. That is why it still makes sense for long-term investors to diversify — to ensure that not all of their money is tied up in the priciest asset at any given moment.
It doesn’t take long for a rat to figure out which light goes with the shock and which goes with the food pellet. All animals, including we primates, are good at making these associations. Pretty soon, we don’t even need the light — the mere sight of the cage can send some of us into a state of apoplexy. And while the workplace is not quite an electrified cage, I think I would prefer a brief jolt of electricity over the intermittent shocks of watching the blinking red arrow of the stock market or the jolts of cutback after cutback by businesses. Everyone I know is scared. Workers’ fear has generalized to their workplace and everything associated with work and money. We are caught in a spiral in which we are so scared of losing our jobs, or our savings, that fear overtakes our brains. And while fear is a deep-seated and adaptive evolutionary drive for self-preservation, it makes it impossible to concentrate on anything but saving our skin by getting out of the box intact. Ultimately, no good can come from this type of decision-making. Fear prompts retreat. It is the antipode to progress. Just when we need new ideas most, everyone is seized up in fear, trying to prevent losing what we have left. I am a neuroeconomist, which means that I use brain-scanning technologies like magnetic resonance imaging to decode the decision-making systems of the human mind. It is a messy business, but a few pearls of wisdom have emerged about the fear system of the human brain and how to keep it from short-circuiting sound decision-making. My colleagues and I conducted a brain-imaging experiment. Our participants were inside an M.R.I. scanner. We attached electrodes to the tops of their feet. Although not unbearably painful, the shocks were designed to be unpleasant enough that the individual would prefer to avoid them. The kicker was that they had to wait for the shocks. Every trial began with a statement of how big the shock would be and how long they would have to wait for it: a range of one to almost 30 seconds. For many people, the wait was worse than the shock. Given a choice, almost everyone preferred to expedite the shock rather than wait for it. Nearly a third feared waiting so much that, when given the chance, they preferred getting a bigger shock right away to waiting for a smaller shock later. It sounds illogical, but fear — whether of pain or of losing a job — does strange things to decision-making. Some people showed strong fear conditioning, and their brains displayed it through early and strong deployment of neural resources to deal with the impending shock. Most of this activity appeared in the parts of the brain devoted to processing pain. That makes sense, but the activity rose well in advance of receiving the shock. All of this worrying took energy. It means that these extreme responders had less available neural processing power to deal with other tasks. Why is this important? The reason has to do with the 'endowment effect', the innate tendency to value things you own more highly than everyone else does. A recent brain imaging study showed that the same parts of the brain we observed in our experiment are also active when people must sell something they are attached to. The cause and effect have not been fully sorted out, but the implication is that when our brains sense pain, or anticipate loss, we tend to hold onto what we have. When everyone does this at once, the result is a downward economic spiral. The most concrete thing that neuroscience tells us is that when the fear system of the brain is active, exploratory activity and risk-taking are turned off. The first order of business, then, is to neutralize that system. This means not being a fearmonger. It means avoiding people who are overly pessimistic about the economy. It means tuning out media that fan emotional flames. Unless you are a day-trader, it means closing the Web page with the market ticker. It does mean being prepared, but not being a hypervigilant, everyone-in-the-bunker type.
In 1987 the stock market went through similar jaw-dropping price swings, a period that is often brought up today. But the structure of the trading mechanisms themselves was vastly different two decades ago, and it was that inefficiency that was to blame for the volatility. In 1987, there were delays in the trading system everywhere. Traders in Chicago didn't know what was happening in New York in real-time. Coordination between equities markets was poor. On Black Monday, Oct. 19, 1987, as the Dow fell almost 23% and the S&P 500 20%, brokers at Nasdaq simply stopped picking up the phone (which essentially halted trading and thus the Nasdaq only fell 11%). The NYSE shut down, as did the commodities markets. Across all the markets, liquidity dried up as everyone fumbled in the dark, trying to piece together what the hell was happening (and in the meantime programmed trading kicked in, exacerbating the problems). Haim Mendelson, a professor at Stanford's Graduate School of Business, has spent more than 25 years studying how liquidity in securities markets affects stock prices. "Research from 1987 shows that there is a strong correlation between the loss of liquidity across stocks and decline in price," Mendelson says. "When the loss of liquidity is dramatic, decline in prices is dramatic." After the meltdown of 1987, the Brady Commission set about fixing the trading mechanisms. Better coordination and connection between equities markets were put in place. Everyone now has access to the same up-to-the-minute information. Nasdaq solved its problems by embracing more electronic trading. Before '87, Nasdaq brokers could run away from their quotes; today that is not possible. The Brady Commission also implemented so-called circuit breakers that halt trading in a stock or the entire market if a swing is too great, in theory, to get people on the other side of the trades and bring liquidity back to markets. Today's stock markets are transparent, liquid (usually) and highly efficient. So why the volatility now? Mendelson argues that the volatility we now see has two main components. The first is a function of the fixes brought about after 1987 and the speed at which new information moves and gets reflected in stock prices. "If you look at Monday's announcement that we were officially in a recession, although we kind of felt and knew there was a recession, nobody knew that it had started so early - so it was bad, new information," Mendelson says. "And that bad, new information should drive stock prices down. And in an efficient market it should happen very quickly. The stock market is functioning correctly, unfortunately it's in a direction we don't like." Whether Monday's news warranted an almost 700 point slide, followed by a 270 point pop the next day, points to the second component of the volatility in today's market: uncertainty. "There is so much fundamental uncertainty about the economy itself, that new information has a big impact on stock prices," Mendelson says. "The way that I look at it is that volatility today reflects new information. You could argue that new information shouldn't have as big an impact, well, OK, so trade against it." As long as uncertainty remains about the economy, so will the volatility, as jittery investors respond to fresh pieces of news. "Suppose that you could know that this crisis would be resolved in a year or two, and everything would return to normal, then maybe you want to buy a lot of stock," Mendelson says. So why don't you buy now? Because you don't know what's going to happen." Unlike 1987, there isn't a structural fix that can soothe the stock market; it's working just fine. And trying to stop investors from panicking or even rejoicing at every piece of news is a non-starter. "You can certainly argue that people overreact to new information, but most people would agree that you don't want to regulate people's psychology," Mendelson says laughing. Volatility is with us for a while, both because it's built in to the market's trading mechanisms, and because we aren't out of the dark economic woods yet. But watching the market for big drops and even big pops is an indication of where things are headed. When Ben Bernanke's pronouncements or the price of oil fails to move markets in big directions, in other words when volatility lessens, it's a sign that the uncertainty about the economy is lessening too. And maybe then, it's time to start buying again.
If we aren't going to have 20% unemployment and gross domestic product down 15% or 20%, historical odds favor the market being up well over 20% in the next year, Miller said at the money manager's year-end briefing. "Panic is really hard to sustain," said Miller, so the worst case for next year "is the market just moving sideways." Any recovery from this year's slaughter, however slight, would likely be a welcome respite for Miller. His Legg Mason Value Trust (LMNVX), which outperformed the S&P 500 for 15 consecutive calendar years through the beginning of 2006, is down more than 59% this year through Tuesday and more than 12% over five years, according to Morningstar Inc. In comparison, the average large blend fund has lost about 42.4% this year through Tuesday, and is down about 3.3% over five years, Morningstar said. "We have performed far worse than I would have predicted we would," said Miller. "We have had maybe a tougher time than most value investors, but few are doing well because value spreads have widened." When those spreads start to narrow, value managers should do very well, he said. Miller said he has seen characteristics of late that are consistent with a market bottom, such as a series of lows over a course of a few months. No one knows for sure whether those signs mark the end of this bear market or just a bear-market rally, he said. But Miller echoed Warren Buffett, saying, "If you can buy U.S. equities at these prices, you are likely to do well over time."
U.S. stock market typically rallied during the second half of a recession. The average U.S. economic recession -- defined as a period of significant decline in economic activity -- on average has lasted about 11 months (see table, below). Investors historically have begun anticipating a recovery in the economy and in corporate earnings prior to the end of a recession. On average, the stock market has begun to recover about halfway through a recession, with the typical rebound being about 25% in magnitude (from market low point to end of recession). Bear markets that have occurred during past recessions also have tended to end during those recessions (73% of the time, 8 out of 11 instances).
Investment implications. No one knows when (if) the current U.S. recession began or when it will end. The typical historical pattern, however, is for new bull markets to begin during -- not after -- a period of economic weakness.
While cheap stock prices are always a welcome development for bargain-seeking investors, low P/E ratios haven’t always been an accurate gauge of predicting turnarounds in the market. If they were, stocks would have surged sharply in the mid to late ’70s, when the market’s P/E ratio sank into single digits. Instead, the S.& P. was pretty much flat throughout that time. “Cheap valuations are simply a symptom of what’s wrong, not the catalyst to get the market out,” said Richard Bernstein, chief investment strategist at Merrill Lynch. After all, just because stocks are trading at extremely low levels today, it doesn’t mean they can’t become even cheaper tomorrow. To be sure, investors may be hopeful now that some respected investors — including Warren E. Buffett, chief executive of Berkshire Hathaway, and Jeremy Grantham, a chairman of the investment management firm GMO — say they’ve begun to selectively buy stocks. But both have gone to painstaking lengths to stress that they weren’t predicting that the worst of the sell-off was over. In an Op-Ed article in The New York Times, Mr. Buffett wrote: “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.” Similarly, Mr. Grantham said in an interview that even though his firm began buying stocks in early October, after prices fell to attractive levels, the market had a tendency to “overshoot” during sell-offs. “Market bottoms have this Murphy’s Law style of being much lower than you ever expected in your worst nightmare,” he said. Mr. Grantham adds that he thinks the odds are roughly two to one that stock prices will sink to new lows next year. If the economy is in a modest recession, Mr. Grantham thinks the S.& P. could fall from its current level of around 870 down to 800. But if the recession turns out to be a severe one, “the S.& P. could fall to a range that’s closer to 600 than 800,” he said. If that’s the case, why did GMO begin to buy stocks in this market? Because Mr. Grantham doesn’t believe in trying to time short-term market moves. Mr. Grantham noted that GMO began buying only after its portfolios had fallen below some key thresholds. For example, in GMO’s global balanced portfolio of stocks and bonds, the firm’s minimum allocation to equities is usually 45 percent. But after the market sell-off, that equity allocation dipped to around 38 percent. So once stock prices began to look attractive, GMO started rebalancing back into what it regards as the most undervalued types of equities: emerging markets stocks and high-quality domestic blue chip shares. After a few rounds of purchases, stocks now make up around 55 percent of GMO’s global balanced portfolio. Mr. Grantham says that although he doesn’t know how well he timed his purchases, “we do know that seven years out, these will be good purchases for us.” But what if you are determined to be opportunistic? How can you tell if the market is poised to rebound anytime soon — or at least sooner than seven years? There is no sure-fire answer. But one way is to pay close attention to the asset allocation recommendations of Wall Street strategists. “It turns out to be a tremendous contrarian signal” for spotting market trends, said Mr. Bernstein. For more than two decades, Mr. Bernstein has tracked recommended equity allocations in balanced portfolios managed by Wall Street firms. He found that when the consensus recommendation for stocks exceeds 60 to 65 percent of a balanced portfolio — as was the case between 2000 and 2004 — it tends to be a bearish indicator for future stock performance. On the other hand, when market strategists recommend keeping only around half of your portfolio in stocks, as was the case in 1997, it tends to be a bullish sign. The most recent survey taken by Mr. Bernstein, about two weeks ago, shows an allocation of around 58 percent stocks. While that’s down from the mid-60s percentages of the start of last year, it’s still far from real pessimism. “We’re still hovering right around the long-term average,” he said. His own assessment is more bearish. He recommends allocating 50 percent in stocks, with the rest in bonds and cash. In addition to investor sentiment, it’s also worth keeping tabs on the sentiment of another group of Wall Street pros: the analysts who follow individual companies. In recent weeks, these analysts have begun to lower their forecasts for 2009 earnings. Mr. Bernstein notes that for the first time in seven years, the ratio of upward earnings revisions to downward revisions has fallen to 0.5 — meaning that for every corporate earnings forecast that has grown more positive, two have become more pessimistic. “Analysts may be finally appreciating that the financial crisis has turned into a full-blown economic crisis,” he said. Still, analysts are far from throwing in the towel on their earnings forecasts, which may be needed for the market to start to rally. While profit projections have declined, they may still be way too bullish. According to a survey of analysts by Thomson Financial, earnings growth estimates for S.& P. 500 companies in 2009 have fallen well below the rosy 22 percent forecast at the start of October. Still, they’re expecting corporate profits to grow more than 12 percent next year. Since many are predicting a difficult first half of the year, thanks to the weakening economy, this would assume a tremendous profit surge in the latter half of 2009. Christopher N. Orndorff, head of equity strategy at Payden & Rygel, an asset manager based in Los Angeles, predicts that “the earnings releases in January are going to be poor.” That should drive down earnings forecasts for 2009 even lower, he said. If earnings forecasts begin to fall substantially, he said, “it will be very difficult for stocks to rally.”
On average the 54 economists surveyed expect gross domestic product to decline 3% at an annualized rate in this year's fourth quarter. That comes after the Commerce Department reported a 0.3% drop in the third quarter. Another negative reading is forecast for the first three months of next year with an essentially flat reading for the second quarter. Slow growth is seen for the second half of 2009, reaching 2.1% by the fourth quarter. "By the third quarter of next year a recovery will be under way," said John Lonski of Moody's Investors Service, but he added that expansion won't return to pre-crisis levels until 2010. A number of economists surveyed gave a much more pessimistic forecast, due in part to pressure on consumers. "We're not only in an economic downturn, but a serious banking crisis. The idea that you can just have a couple of quarters of negative growth and then we're off to the races is just too optimistic," said Paul Ashworth of Capital Economics, who is predicting GDP contractions throughout next year. Government action is one reason why some economists see the landscape eventually improving. Nearly two-thirds of respondents say the Treasury Department's Troubled Asset Relief Program, which has taken stakes in major financial institutions, is helping markets. "The cost of doing nothing is greater than the cost of doing something, as we saw in the case of Lehman," said Diane Swonk of Mesirow Financial, referring to the collapse of Lehman Brothers Holdings Inc. in September. "The idea is still to save the core ideas of a market-based economy, even if that means using government as a bridge to get there." Economists were supportive of more government stimulus. More than 80% favor a stimulus package in January, even if one is passed before the end of 2008. Some 34% of respondents said the top priority in such a package should be permanent tax cuts. On average, economists said the total size of government stimulus this year and early next should be more than $250 billion. "By the second half of next year the impact of measures to stimulate the economy should become evident," Mr. Lonski said. Economists saw other factors boosting the chances of recovery. "Stimulus will help, but it won't get us out of the problem. It's tantamount to taking aspirin, as it will only temporarily ease pain," said California State University's Sung Won Sohn, who cited rebuilding confidence as essential for recovery. President-elect Barack Obama "needs to extend unemployment, work to stem foreclosures and use other plans to demonstrate that he's doing something. To stabilize confidence, you need programs to ease pain. People see that they can count on you, and confidence recovers," he said. Confidence is in short supply these days. In October, the Conference Board's measure of consumer confidence posted the lowest reading since the survey began in 1967. Consumer spending also has suffered, recording a 0.3% decline in September. Mounting job losses have exacerbated the consumer downturn, and even though economists are forecasting some improvement by late next year, the picture for the labor market remains grim. On average, respondents expect the unemployment rate to rise to 7.7% by December 2009, up from 6.5% last month, while they see the economy shedding more than 100,000 jobs a month over the next year. If the economists' average forecast were to materialize, the depth of the downturn would be about on par with the 1990 recession, but it wouldn't reach the low levels seen in the early 1980s or 1970s. "We're at the very beginning of this process of unwinding a credit bubble and an asset-price bubble that took place over decades. It got out of control in the last five years, but it didn't appear in the last five years," said Joshua Shapiro of MFR Inc., who also is forecasting a shrinking economy through all of 2009. "People think in terms of a calendar as opposed to economic fundamentals. The cycle doesn't know from the calendar."
The idea of a large company making a stock market debut is highly improbable in the current environment. Partly, that is because, with volatile swings in equity markets becoming the norm and the S&P 500 down more than 34% for the year to date, analysts and investors are reluctant to call the bottom in equity markets. The volatility is best reflected by the Vix index, often referred to as Wall Street's fear gauge. This reached a peak of almost 90 last month. Although it is now trading much lower than this, at 55.4 it still indicates severe levels of distress in the markets. As a result, there are compelling reasons for investors and companies to tread carefully. The amount of money raised through equity capital markets, which encompasses IPOs, follow-on (or secondary) offerings and convertibles, reached $557 billion globally for the year until the end of October, a 27% drop compared to the same period last year, according to Dealogic. The declines are sharper for IPOs, where volume is down 65 per cent for the year, and convertibles, which are down 35%. Only 16 IPOs priced globally in October, 12 of those from the Asia-Pacific region. No European IPOs priced at all last month and no US listed IPOs have priced since August. Follow-on volume is actually modestly higher than for last year with the increase largely due to the huge upsurge in capital raisings by financial companies embroiled in the credit crisis. Lower IPO volumes have led to lower underwriting fees for many investment banks, placing further pressure on revenues and jobs. In spite of the dearth of deals, there remain plenty of companies that would like to raise money if only markets were more stable. "Although the pipeline has virtually maintained its level from the second quarter, only four companies successfully went public last quarter," said Maria Pinelli, Americas director for strategic growth markets at Ernst & Young. "Companies are clearly waiting for the market to open up. In the meantime, private equity and other strategic partners are looking to companies in the pipeline as targets for possible investments, mergers and acquisition opportunities," she added. Seventy-nine companies remained in the IPO pipeline at the end of the third quarter, according to the quarterly Ernst & Young US IPO Pipeline Report. One head of equity capital markets at a large European bank, said: "The outlook for the equity capital markets is not necessarily as gloomy as the recent lack of activity may suggest. A short period of relatively stable equity market performance could see the raft of companies that have registered for IPOs rush to market in the coming months." But while the outlook may not be as bleak as recent inactivity suggests, equity capital markets globally have yet to turn the corner in spite of signs of a tentative recovery in stock markets. One relatively bright spot is the Middle East, where 12 initial public offerings in the third quarter raised $3.61bn, still a 23% decline on the same quarter last year, but better than the other regions.
Of course, such a volatility-avoidance strategy faces long odds. As the critics of market timing often point out, the stock market tends to produce the bulk of its gains in just a few explosive sessions. Miss those days and your portfolio’s returns are likely to disappoint you. Consider someone who was fully invested in stocks over the last decade — except for the market’s 20 best days, during which he held cash. Despite holding stocks more than 99% of the time, this investor would have lost 57% through the end of October, as judged by the Dow Jones Wilshire 5000 index. That is 70 percentage points worse than the 13% gain he would have achieved had he held stocks mimicking that index for the entire 10 years, including the market’s 20 best days. Market-timing advocates say it’s unfair to focus only on the consequences of missing the very best days, because the bulk of the market’s declines are also concentrated in just a few sessions. For example, a portfolio fully invested in stocks during all but the 20 worst days of the last decade would have gained 215%. That’s more than 200 percentage points better than the return from a straightforward buy-and-hold approach. The volatility-avoidance strategy takes the middle ground between these two extremes. It aims to sidestep at least some of the market’s biggest down days and is willing to miss some of the biggest up days, too. Because the best and worst days tend to balance each other out during volatile times, a strategy that moves your portfolio into cash during such periods should produce long-term returns that are close to those of the overall market, while incurring much less risk. This rough equivalence in returns has prevailed in recent years. Over the last decade, an investor who was out of the stock market during both the 20 best and 20 worst days would have gained 18%. That’s just a little better than buying and holding. Yet the volatility of this investor’s monthly returns would have been 9 less than the market’s. But how can you sidestep even a good portion of the biggest down days? A growing body of academic research has found that the periods of greatest volatility are in large part predictable. This means that the market sessions with particularly good or bad returns don’t occur randomly, but tend to be clustered together. Perhaps the researcher most widely credited with documenting this tendency is Robert F. Engle, a finance professor at New York University who was the Nobel laureate in economics in 2003 for his work along these lines. The market’s behavior over the last couple of months illustrates of this clustering: By Sept. 18, the VIX, the widely followed volatility index, had climbed to what was then its highest level in five years, greatly increasing the likelihood that the ensuing period would have above-average volatility. Sure enough, 9 of the 20 biggest daily percentage losses of the last decade occurred in the subsequent six weeks, along with 6 of the decade’s 20 biggest daily gains. But even if they’re successful, volatility-avoidance strategies aren’t for everyone. Long-term investors, for example, presumably don’t care about shorter-term gyrations, and therefore aren’t interested in market-timing approaches whose major benefit is reducing volatility rather than increasing return. Such strategies require close attention to the market, and generate higher costs than simply holding stocks for the long term. Still, a successful volatility-avoidance strategy would appeal to many investors who have been scared away from the market, worried that they would suffer through more extraordinary fluctuations like those of recent weeks.
“The markets reached their most extreme levels of panic and fear in modern times,” said David Kovacs, chief investment officer of quantitative strategies at Turner Investment Partners. “We’ve not seen anything like this since maybe the 1920s or ’30s.” Based on the VIX alone, Mr. Kovacs said, you might conclude that “the markets have experienced meaningful capitulation,” defined as that state of hopelessness that is often said on Wall Street to be the prerequisite for a big rally. Yet he said it was too soon to tell if we have witnessed “final capitulation,” when the sense of despair among investors reaches such cathartic levels that it signals the end of a bear market. The problem is that aside from the VIX, several other pieces of evidence aren’t entirely convincing. The first is the odd behavior of the market itself. On Thursday, the day of great panic, according to the VIX, the market rallied toward the latter part of the day, helping to propel major stock indexes up for the entire week. Yet the market declined again late on Friday. There doesn’t seem to be a clear pattern in these movements. Then there is the question of fund flows — whether investors are literally walking away from their investments. Recently, there has been some evidence that investors have begun to give up. October is on track to be the single worst month for equity fund net redemptions since this data started to be recorded in 1984, according to TrimTabs Investment Research. Through Thursday, investors have yanked more than $55 billion from their stock funds. But on Thursday, when the VIX spiked to its record high, investors actually added to their stock funds, by a net $330 million. It was one of three days this month that they increased their equity fund stakes. “I think you clearly have seen a blowout among institutional investors, but it’s not so clear if individual investors are panicking to the same extent,” said Jack Ablin, chief investment officer at Harris Private Bank. Capitulation among retail-level investors, Mr. Ablin said, is likely to come later, once they “realize how hard this economic downturn could be.” One group that doesn’t seem all that worried about a potential recession is Wall Street analysts, at least not yet. This raises another question: whether there is enough hopelessness in this market to say that true capitulation has been achieved. Ninety percent of money managers surveyed recently by Merrill Lynch now think that the domestic economy is likely to slip into recession in the next 12 months. Yet surprisingly, stock analysts are holding out hope that corporations remain healthy enough to increase their earnings substantially in the coming months and quarters. According to a recent survey by Thomson Financial, Wall Street analysts are expecting earnings for companies in the S&P500 index to soar 40% in the fourth quarter, versus the year-earlier quarter, and 20% in 2009, versus 2008. Even more astonishing, those consensus 2009 projections have remained fairly steady in recent months, despite growing fears among investors that a recession is unavoidable. “Wall Street analysts are notorious for being overly optimistic,” said Christopher Orndorff, head of equity strategy at Payden & Rygel. “However, the cold, hard reality of disappointing earnings will be with us for some time longer.” Faced with the reality of a deepening recession, the analysts may well do an about-face. Mr. Kovacs thinks so. He expects that fourth-quarter earnings forecasts “will come down severely” in short order — once analysts get over their shock and companies start to offer guidance for their performance in the slowing economy. That’s when “the reality will set in that we could be in a deep recession — the likes of which we have not seen since possibly the ’70s — and that the damage to earnings will be catastrophic,” Mr. Kovacs said. Once that occurs, the market is likely to revisit its October lows. “If you see a meaningful decline in earnings and see earnings guidance come down — and keep hearing that there’s a lack of visibility for future business conditions, that could be a big negative for the markets,” he said. If this occurred, the October lows in the S&P500 might not hold, he said. At that point, investors might truly capitulate.
The so-called smart money seems to avoiding three big investment categories: index funds, dividend-paying companies and small-caps. On paper, that seems to make perfect sense in these times. If you do a little homework, however, you will notice that some of these ideas haven’t panned out. At least not yet. To Index or Not There is a simple reason for making the case that investing in index funds won’t work in this crisis: Financial stocks represent one of the two biggest sectors in the S&P500 index, currently accounting for 16% of it. Actively managed funds would seem to have an advantage, since their managers have the freedom to step out of this losing sector and redeploy that money. That is the theory. In reality, most actively managed funds didn’t have the foresight to avoid the meltdown in the financial sector. At the start of September, for example — before the government’s takeover of Fannie Mae and Freddie Mac and its bailout of the American International Group — the average actively managed large-cap fund invested nearly 15% of its assets in financial services. That was almost exactly the sector’s weighting in the S&P500 at the time. That may explain why active managers haven’t been able to outperform basic index portfolios lately. Morningstar did the calculations and found that the average large-cap index fund fell 26.8% over the past year through Sept. 29. That is almost the same as the 26.7% decline for actively managed large-cap funds. Over the past three years, their results were exactly the same: both active and index funds posted annualized losses of 2.2%. Among small-cap portfolios, index funds actually beat the average actively managed fund over the past year, three years and five years — even though small-cap index funds maintain a far greater weighting in financial stocks than their actively managed counterparts. The Dividend Question Financial stocks account for roughly a quarter of all the dividends paid out by the S.& P. 500 index, leading many people to say that investing in dividend-paying stocks isn’t advisable now. As banks, brokers and insurers have run into hard times, many firms have cut or eliminated their dividends. This year, 30 financial companies in the S&P500 have cut their payouts to the tune of $24.1 billion, according to Standard & Poor’s. This certainly shows the dangers of betting on a handful of individual dividend-paying stocks. “If you’re trying to get income by owning just three or four high-yielders, you’re taking a big risk that one or more will run into trouble,” says Luciano Siracusano, director of research at WisdomTree asset management. But Mr. Siracusano noted that this doesn’t mean that diversified dividend investing strategies will fail in this market. In fact, they are working. Not only did dividend-paying stocks in the S&P500 beat non-dividend-payers in September — the height of the financial crisis — the dividend-payers have also outperformed over the past yearlong bear market. In the 12 months through September, around the market’s peak, dividend-paying stocks have fallen 22.1%, versus a drop of 27.5% for nonpaying shares, according to Howard Silverblatt, S.& P.’s senior index analyst. Some funds focus on dividend-paying stocks that have consistently raised their payouts, and these funds are performing particularly well. Consider the SPDR S.& P. Dividend E.T.F., an ETF that tracks the S.& P. High Yield Dividend Aristocrats index. It includes only high-yielding stocks that have managed to raise dividends for 25 consecutive years, and it is down just 6.8% since the start of the year. Compare that with the 25.1% year-to-date loss for the S&P500. Large VS. Small Stocks Many economists and market watchers believe the financial crisis will push the economy into a recession, if it’s not already in one. “I can’t think of anyone who thinks there’s not going to be a recession now,” said Michael P. Balkin, co-manager of the William Blair Small Cap Growth fund. If that is the case, the market could be in for a sustained period of volatility, which naturally drives investors to the safety of large, industry-leading companies. This may turn out to be the safest strategy. But here’s a surprising twist: Since the middle of March, small-company stocks are holding their own. Since March 10, the Russell 2000 index of small stocks is down 3.7%. To be sure, small-cap stocks were punished in September, when the financial crisis really started to frighten the markets. But even then, small stocks lost 8% in the month, versus a drop of 9.5% for their large-cap cousins. Earlier this year, the small caps’ superior performance was regarded as a sign that this economic downturn might be short-lived. Today, few people think that the economy is on the verge of accelerating. But the real reason for this performance could be simpler than that: small-stock earnings have just held up better in this crisis. Steven G. DeSanctis, small-cap strategist at Merrill Lynch, noted in a recent report that small-cap earnings were expected to climb nearly 2% in the third quarter, versus an expected decline of 5% for the S&P500. If this happens, it would be the fifth consecutive quarter when small-company earnings have held up better than those of large firms. Nevertheless, in the short term, small-cap stocks may not perform as well as they have recently, Mr. Balkin warned. “They could just mark time, ” he said, especially if economic concerns come to the fore. But if the recession ends sometime in the first half, he said, 2009 could turn out to be a decent year for small stocks. How Fund Categories Fared WSJ 10-01-2008
As the bear market of 2000-02 was unfolding, it was easy enough to find ground zero: funds heavy with go-go technology stocks. This time around, it's harder to isolate the danger. Even some short-term-bond funds billed as safe alternatives to money-market funds have tanked with exposure to defaulting mortgages. Money-market funds themselves have been in the headlines for soured investments. What's more, dividend-focused stock funds that supposedly have less to lose in bad times than funds with aggressive holdings have stung their investors. And foreign funds that investors hoped would provide diversification have lost even more than U.S. ones. For the third quarter, the average diversified mutual fund holding U.S. stocks lost 10.3%, bringing the year-to-date loss to 19.7%, according to preliminary figures from Lipper Inc. That was far worse than the 3.7% quarterly decline in the Dow Jones Industrial Average and also behind the 8.4% negative return of the Standard & Poor's 500-stock index, hit hard by financial-sector woes. The two indexes are down 16.6% and 19.3% year to date, respectively. (All figures include reinvested dividends.) Experienced investors know they have endured worse; the tech-stock collapse led to declines of more than 10% in the average fund in four separate quarters, including one nearly 17% fall. Still, investors are in uncharted waters: Financial-rescue plans coming out of Washington will determine in large part what happens now. With 2008 entering its final stretch, we decided to take a look at some of this year's many twists and turns, trying to find lessons to be learned to help investors as they brace for the fourth quarter. Here is what we found. Reaching For Yield Can Be Perilous With money-market funds sporting paltry yields in recent years, investors flocked to "ultrashort" bond funds. In general, the perception was that these funds were "a safe haven, cash-substitute investment," says Arijit Dutta, associate director of fund analysis at fund tracker Morningstar Inc. Between 1999 and 2007, the category swelled to 49 funds from 37, totaling about $50 billion at the peak, according to Morningstar. Then, a handful of these funds stunned investors, plunging by double-digit amounts for the nine months through March 31 of this year. The average fund in the group dropped 1.65% from mid 2007 to March 31, while the average taxable money-market fund gained roughly 3%, according to Morningstar. What is particularly frustrating here is that there were so few warning signs. Indeed, one hard-hit fund, Fidelity Ultra-Short Bond, was a Morningstar recommendation, praised for its broad diversification and high-quality holdings. Its returns were solid - in the category's top quartile in 2005 and 2006 - but didn't suggest aggressive bets. The fund is down nearly 11% over the past 12 months; for the year's first nine months, it is down 7.1%, about eight percentage points worse than its benchmark index. In an effort to improve matters, Fidelity assigned the fund to a veteran manager with experience managing short-duration accounts. To reduce volatility, this manager has lowered the fund's stake in asset-backed securities and other types of securitized bonds, and he has beefed up cash holdings, a Fidelity spokesman says. This summer, Morningstar sought to figure out why its standard risk measurements hadn't picked up on the danger lurking within this and several other bond funds. The conclusion: The complex subprime-mortgage securities these funds held, which carried high bond ratings, were too new to have shown problematic tendencies in the "benign" period before subprime defaults escalated, says Mr. Dutta. In retrospect, he says, there was one missed clue -- the most problematic securities generally traded infrequently. As the credit crisis grew, they became even more illiquid, worsening the price declines. Morningstar's analysts are now trying to get a better handle on "liquidity risk" as they assess funds, he says. The upshot: If you move money into a bond fund because its yield is higher than your money-market fund or a certificate of deposit, know that risk comes with it, no matter how safe it appears. Small investors have voted with their wallets, fleeing not just the few hard-hit ultrashort-bond funds but others as well, worsening many funds' returns as managers were forced to sell bonds to raise cash. The ultrashort-bond category held less than $20 billion as of mid-summer. Choose Money-Market Funds Carefully Money-market mutual funds are different from bond funds in a key regard: The Securities and Exchange Commission sets rules on what they can buy, known as the "quality, maturity and diversity standards," says Peter Crane, president of Crane Data LLC, Westboro, Mass., which tracks money-market activity. As a result, money-market funds own a very wide range of highly rated securities that generally mature in 90 days or less. But that doesn't mean they can't lose money -- as investors in the Reserve Primary Fund learned last month. The big fund, popular with institutional investors, "broke the buck," meaning losses dragged its net asset value below the $1-a-share mark that is standard for these funds. It declined to 97 cents, hit with losses from debt securities of Lehman Brothers Holdings, the Wall Street firm that filed for bankruptcy last month. There are several steps you can take to avoid being in a money-market fund that one day makes the headlines. First, you can check to see if your fund has signed up to participate in the U.S. Treasury's new temporary guaranty program; the effort is limited to money that was invested in money-market mutual funds as of the close of business Sept. 19. It initially is in place for just three months. For those willing to do homework, many fund firms post lists of holdings on their Web sites. Some are specifying exposure to troubled companies in the news. But beware: Holdings change, so the list you look at before you invest might be quite different months down the road. Also, what do you look for? As 2008 opened, who would have thought that insurance powerhouse American International Group Inc. would need a life-saving $85 billion government infusion? One possible approach: Invest in a big fund at a well-established fund firm. The larger and more established the firm, the more likely it is to step in and bail out a fund if something goes wrong, to prevent devastating runs of panicked investors and a huge hit to its reputation. The Reserve fund's parent, Reserve Management Co., long has offered some of the nation's oldest and largest money-market funds, but it is small compared with big players that in recent months have bought troubled securities out of their funds or taken other steps to make their funds whole, including Bank of America, Legg Mason and Northern Trust. Though small investors may have access to an institutional money-market fund in a 401(k) or brokerage sweep account, most are probably better off in "retail" funds, analysts say. Funds that cater to hedge funds and other big accounts may be subject to money moving in and out as these investors chase slight yield advantages. What's more, fund firms may be more willing to protect small investors from losses than sophisticated clients in institutional funds. A fund's yield can reveal potential problems. The Reserve Primary Fund's 12-month yield as of Aug. 31 was 4.04%, the highest of more than 2,100 money-market funds tracked by Morningstar -- while the average was 2.75%. If your fund is yielding more than others in its category and charges a similar expense ratio, you can assume it is taking on more risk to deliver the added reward. This raises another point: The funds with the lowest costs have the least need to take on risk to deliver a competitive yield; an annual expense ratio is a hurdle a manager has to clear before you get any return at all. Ratios in money funds tracked by Morningstar range from no current charge to 2.25% of assets. "In all, your best bet is to stick with low-cost money-market funds that don't need to stretch for yield," run by "large reputable shops that have the resources to fulfill their promises," Morningstar analyst Karen Dolan sums up in a recent report. Diversification Carries Its Own Set of Risks Many investors who experienced the bursting of the tech-stock bubble remember that "value" stocks were poised to take off when the S&P 500 index swooned, says Christine Benz, who directs Morningstar's personal-finance research. These are shares deemed cheap on the basis of, say, the ratio of stock price to earnings per share. They're often seemingly dowdy, dividend-paying companies, and during the tech-stock boom they were shunned as investors favored shares of companies with fast-growing profits. Many investors came away from that experience with the belief that value stocks are safer than "growth" counterparts, says Ms. Benz. That value stocks would hold up better "makes intuitive sense, too," she says. "After all, most market downturns involve a purging of previous excesses," and because value stocks are usually defined as those trading at prices below what value managers judge they are worth, they wouldn't have as far to fall as growth stocks. But many value funds haven't been so rewarding this time around. The main culprit: the deteriorating financial sector. Long a steady source of dividends, banks and mortgage businesses have been hammered by mounting defaults. Similarly, international-stock funds have disappointed. They can help diversify results over time, but here's the rub: U.S. and overseas markets tend to move together during severe downturns as gloom spreads around the globe. For the year's first nine months, most overseas stock-fund categories fell much further than U.S. ones, many off nearly 30%, according to Lipper. The average emerging-markets fund was down 37%. Ronald Florance, director of asset allocation and strategy for Wells Fargo & Co.'s Wells Fargo Private Bank, says that value and international stocks remain key elements of diversification, but investors need to know their risks. People often don't appreciate how [investment] styles can have large sector exposures," he says. As for this year's international declines, "that's just one more reminder of why you don't place all your eggs in one basket," he says, as some were tempted to do when foreign markets were outpacing U.S. ones in recent years. "If your long-term asset-allocation strategy addresses all of your financial goals, you shouldn't let this year derail" the approach, he adds. Instead, this year is a reminder of why it's wise to be well-diversified. What Goes Up Too Far Eventually Does Come Down Just one more word: potash. A fertilizer ingredient that has been in short supply, potash is a low-profile but important piece of the big commodities rally that lured in many small investors during the year's first half. In fact, some of the most impressive returns during the year's first half came from Potash Corp. of Saskatchewan, Mosaic Co. and other stocks of fertilizer producers, says Morningstar analyst David Kathman. In early July, Mr. Kathman screened for the 10 mutual funds with the most-concentrated fertilizer bets. The funds he identified had 8.8% to 25.2% of their money in the sector. Some specialize in basic-materials stocks: Fidelity Select Chemicals, ICON Materials and Rydex Basic Materials. But one of the biggest concentrations -- nearly 11% -- was at CGM Focus. CGM Focus was in the top 1% of Morningstar's "large blend" category for the 12 months through June 30, with a 71% total return. Then, in one of the most predictable things that happened this past quarter, because what goes up far too fast almost always comes down hard and fast, commodities prices dived. CGM Focus slid 29% in the third quarter, falling into the bottom 100th percentile of its peers. "All too often, investors buy whatever has been hot and shun whatever has not, and they frequently do so at just the wrong time," Mr. Kathman writes at Morningstar.com. At CGM Focus, new shareholders can take some comfort that the fund has an excellent long-term record -- it is in the top 1% of its category for the past three years, five years and 10 years -- and Morningstar considers its skipper, Kenneth Heebner, one of the most experienced in the industry. "A key part of investing well over the long term is learning how not to get swept up in the emotions that short-term gains or losses tend to bring out, and how to keep an eye on the bigger picture," Mr. Kathman concludes. Quick Facts, Stats & Opinions There is a flaw in the belief, widely held in the 1990s, that all one has to do is “buy and hold” equities to ensure a handsome return in the long run. Just ask Japanese investors. The Nikkei 225 average recently fell to a level last seen only in 1982 and even after a rally still trades at less than a quarter of its 1989 peak. (The Economist 11-10) Dividend yields are at giddy levels right now. Don’t expect it to last. Currently, the dividend yield on Standard & Poor’s 500 companies is 3.1%, compared with 1.89% at the beginning of the year, 1.67% five years ago, and 1.59% ten years ago. In the coming months, however, even if share prices don’t repair themselves and shoot up, dividend yields will be under significant pressure. Standard & Poor’s has cut its estimate for 2008 dividend payments by the members of its S&P500 index and said fourth-quarter dividends are expected to fall 10% — the worst quarterly performance in 50 years. The index provider now sees S&P 500 companies paying a combined $28.05, down 80 cents from S&P’s prior estimate. That would be the worst performance since 2001, with payments dropped 3.3% as the Internet bubble deflated. (Geoffrey Rogow, WSJ 10-22) Home Page Previous Factoid Top Sites
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