(excerpts from email sent 11/3/2008)
To our clients:
As you are probably aware, your portfolio with us suffered a substantial decline in market value in October, a victim of the extraordinary global financial debacle in which we find ourselves.
You were not alone. The damage was widespread, affecting not only you and the rest of our clients, but investors of all types around the world, no matter how conservative or aggressive. That includes those of us here at Brinton Eaton, whose personal portfolios are invested according to the same strategies that we employ for you.
It is not our practice to report performance on a monthly basis. Indeed, quarterly (or even annual) performance tracking is arguably of little relevance for long-term investors such as you. But, in a number of respects, the markets’ performance during October was truly historic, and deserves comment.
You have, no doubt, heard that the stock market’s decline this past month was among the worst on record, and its daily volatility set a new standard. October 2008 included two of the largest single-day percentage gains ever in the S&P 500 Stock Index, in the midst of a month that was the index’s worst since October 1987 (which, in turn, was the worst since May 1940, before which double-digit monthly percentage declines were more frequent). Prior to a partial recovery in the last few days of the month, comparisons were being made to the Great Depression almost eighty years ago.
What has not been as widely reported is that the value destruction extended well beyond the domestic stock market and into virtually every asset class in which you can invest. During the month, bonds, real estate, commodities, international investments, and equities in every industry sector all declined by very significant amounts. This almost never happens. For one of the very few months in history, diversification did not work.
But history is also a source of some solace. Clearly, the markets recovered from every prior downturn. Moreover, in the wake of many of the most severe episodes, the recoveries were not only sudden but also very substantial. It has been said that periods like what we just experienced are the inevitable temporary interruptions in a permanent upward trend. And it is simply implausible that broadly divergent asset classes, which have been excellent portfolio diversifiers throughout their history, have suddenly — and permanently — become perfectly correlated; it is, in other words, unlikely that well-diversified portfolios have forever been rendered obsolete.
So when will things return to normal? No one can answer that. The situation could possibly get worse before it gets better. Therefore, our personal experience with past market aberrations, our research and analysis of many decades of financial history, and our informed views of current pressures and trends have led us to certain decisions in the interim that seek to protect your future. Let us describe in some detail the things we have done and are doing.
1. As we have reported to you earlier, we do not want to react to these events in an extreme or emotional way. In particular, unless you have advised us (with or without our prompting) that you need extra cash for short-term expenses, we have not moved your portfolio to cash to any substantial degree. Staying invested provides your portfolio the ability to rebound when the markets do so. Having said that, and as we also reported, we have let your portfolio’s natural build-up of cash (through dividend and interest payments) occur without immediate redeployment into the markets. This effect is small, and simply tilts your portfolio slightly to a more conservative posture, but still within the bounds of the long-term investment strategy that you directed us to follow for you.
2. We are continuing with our temporary suspension of normal portfolio rebalancing activity. A large part of the reason for this is the excessively high level of volatility in the markets. A normal level of volatility is good, and makes rebalancing work to your benefit (higher returns, lower risk). But the current level of volatility throughout the trading day makes the determination of the proper rebalancing amounts problematic, as rebalancing trades are, by their nature, relatively small “fine tuning” trades. We liken the situation to trying to cut a diamond in the midst of an earthquake. We monitor volatility daily, and are eager to return to rebalancing when the markets settle down within a band we have determined. At the same time, we will also be examining whether inter-asset-class correlations (another key ingredient to making rebalancing work) have begun to revert to normal.
3. We have lightened your portfolio’s exposure to non-U.S. investments by exiting positions in international small-cap equities, emerging market equities, and international real estate. These actions were taken because it is our judgment that the dollar may continue to strengthen against foreign currencies for the next few months, as the financial crisis works its way throughout the world, and global assets likely continue to migrate toward the dollar as a safe haven. A strengthening dollar hurts the performance of those three international investments, even as the underlying holdings perform equivalently to their U.S. counterparts when expressed in their local currencies. Since (see point #1, above) we did not want those proceeds to be out of the market for any length of time, we are redeploying them into domestic small cap equities, large-cap domestic industry sectors that tend to do relatively well during economic downturns, and a bond equivalent that includes a healthy allocation to investment-grade corporate bonds. The latter has a yield that we believe is currently at least competitive with commercial real estate alternatives. Here again, these moves still permit your portfolio to remain in conformance with your desired investment strategy.
4. A strengthening dollar and a weakening global economy also exert downward pressure on commodity prices. While we are not exiting commodities, we are temporarily letting your allocation remain at the low end of the rebalancing range that we have established around your target allocation. We are closely monitoring world economic events and will return to normal allocations to commodities when we believe it is appropriate.
5. We always have been, and will continue to be, aggressive in taking advantage of tax loss harvesting opportunities where appropriate. These tax losses can be used to offset taxable gains that you may already have in your portfolio for the 2008 tax year, as well as those that arise in future tax years.
You may wish to consider actions similar to some of the above in any accounts not directly under our management (for example, 401(k) accounts). We would be happy to assist you in this.
We want to conclude with a sincere expression of our gratitude to you. Your continued faith in our ability to get you through this tough time, which some of you have gone out of your way to express (including, but not limited to, transferring additional family assets to our management), is a source of great comfort and inspiration to all of us here. We each take our responsibility to you very seriously, and we know you are counting on us to act with utmost prudence on your behalf.
As always, please call us with any questions.
Your Team at Brinton Eaton