(text of email sent 3/16/09)
During what appears to be a respite in the markets’ frenetic activity over the last six months, we thought we would share some of our long-term thinking. We hope that this will provide a fuller strategic context for our recent and upcoming tactical activities with regard to your investment portfolio.
First, let us reiterate, and state the basis for, our optimism — about the U.S. and global economies, and about the capital markets.
The Economy
The U.S. has repeatedly exhibited one of the strongest and most resilient economies in world history. Our country’s core values — our freedoms, our entrepreneurial ideals, our work ethic, our innovative drive, our educational system, our rule of law, our protection of tangible and intellectual property rights, to name a few— provide such a fertile breeding ground for success that it is unwise to bet against our long-term economic well-being. There have been, and always will be, periods of trouble. But our problem-solving capacity and commitment to get swiftly through those periods are world-class, and will continue to confound the pessimists.
That being said, it is clear that the U.S. that emerges from this recession will be quite different from the country that entered it. Some of these changes (e.g., the movement to a knowledge-based, and away from a product-based, economy) simply represent an acceleration of long-term trends. Others (e.g., massive deleveraging, greater transparency of complex financial instruments) are necessary corrections, and good for the economy’s long-term viability, however painful the transition may be. All of these changes influence the investment decisions we have been, and will be, making for you. (They are why, in part, we have made certain tactical changes by industry sector.) Also, whatever your view on the various government interventions in recent months, we are likely headed for a period of elevated inflation as the cost of funding these initiatives winds its way through the system. (Which is why we favor inflation-hedging investments in your portfolio. It is also another reason we don’t believe cash is a prudent long-term “investment” — it is virtually the only asset guaranteed to lose value in an inflationary environment.)
Over the longer term, furthermore, it is unrealistic to think that the U.S., however strong, will always and forever be the world’s leading economy. It is probably only a matter of time that countries such as China and India, as they slowly and fitfully migrate toward the core values cited above, will rival us in global economic influence simply by virtue of their sheer size. This is not to be feared; these things have always run in cycles throughout history (we are fortunate, perhaps, to be living in the current U.S.-dominant cycle). Instead, it should be seen as broadening your investing opportunities. (That is why we had you exposed to emerging market equities — and will soon again, once we observe that the short-term strengthening of the dollar has run its course. It is also one reason we have introduced global infrastructure investments into your portfolio.)
The Markets
As we’ve often said, there is the economy, and then there are the capital markets. They are not the same animal, and they do not run on the same cycles, but they do bear some relationship to one another. The equity markets, for example, tend to anticipate changes in the economy — in both directions — usually by many months. So if we’re long-term optimists about the world’s economies, it stands to reason that we’re long-term optimists about the markets.
Here’s our view of the markets in a nutshell: they go up, they go down, but over the long haul, they go up. Our investment strategy has always been designed to exploit this simple fact by keeping you constantly invested across a wide range of diverse asset classes — all of which tend to go up in the long term, and whose short-term cycles tend to at least partially offset each other (the last six months notwithstanding, which we’ll come back to in a moment). As we’ve pointed out in earlier bulletins and briefs, this is a winning strategy available to those investors with (i) investment horizons longer than a few years* and (ii) the resolve to withstand volatility — including the possibility of material short-term market value declines — in the interim. Those of you who don’t thoroughly fit that description we’ve encouraged to keep anywhere from six to 24 months’ worth of living expense in ready cash, and to let us invest the rest for you.
Your Portfolio
If we are such optimists, and believe in the virtue of staying in the markets, then why have we accommodated the desire of some (albeit a small minority) of you to exit the markets to some degree (beyond the need for ready cash) or, equivalently, to move to a markedly more conservative portfolio, even if over the short term? The answer to this question should give you additional insight into how we view our relationship with you. We have tried to do a good job, over the course of our relationship, of explaining the cold, hard economic facts about the virtues of being invested, and of the way we invest. But life is about more than cold, hard economics. We recognize that your investment portfolio is simply a means to an end, namely, your enjoyment of life. And we understand that, for some of you, the short-term beating that the markets have rendered upon your portfolio has left you literally ill, and less able to enjoy yourself. We feel strongly that your mental well-being is no less important than your financial well-being, and we are therefore as interested in helping you deal with that part of the equation. Our responsibility to you, when it comes to your making investment decisions that are angst-related, is to make sure you clearly understand the financial implications of those decisions. It is not our role to substitute our risk tolerance for yours and make that call for you without regard to your own unique psychological make-up and tolerance for pain. Once we have assured ourselves that you understand the implications, and we have determined that your decision is not out-and-out imprudent for you (i.e., it would not dangerously compromise your long-term financial future), we stand ready to help you enjoy your life better. Those of you who have engaged in those discussions with us know, we trust, that that is where we are coming from.
Where do we go from here? First and foremost, given all we’ve said above, and within the confines of your enjoyment-of-life parameters, we want to keep you fully invested across a wide range of independent asset classes, and diligently manage your portfolio through intelligent rebalancing and other adjustments as necessary. We strongly believe that this is the formula for long-term success. However, this formula, along with just about any other investment formula you can think of, has not worked very well over the last six months. It is important to understand why.
Equities of all types lost value; commodities lost value; real estate lost value; most categories of bonds lost value. The remarkable event of the last six months is not the degree to which virtually everything you could invest in lost value, it is the fact that all these asset classes lost value at the same time. Of all the “unprecedented” things that have happened recently, that is genuinely the most extraordinary. Let’s just take two of those asset classes — equities and commodities — to make the point clear. The oldest of the popular commodity indexes is the Goldman Sachs Commodity Index, which has existed since February 1970. The S&P 500 Stock Index has existed far longer, so through August 2008, we have 463 uninterrupted months over which those two indexes have co-existed. How many times, over those 463 months, have both indexes had material (5% or more) declines in the same month? Exactly three times (and one of those three months included the truly devastating events of September 11, 2001). How many times has it happened in the last six months, beginning September 2008? Five! So, we have suddenly gone from an extremely rare event, with a frequency of less than two-thirds of one percent, to one that occurs with a recent frequency of 83 percent! And, clearly, these are not the only two asset classes so afflicted. As we have stated in our earlier bulletins, we believe this so-called contagion is an unsustainable phenomenon. And there are sound, fundamental reasons for believing so. Before long, asset classes that have no business being so strongly correlated with each other will likely revert to their mutually-counter-cyclical form. But before they do, they might very possibly rebound together for a time. This can happen quite suddenly. And we want your portfolio to be ready to benefit when they do. Note that we are not counting on everything in your portfolio rebounding at the same time. Far from it. Another reason to be widely diversified is so that you don’t have to make a bet on which asset class(es) will recover first. You are well positioned to ride the recovery whatever form it takes.
But what if this recovery takes a while yet? And what if it’s not all that smooth, and there are several periods of painful downturns yet to come? And after the recovery, how do you defend yourself the next time this sort of phenomenon occurs, however unlikely that may be? All of that is where portfolio protection comes in. As we’ve mentioned in previous communications to you, we are working with some of the world’s largest and most respected financial institutions to custom-design a structure that would protect your specific portfolio against those eventualities when they do occur, and not be a drag on your portfolio when they don’t. This is a painstaking process and we have not yet arrived at a structure whose terms (trigger events, level of protection, cost, liquidity, marketability, suitability, transparency, etc.) we find acceptable. But when and if we do, we will act promptly to implement it on your behalf. Unlike the process we employed over the last few weeks for the stop-gap, equity-only “structured note”, under which you had to explicitly opt in (because, given the terms of that note, we felt compelled to have you do so), we will implement any new approach under the discretionary authority you have given us to manage your portfolio. But be assured that we will do so only when and if the terms are acceptable to us and, by presumption, to you. Your feedback on the stop-gap note has been very valuable in helping us calibrate what is, and is not, acceptable in this regard. As ever, we sincerely appreciate the trust you have placed in us to make such decisions.
Again, we hope that by continuing to share our thinking, we will help you better understand the rationale behind our actions during these uncertain times. We also hope that you’ll share our optimism that better times lay ahead.
Please call us if you have any questions, or wish to discuss any aspect of your investments or your broader financial plan in more detail.
Your team at Brinton Eaton.
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* Investment horizon is the time over which you expect to actually spend the majority of your investment portfolio. Investment horizon is not, for example, the time left until retirement. Unless you are well into your 80s and/or in failing health, and you do not intend to leave an estate (otherwise, you’re investing, at least in part, for your heirs), your investment horizon is measured in decades.
