3rd Quarter 2008

Market Health Outlook

Dear Friends and Clients:

This quarter’s letter will be a bit longer than normal, but I wanted to let you know my current thoughts. We are in very unusual times and I desire to help each person who has questions.

You already know that your statements this quarter are going to look ugly. I’m angry, but I don’t know who to be the most upset with. Homeowners who unwittingly took out more mortgage than they could afford; the bankers who encouraged the loans; investment bankers who sliced and diced the mortgages into financial packages that are too complex to analyze; rating agencies who gave large corporations high ranking; or the Government who fell asleep at the helm.

The political posturing by both parties in our time of crisis has been embarrassing. Americans are angry and don’t want to write a blank check to bailout individuals who overspent or greedy companies. Personally I have mixed feelings; we are in a Catch 22. If we solve the problem in the short term we will have additional national debt to payoff. If we don’t we will have some severe economic problems immediately.

Most of us could not conceive that our financial system was built on such a house of cards. Sure, home prices have declined in many parts of the country, but where is the margin of safety that should be present in all financial decisions? Regardless of who we wish to blame, we are where we are, and each of us will need to decide how to proceed. I will help each of you to do what together, we feel is best for your financial future.

I have my own blame to carry. In 2007, I started getting cautious and encouraged new clients to slowly put their money into the market. The market, however, performed better than I was anticipating and clients felt like they were missing out on potential profits. There are always doom and gloom stories to read, and I guess after awhile you begin to ignore them. I gave into the pressure and by 2008 had convinced myself that everything was going to be okay. The economic indicators appeared reasonable. What I did not realize is that some very dangerous information was being held back. In reality, we were being lied to. All of these large corporations did not suddenly go bad in one month.

Prophecy Fulfilled:

Let me introduce you to Larry Burkett, who in 1990 wrote a book called “The Coming Economic Earthquake”. The book warned of the impending danger of America’s flamboyant use of debt.

He projected a collapse by the end of the century. His timing might have been a little off, but his warnings now appear prophetic. Fortunately, his message ends in a positive message for those who heed his warning, and America eventually regains her glory after a painful adjustment.
The message of Burkett’s book had a profound influence on my life. I dedicated myself to being personally debt free, and helping my clients get debt free. My story can be found in Chapter 7 of the book I wrote last summer, “18 Common Sense Rules for Enjoying a Successful Retirement”. Most of you know that I have been encouraging my clients to become debt free for years. When my debt is zero, I’m not forced into poor decisions in times of stress. My stance has brought me some ridicule from a few bankers and other advisors, some of whom were advising their clients to borrow the maximum on their home and invest it. Fancy terms like “Equity Harvesting” filled the pages of books like “Second Chance Millionaire” and “Stop Sitting on Your Assets”.

The portfolios I manage are diversified. We don’t have any stocks and only a tiny amount of bonds in bankrupt companies. We have been dinged up a little, but not wiped out. T. Boone Pickens reported to have lost over a billion dollars, and one hedge fund I was reading about invested several billion into Washington Mutual Bank just months before losing it all. Ouch, I should feel fortunate.

I’m still in the process of evaluating who the winners and losers are in our portfolios during this difficult period. Some of the winners are Berkshire Hathaway (even though it has been volatile) and my favorite bond management company Pimco (average return of 8% over the past 10 years). Janus Mid Cap Value and Vanguard Wellington have also been strong, but still down some. On the losing side is my long-time favorite fund, Dodge & Cox as they had too much exposure to the financial sector. Dodge & Cox was simply heroic during the 9-1-1 crisis, and I will give them some time. They are smart managers. Janus Growth & Income has been weak.

Where do we go from here?

Warren Buffet says that in 3 to 5 years, we will look back and realize there were great bargains today. Jim Cramer says, “This market is the most difficult I have ever witnessed. It brings to mind the 1987 crash and makes me remember the incredible gains I was able to realize on the heels of it.”

If you can even be partially optimistic, then the fastest way to recover your money is to stay the course.

After 9-1-1, I was optimistic and encouraged most clients to hold on. This strategy worked. In a few years their money was recovered. Those who sold early are slowly clawing back in fixed income. I never criticize people who sell because the pressure is too great. We all have to do what we feel is best in difficult times. The fact of the matter is, no one can accurately predict where we are going from here.

Things certainly could get better, but we will probably work through a recession first. Stock markets don’t always do poorly in recessions and typically start building in the second half of the recession. Once the market can see the light it will begin to climb out. It’s possible that we are already well into a recession right now. The typical recession lasts 18 months.

Former General Electric Chairman Jack Welch says the US economy faces a deep down-turn in the coming quarters. He did not say “years”, so I assume he feels there is hope at the end of a set time.

If you are pessimistic, safety of cash and bonds should be your first priority. You will sleep better if things do get worse. The difficulty is that nobody rings a bell when the worst is over to tell you to get back into the market. You miss a lot of profit when the market does get better because it moves quickly. The other danger of taking the safe path is that the earnings on the portfolio could fail to provide the income you need.

I don’t know whether I should be optimistic or pessimistic. We simply don’t have enough facts yet, and the American spirit seems to prevail through the toughest of times. Right now I’m leaning toward the negative. I don’t see a quick snap back this time (which is called a “V” recovery). We might experience a “U” recovery or even an “L” with a slow improvement over time. Our country has some serious adjustments to make to get back to a sound financial base. Unless you are of the highest risk tolerance, you should have me reduce the risk of your portfolio some.

Should you adjust your risk?

My view is that risk has increased overnight and reducing the risk of your portfolio one notch makes perfect sense. If you were 80% stocks and 20% bonds, it might be wise to move to 60% stocks and 40% bonds. This still leaves some room for growth if things get better.

If we move into a recession, we will experience lower economic growth and low rates of interest. Typically in recessions, investments in real estate and commodities can do well, but a lot of national real estate is still overpriced. Commodities are just coming off a bubble and will probably continue to be volatile.

Local real estate agents tell me houses are selling well because of low interest rates; maybe this same effect will happen nationally. Local real estate can be profitable if that is a skill of yours. It is not one of mine. You would also think that gold would do well, but gold has been very volatile lately. Over the long term, gold seems intuitively appealing but has proven to be high risk and low return. I have never used gold in my portfolios but am currently challenging all my thoughts.

As of this writing, we have possibly added 700 billion to our national debt. This is on top of a system that is already stressed with overspending and facing huge expenditures for the entitlement programs of Social Security, Medicare and Medicaid. Not a pretty picture. But like Mr. Burkett’s analysis, it’s difficult to know when to adjust a portfolio to stay out of trouble. Often a lot of opportunity is lost trying to time the market, and emotions mess up the analysis.

Rules to live by during tough markets:

I thought about the last market turmoil in 2002, revisited some rules I created back then, and added a few more thoughts.

1. During periods of high stress, try to think clearly and don’t overreact. Things typically normalize. Get advice, take a deep breath and set a new course if necessary. You hire me to do the worrying, and I have been putting in overtime lately. My nights have been more than a little restless.

2. Diversity matters more than ever.

3. Where can other problems exist? We did not hear from the large banks and bank investment companies until it was too late. This has lowered my trust dramatically. Insurance or Pension failures would also send shock waves through our economy. I’m not predicting this will happen anytime soon, but I do have concerns. We all need to keep our eyes open for signs of trouble in these two areas.

a. Do we really know what the risk is in insurance companies? Annuities might say they have guarantees, but they are not covered by FDIC insurance. The guarantee is only as good as the company itself. The other insurance companies doing business in the state are required to insure each other. As we saw with the banks, a domino effect can occur. I hope that investors who have bought annuities with guarantees have diversified over multiple companies. These guarantees are sometimes higher than current bond yields so you have to wonder if the yields can be sustained over the contract period. My question is this; what are the insurance companies investing in themselves to back up their guarantees? They have to go out into the market and invest like the rest of us.

b. Another potential future pitfall is in pension plans. Simply put, promising fixed payments into the future for a group of retirees could put the plan at risk unless the underlying investments backing up those payments, is sound.

4. Watch your spending and reduce your portfolio payments if you can. If your withdrawals exceed 5% of your portfolio value, your long term nest egg could be in jeopardy. If you choose to lower the risk of your portfolio by including a substantial amount of bonds, 4% would be a better guideline.

5. I personally believe that the US dollar has seen its glory days as the world leader. Socialistic Europe will not be assuming the leadership. We are in long-term decline in prominence with the Asian countries growing in importance. This is not a sudden shift, but rather a gradual process. And it doesn’t mean America is going to be a third world country. The standard of living in the US has far exceeded the rest of the world, and we can expect other Asian countries to move up while the US flat lines. Typically I have limited our international exposure to 20% of the portfolio. We have to be careful about a worldwide recession, but I believe we should begin increasing this percentage to 40%, with emphasis on Asian economies. We should also add these foreign bonds to the portfolio as their rates exceed ours. Once again diversity is critical.

6. Don’t try too hard to fix things. You might be inclined to try and make a quick score to make up ground. It might seem wise to aggressively buy back into stocks (using your bonds) while stocks are low. Typically when I try too hard to fix a portfolio things get worse. We need to keep sight of proper investing rules. If you happen to be out of the market on one of these high volatile days you potentially could lose several percent of the total return for a given year.

7. I am currently thinking about building a new defensive portfolio that will be heavy in bonds (30% to 50%). It will also include foreign bonds and stocks up to 40%. Allocations will be included for health care and infrastructure (utilities, roads, water, hydro-electric plants, industrial and energy companies, etc). This portfolio could also include a small percentage in commodities (gold, oil, agriculture, etc.). This type of portfolio will be defensive and may not do as well as other portfolios in good times. This is a difficult decision to make. If you are interested, we can visit more when I have it put together.

What to do?

Here are a few guidelines depending on your situation:

If you are under age 50 and can tolerate the risk, keep investing every month in your retirement accounts. You want to buy low and sell high. This is the first course of action I plan to take for myself. If the market risk is too much, let’s adjust your portfolio.

If you have too much debt, look for ways to reduce your debt to a manageable level. Have a long term goal of being totally debt free. If the worst case projections come true you may take some dings on your portfolio but you will still have your home.

If you are retired or close to retirement and you don’t need your portfolio to provide a monthly income, consider your risk tolerance given the new cards we have been dealt. Given the new facts it’s perfectly okay to say, “I don’t want as much exposure to risk”. We can reduce the risk of your portfolio. The trade-off is potential return.

If you are retired and you need your portfolio to provide monthly income, the unfortunate news is that you need to keep your portfolio withdrawals to as little as 4% of the value of your portfolio. I can help you determine a prudent amount. Previously, I have suggested a 5% withdrawal rate, but you need to give your portfolio a chance to recover. Some of my clients have higher withdrawal rates that honestly make me cringe. If you simply cannot cut your budget, then you have to do what you have to, but realize withdrawing money plus having the market turn down can be a disastrous combination.

A potential Catch 22 for some folks is that reducing the risk of a portfolio will mean less potential income. Short term CD’s and Short Treasury Bills are currently paying very low rates of return, less than the inflation rate. A lot of money market funds had a lot of money pulled out recently and long-term tax free municipal bonds are paying over 5%. This sounds good, but long term bonds can fluctuate in price so you should only buy them to provide yourself a solid income without regard to their potential value.

Lunch with Ron:

I realize this letter contains a lot of information. Starting by the end of this month I will be hosting a lunch for my clients each week. I’m thinking Tuesdays. We will also have an after work meeting with dessert for those who can’t attend during lunch hour. I want to bring my clients into our office in groups of 6 to 8 to discuss the current events.

As you know, I wrote a book last summer. After hosting some seminars to announce the book, I was fortunate to grow the business. I am stopping any marketing efforts at this point and just want to spend time with my current clients, helping them through these difficult times. If you know someone who is experiencing stress, or has questions, feel free to invite them to one of our meetings.

For the long term, I plan to continue the meetings if there is strong interest. I am also available by phone and private consultation as you need me.

Sincerely,

Ron Dickinson, CFP®, CPA, MPA-Tax.