Quarter 2, 2012 – An Anniversary

Recently, I had the opportunity to glance at the calendar, and I realized as of March 2012, I am now a 20-year veteran of the financial services industry. Seems like only yesterday when I was known as “New Guy” to the experienced advisors in our office, and spent more time fetching lunch and climbing to the office roof to knock the snow off the satellite dish (long before the Internet) than actually speaking with clients.

Given this milestone, I took the opportunity to look back at the significant market events we’ve experienced throughout my career:

1992 — I entered the business at the height of the Japanese Asset Bubble, where the strong yen had investors in that country purchasing every available U.S. real estate asset that came to market. The collapse has had a decades-long impact on the Japanese economy.

1992 — “Black Wednesday” occurred when the U.K. is forced to withdraw from the Eurozone, as George Soros shorts the pound sterling and crushes the U.K. currency. 1994 — A slight shift in interest rates caused my first 10% correction, taking the Dow from 4,000 to 3,600.
1997 — “Asian Contagion” hit and Asian markets collapsed; Dow trading curbs kicked in at -550 points.
1998 — Russian Currency Crisis occurred, and Russia devalued the ruble and defaulted on its debt.
1998 — Long-Term Capital Management conducted the “test run” for destroying the global banking system using mortgaged-backed derivatives.
2000 — Dot-com bubble burst; NASDAQ fell 50%.
2001 — Terrorism struck on U.S. soil on Sept. 11.
2002 — Accounting scandals destroyed Enron, WorldCom, Arthur Andersen, Adelphia and others; S&P declined 50%.
2007 — Chinese stock bubble deflated; Dow dropped 416 points in one session.
2008 — Global banking crisis hit, causing Bear Stearns, Lehman, and Countrywide to disappear.
2009 — Dubai debt crisis happened; Dow dropped 2.3% at the open.
2010 — European Sovereign Debt Crisis prompted discussion over the Greek economy and future of the Eurozone. The U.K. sent George Soros a thank-you card and nice gift basket.
2010 — “Flash Crash,” a still-unexplained trading anomaly, sent the Dow down more than 1,000 points in just minutes.
2011 — U.S. lost its prized “AAA” credit rating; Dow declined 635 points.

Pretty horrible, right? Here’s the interesting part: At the end of March 1992, the Dow stood at 3,231. At the end of March 2012, that index stood at 13,212, a gain of virtually 10,000 points and an annualized return of approximately 7.3%, before any consideration for dividends.

To me, the lesson here is investing in the markets work … over time. The key is you need a comprehensive investment strategy that provides the liquidity, cash flow, and security you need, so the component of your portfolio allocated to stocks (capital appreciation assets) is given the time it needs to work to your benefit. You need to be able to “stay in your seats” through the trials and tribulations of the marketplace to extract the benefit of your investments.

Recent events offered me another very valuable lesson about the importance of time when determining investment strategies. I was honored to attend the national DECA “Stock Market Game” competition in Salt Lake City, UT, and serve as a judge for the finalists in the game. This competition brings together more than 14,000 of North America’s best and brightest high school students, along with 1,000-plus teachers and almost 2,000 judges. Competitors present written projects they’ve completed over the past year in a wide variety of business and marketing facets. In judging the stock market competition, I was afforded several insights into the investor’s view of the marketplace.

First, I discovered I am apparently really, really old, and somewhat slow on the uptake about what is going on in the economy. For instance, we repeatedly heard about the importance of building a portfolio of the best blue-chip companies, like Google, Apple, and Amazon. We also heard about some “lesser known” companies like Dell, Hewlett-Packard and 3M. In fact, we saw a presentation, lasting several minutes, on 3M and all the different, wonderful products it makes.

As I watched the presentations I realized the shift in market dominance that has taken place in the area of technology. I recognized how the companies we once thought of as earnings leaders have certainly moved out of the limelight, not only in share price but also in terms of total market capitalization. These three companies (Google, Apple, and Amazon) have combined market capitalization of approximately $900 billion, whereas the Dow 30 stocks combined make up a little more than $1.3 trillion — a difference of only $400 billion. Whether or not you believe these companies deserve their existing market capitalizations, it is clear they have attracted significant investor attention, and their movements and business operations deserve to be continually monitored.

Second, I found I have a very different opinion of what “long term” means, compared to most 17- and 18-year-olds. To them, two years was about as far back as anyone looked when evaluating a company. When asked about significant market events such as the dot-com bubble/bust, none had even heard of that. (Given that most of the competitors were between 6 and 8 years old at the time, I guess that shouldn’t be surprising.) However, the competitors’ lack of knowledge gave me a little comfort, in that I realized what investors actually are paying us for is the miles we’ve walked, the experience we’ve gained, and the lessons we’ve learned from that journey.

At Cascade, we believe the time has come to start thinking about portfolio construction differently, to allow you to confidently remain in the markets when current events might challenge the belief in those markets. Traditionally, investment advisors have used “asset allocation” as a method of diversification to stabilize returns in volatile times. We have all seen the pie charts representing “slices” of stocks, bonds, international investments, large-cap, small-cap, value, growth etc., etc., etc. While asset allocation makes some sense, it does little to reassure investors when markets move down in lockstep, as many markets did in 2008.

Further, asset allocation has traditionally relied heavily on bonds as the harbinger of safety and income, yet after a 30-year bull market in bonds, it looks as though that may no longer be the case. Indeed, Warren Buffett, in his 2012 letter to Berkshire investors, commented: “Bonds, formerly thought to provide risk-free return, are now in a position to provide return-free risk.”

Given these factors, our experience tells us the way to achieve success in the investment market is just as dependent on “strategy allocation” as it is on “asset allocation,” and a solid plan of investment must be based on a solid foundation of strategy. To us, this means making sure your “Operating Portfolio,” or the money you need to live on — the money that pays the bills, provides liquidity, and funds your “rainy day” account — should be thought of and managed differently from funds dedicated to capital appreciation. In an effort to “let the markets work over time,” it is important that the timeline for those assets be clearly defined, your liquidity and income needs clearly determined, and your investment strategy built to support those objectives. Take a peek at the chart below:

Source: AthenaInvest, Thomson Reuters Financial, Center for Research In Securities Prices, St Louis Federal Reserve FRED data base.

Source: AthenaInvest, Thomson Reuters Financial, Center for Research In Securities Prices, St Louis Federal Reserve FRED data base.

This chart, which depicts the volatility of the S&P 500 Index over various holding periods, clearly shows us why this is important. Using the S&P index as a proxy (which is a representative index, but cannot be directly invested in), holding periods of just one year have historically provided wide swings in potential returns — ranging from great years of as much as 56.5% annual return to dramatic downsides of as much as -45.2%.

By stretching the hold time to only five years, that volatility is dampened dramatically, with a clear bias to positive returns. At 10 years, that bias becomes more pronounced, and as the chart shows, there have been no 20-year hold periods that have produced a negative return in more than 80 years of market data. That includes all the bad stuff we listed at the beginning of this note. To me, the message is clear: Equity investing remains a solid strategy, but your investment plan must be designed to let you stay the course.

Cascade Newsletter Q2-2012 img2Unfortunately, the 2012 Quantitative Analysis of Investor Behavior study from Dalbar shows us that most investors don’t follow this strategy. Indeed, average investor hold times are well below five years, with the current average hold of an equity fund investor being a little more than three years.

How has this worked out for the average investor? Not too well:

Cascade Newsletter Q2-2012 img3

As it has done for many years, the Dalbar study shows that typical investors significantly underperform the markets they invest in. The data show us that improper strategy, and the time commitment to that strategy, lead to less satisfactory results for these investors.

With the long-term perspective solidly in place, let’s take a quick look at current market conditions. One question we occasionally hear is: “Is it too late to get into the market?” Certainly, with the Dow back in the 13,000 range, it might be tempting to think so.

Source: Standard & Poor’s, First Call, Compustat, FactSet, J.P. Morgan Asset Management.

Source: Standard & Poor’s, First Call, Compustat, FactSet, J.P. Morgan Asset Management.

Look at this chart; it may seem like the best opportunity has passed. But it’s important to remember what we learned back in the chart on page 3, which is that history shows the market has a positive bias over longer hold periods. More importantly, we are just now seeing very encouraging developments in the economy, which may portend positive market influences for some time to come.

Source: BEA, FactSet, J.P. Morgan Asset Management, Census Bureau

Source: BEA, FactSet, J.P. Morgan Asset Management, Census Bureau

Source: BLS, FactSet, J.P. Morgan Asset Management

Source: BLS, FactSet, J.P. Morgan Asset Management

As these charts show, economic activity in automobiles, inventories, capital-goods orders, and, finally, even housing is moving into encouraging ranges. Couple this with slow but fairly steady improvements in the employment picture, and it appears there are actually economic “signs of life” that could lead to a spark of renewed interest in equity markets. Of course, we have Greece’s debt crisis, North Korean nuclear tests, shifting leadership in the major EU countries, and myriad other things to worry about. If you get concerned about any of these, look back at the list of crises from page one, and ask yourself: “If we could get through these, what might we be able to do now?”

Have a fabulous summer.