3rd Quarter Client Note

It seems like every time I sit down to write a quarterly client note reviewing the investment news of the most recent quarter, there’s a conflagration brewing in the current quarter that overwhelms the discussion. This quarter is no different. Unless you’re living under a rock, it’s impossible to ignore the lingering government shutdown caused by the failure of the Congress and President Obama to reach an agreement on the budget.  Compounding the crisis is the urgent need to raise the debt ceiling.  More on that in a moment.

Despite the continuing turmoil and uncertainty (and even with the market falling on seven of the last eight trading days), worldwide equity markets performed strongly in the 3rd quarter. The S&P 500 Total Return Index gained 5.24%, making for an increase of 19.79% year-to-date.  The Russell 2000 Small Cap Index increased 10.21%. And the MSCI World (ex-USA) Index was up 11.31%. Bonds, which suffered one of their worst quarterly losses in history during the 2nd quarter, steadied a bit; with a small gain of .57% in the Barclays Aggregate Bond Index.

The current political crisis is really just the latest chapter in the saga that largely began during the height of 2008 global financial crisis. Time for a short, and perhaps painful, history lesson.

The Fall of Lehman Brothers – A Five Year Anniversary

The watershed moment of the financial crisis was when Lehman Brothers declared bankruptcy on September 15, 2008, after the government decided not to provide the firm with a direct bailout. The previous day, the Federal Reserve had engineered a takeover of the insolvent Merrill Lynch by Bank of America.  In response, the Dow Jones Industrial Average dropped 504 points (4.4%).

And who will ever forget the September 29 first vote in the US House of Representatives on the Emergency Economic Stabilization Act to provide $700 billion in emergency support for the financial system? The bill was defeated 228 – 205. The Dow continued its precipitous plunge; dropping 777 points that day, its largest single-day point drop ever. With Congress (and the rest of the country) in shock, the bill finally passed both houses on October 3.

Senators (and presidential candidates) Barack Obama and John McCain (having suspended his campaign) both voted for the bill. But conservatives and libertarians in Congress were adamantly opposed to the bailout, citing the role of government in a free market economy and the size of the bill.  The debate was vociferous on the floor of the New York Stock Exchange, led by the infamous Rick Santelli.  (http://www.youtube.com/watch?v=I-1g0OZJIdk)  Four months later, on February 19, 2009, the Tea Party was born, midwifed by Santelli’s notorious rant. (http://www.youtube.com/watch?v=wcvSjKCU_Zo)

Lessons Learned – And Not

The 2008 financial crisis provides ample learning opportunities for both policy makers and investors. For policy makers, the results seem to be mixed. Despite Dodd-Frank, the big banks are getting bigger and a few are probably still too big to fail. And the so-called Volker Rule, designed to prevent banks from making risky bets with their own capital, remains un-implemented.

But for investors the lessons are pretty clear:

  • Maintain sufficient liquidity to fund expenses so that losses are only on paper, not permanent.
  • Have a plan that you believe in, so that emotions don’t drive your decision making.  Don’t panic.
  • Asset allocation and rebalancing, while not a 100% guarantee, works well; even in a crisis. Investors with balanced portfolios fully recovered within about three years.
  • On the fundamentals, we’re still in for a long slow economic recovery. Unlike most recessions, which are the natural byproduct of the business cycle, this was a financial system catastrophe based on too much leverage and too much speculation. Restoring the health of the entire financial system takes much longer than a typical recovery.

Applying the Lessons – Taking it in Stride

We are in day fourteen of the government shutdown. The debt ceiling will be reached sometime between October 17th and the end of the month. While there is some debate as to what happens on the exact day the ceiling is reached – can the President prioritize payments toward debt and away from other obligations? – there is no question but that the longer this goes on, the more likely it is that the market will begin to take matters into its own hands. The last time we got this close – in July of 2011 – Standard & Poor’s downgraded the US credit rating (even after a last minute deal was reached) and the stock market dropped 635 points (-5.55%) on August 8, 2011. It seems unthinkable that the Congress wants to go there again. But you never know…

2008 was a real financial crisis. While we do have to get our fiscal house in order, lurching from one artificial crisis to the next with interim short term agreements is a terrible way to run a government. There must be a compromise and it’s only natural that the party with the stronger hand and political standing should get more of what it wants in the budget negotiations.

In the meantime, take comfort in the lessons of 2008. You can’t “Congress proof” your portfolio. It is impossible to predict just when – or if – the market will go down. And even harder to get back in when the storm has gone out to sea. So stay the course. This, too, shall pass.





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