Stop Losing Money

Election Day 2008 and the markets roar. Guest analysts on radio and tv brazenly state that we are surely turning the corner. After all, the economic news was dismal. September Factory Orders dropped sharply, more than three times what analysts had been predicting. Other economic news was just as troubling. But what did the market do? Up over 300 points to 9,625 on the Dow. This proves, some said, that the market has bottomed!

Also rallying sharply were bond prices. Yields on the ten-year notes (TNX) fell nearly 0.25% to 3.765. Rates appeared to be in a free-fall during the afternoon while stock prices surged higher. Rates were not shrugging off the bad news. As my earlier posts have indicated, this kind of market action spells trouble for normal investors who rely on their asset managers to help them reach their goals. While investors are thrilled at times to see their monthly statement show all aspects of their diversified portfolio going up, they should be questioning the value of their money managers who rely strictly on traditional diversification.

One important feature of diversification is that gains in some instruments offset losses in others thus smoothing out returns over time. To achieve diversification, money managers strive to find assets that are not correlated with each other. Normally, stocks and bonds are negatively correlated meaning the when stocks go up, bonds generally go down. When markets are operating normally, the one can expect to get pretty good portfolio returns in up markets as stocks provide growth and dividends. Bonds generally do not perform as well but because they generally pay out interest periodically, the interest return helps temper any losses on the bond funds. And if the interest is reinvested, because the bond prices are lower, one can build up a larger position in this asset class and can reap higher rewards when bonds finally rally.

Prior to recent months, the last down market occurred from 2000 to 2003. Markets were acting normally then in that stock prices and bond prices were negatively correlated. When stocks went down, bonds went up. To validate my idea, I looked at the Vanguard S&P Index Fund (VFINX) and the Vanguard Long Term Bond Fund (VBLTX) as my proxies for stock and bond markets. Any interest and dividends were reinvested for the sake of the study.

A correlation study for these two funds from the beginning of 2000 to the end of 2002 showed a -94 correlation. During that period, the S&P Fund fell nearly 38% but bonds rose 44%. A 50/50 mix of stocks and bonds (not rebalanced over time) showed a net gain of 3.2% during those three dismal years. Those who had such a diversification, while not especially pleased with such a small return, were more than grateful that their portfolios weren't devasted like portfolios of their friends. Here, stock and bond diversification worked!

In 2005, this important negative correlation between stocks and bonds stopped. In fact, it was common for stocks to rally even on bad news. The whole investor mindset was totally distorted. I'll never forgot the big grins on the faces of the stock market commentators as negative economic news resulted in skyrocketing stock prices. 'Home owners can now refinance at lower rates, helping to further stimulate the economy' was the logic. Eventually markets must return to reality. Weak economic news means lower corporate profits, less employment, less spending and an eventual market meltdown.

From the period of 2005 to the end of 2007, stocks and bonds, based on the two Vanguard proxies, had a positive 77 correlation! For this period, stocks returned 27.7%, bonds returned 15.4% and the 50/50 mix returned 19.7%. NICE!! They called it the "Goldilocks Economy." Not too hot, not too cold, just right. Everyone was happy except a handful of renegades who saw through this charade. The high correlation between stocks and bonds continued on and so far this year, the correlation is a positive 92 but now, stocks and bonds are both falling. All of the traditional diversification is totally useless in this environment until stocks and bonds have a negative correlation.

But is this ANY EXCUSE for you losing money??? Why have others made millions, even billions in the recent market action and you, my dear friend, must delay your retirement. I won't go as far as to suggest that your money managers might be incompetent. I am sure that they are seeped in modern portfolio theory and are struggling to maintain their composure. The truth is, they don't have a clue. They don't know why the markets are acting like they are acting, nor do they have any idea on how to make you money. Nope, they stand firm telling you that the market will come back. You have to be patient. After all, the market has always come back, hasn't it? Those who sold during the bottoms of the last market meltdowns can only kick themselves for not being patient. But in the end, the market is a tricky devil my friend. The market knows how to take all of your money.

The dark clouds continue to gather overhead. Our Federal Reserve and Treasury Department know no other way to solve a crisis other than throwing money at it. This is one of the reasons we are where we are today. The causes of the problem were never solved. Only the symptoms were treated with lower interest rates and additional liquidity. For years, the government has tried hard to keep interest rates low to keep their debt servicing payments low. But how long will this be possible? How long can the US be the world's safe haven? At what point will foreign governments stop buying and holding US debt? Hopefully forever but there is anger out there over the recent financial crisis. When demand for government bonds and the US Dollar wane, interest rates will rise. Rise they will. It will snowball. As rates rise, it will cost the government more to service their debt, causing them to incur even more debt. Or, they just print more money (as they have been doing). Somewhere though I read that this could cause inflation. Too many dollars chasing too few products (or investments). Will interest rates rise? (Causing bond prices to fall). Will this high positive correlation continue to exist (stock prices fall along with bonds)? Where can one run for cover? What will your asset manager say then? Stay the course? Things will get better??????? (at Dow 5,000??).

Who can say what market reforms will occur now that Barack Obama will be the new president. With control over the House and Senate, he might be able to act quickly to stop utter financial devastation from occurring. But he's got himself quite a mess to fix. Will we get through the next two months? What new bailouts and giveaways will the Republicans pull off before Obama takes control?

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What can you, a normal investor do to profit, even in times of chaos? Unfortunately, unless you take control over your investments, you are left to traditional money managers who only know the basics: mutual funds, individual stocks, cash. But the investment world is much more dynamic and those who fail to get up to speed with other products and instruments will soon find themselves out of business.

(To be continued)