JFL Consulting Newsletter 01.20.2009

Well, thank goodness 2008 is over! For many of us, that was the worst annual economic decline we’ve ever experienced. There were so many negative events—many of them record-breaking.

It is no surprise, then, to note that the stock market declined sharply for both the quarter and the full calendar year. Let us look at the numbers.

The Dow Jones Industrial Average fell 18.4% for the fourth quarter of 2008 and 33.8% for the year ending December 31, 2008. In fact, four of the 20 biggest daily percentage declines in Dow history happened in the last 4 months of 2008. The Standard and Poor’s 500 Index fell 21.9% in the fourth quarter and lost 38.5% for the full year. 2008 stands as the worst year for stocks since this index lost 38.6% in 1937, and the Great Depression didn’t beat us out by much. The NASDAQ had its worst year ever, falling 40.5% for the year and 24.6% for the fourth quarter.

Unfortunately, this decline was so pervasive there was almost nowhere for investors to hide. Even conservative strategies took a beating. For example, dividend-paying stocks typically hold up better in a down market and often provide stable finances. Unfortunately, many of these dividend-paying stocks are in the beaten-down financial sector, which experienced a significant drop last year. In fact, out of the 16 different asset classes that are tracked by the investment firm of Research Affiliates in Pasadena, every single one was down in September except U.S. Treasuries. That was the first month in 3 decades that 15 out of the 16 categories were down at the same time.

If these index percentages don’t have enough impact, just take a look at the decrease in real dollars in the value of your personal accounts since September 30. Those of you who decided to turn off the TV and throw out the newspapers to make all the negativity go away (at least temporarily) will be in for the same rude awakening as those of us who listened to the stock market’s bad publicity and thought we were prepared.

The hard truth is, many investors might compare the loss in their portfolio over the last 12 months to how much money they made when they were working. It is truly upsetting to see how much a portfolio can decline in value during such a short period of time, and this shock can then create a heightened sense of concern, fear, and insecurity.

The toll has been especially heavy on investors either nearing retirement or currently retired, many of whom are very worried about the possibility of outliving their money during retirement. Without a steady income the losses are more difficult to make up.

Are you worried that the losses reflected on your current statements will continue until the value of your portfolio drops to zero? If you are, I urge you to read on. One of the main reasons for preparing this economic report is to put the year 2008 in perspective through realistic observations, even-handed commentary and reasonable projections. By avoiding the hyperbole and drama often found in the press, I hope I can help reduce your anxiety and encourage you to take a positive attitude towards solving the financial problems we are faced with today.

Global Economies
America does not stand alone. This financial turmoil has affected economies throughout the world. According to Citigroup, many stock valuations have fallen to a level roughly equivalent to the one that prevailed during the 1970s. In fact, global stocks were trading at roughly 10.3% of their earnings for the previous 12 months, even lower than the average of 11.4% through the 1970s.

Are we facing a global economic slowdown? Yes, but I believe we will probably avoid a depression, and I will go into more detail about that in the next section. Now, unlike in the Great Depression, central banks and finance ministries know it’s better to incur deficits and print money than to suffer massive losses of output and jobs. Many countries around the world have implemented stimulus packages recently in order to help jump-start their economies and assist in solving our worldwide problems.

It may seem hard to believe, but the U.S. stock market has actually been among the world’s stronger investment performers for 2008. While the S&P 500 stock Index fell 38.5% during 2008, the damage outside the U.S. has been even worse, with the world index falling 41.9% for 2008, and the rate of returns in the emerging markets have been devastating. Even so, there are good reasons to stay invested overseas. The U.S. represents less than half of the global market capitalization, and many overseas countries (especially Brazil, India and China) continue to grow at a faster rate than the U.S. Over the long-term, adding foreign stocks as an asset class has helped to diversify a portfolio and historically has helped to increase a portfolio’s return potential. The current depressed equity prices offer a chance to buy globally at discounted prices compared to a year ago (see chart below).

Another upside: in many parts of the world, the dividends that stocks pay as a percentage of their current prices usually are higher than the yield on their Government bonds. In Europe, for example, at the end of 2008, the estimated dividend yield on stocks for 2008 was 5.2%, while the European Central Bank’s key interest rate is 3.75%.

In addition, many countries have introduced U.S.–style deposit insurance, which means banks overseas are less vulnerable to runs by depositors than they once were.

Recessions and Depressions
Now that we’ve taken a global perspective, let’s look at the historical perspective.

How often do recessions occur? In the 27 years the United States has 4 recessions. That averages to about 1 every 7 years. While that can be difficult to endure, it is important to keep in mind that economic cycles are necessary to get things back in balance, such as leverage, housing and inflation.

Is this recession different from past recessions? Certainly, all declines come with their own set of causes and conditions, but there is at least one aspect typical to most stock market downturns: the sense of fear that magnifies perceptions of risk and causes stock prices to discount more than fundamentals would dictate. Just take a look at a CNN/Opinion Research Corp. poll taken October 4th-5th. The poll states that 60% of Americans now believe that the U.S. economy is somewhat or very likely to fall into a depression. While our financial system is not as healthy as it needs to be, we are still incredibly far from the economic difficulties seen in the depths of the 1930s.

Please note the chart below that illustrates the various U.S. recessions since 1931. As you can see, even though the value of the S&P 500 fluctuates, its trend is still upward over time.

What exactly is a depression? “Depression” is a term of art. It has no precise definition. It appears that depression is in our minds, not the economy. People fear what they don’t understand or expect, and the specter of depression appears to have shocked America and created widespread pessimism and anxiety. Thanks to rhetorical overkill in the news media, we hear the word over and over: Are we in a depression? Are we headed into a depression?

Let me state this clearly: Most economists do not believe that there will be a repeat of the Great Depression. For all the problems our financial system has incurred, it is in much better shape than during the 1930s, when bank runs and failures were endemic. The crisis of confidence we have today also pales in comparison with that of the 1930s. Today, the Fed, Treasury Department and Congress have all acknowledged existing problems and taken dramatic action aimed at curtailing the pain.

Is our current situation similar to the Great Depression? The Great Depression of the 1930s – the last time the term rightly applied – was industrial capitalism’s worst calamity. Unemployment peaked at 25% in 1933 and averaged 18% for the decade. Economic historians ascribe the depression to a Federal Reserve which, unlike ours today, remained passive, failing to stop bank panics and letting a dramatic drop in the money supply worsen deflation. From 1929 to 1933, 40% of U.S. banks failed. People lost deposits, businesses and consumers lost access to credit. Over the same period, wholesale prices fell by a third, driving farmers and firms into bankruptcy. Farm foreclosures, bed lines and shanty towns followed. This was a social, as well an economic, breakdown.

The economic situation today bears no resemblance to this. In December, unemployment was 7.2% (the average since 1960 has been 5.8%). It’s true, banks and investment banks (Citigroup, Merrill Lynch, Wachovia) have suffered large losses, but on the whole, the banking system seems fairly strong. In fact, the economy itself has weakened but is amazingly functional despite the onslaught of negative news recently—higher oil prices, the housing implosion, and large layoffs in industries like autos, airlines, construction and mortgage banking, just to name a few. The credit squeeze triggered by losses on subprime mortgages also had a major impact and despite all of that, the economy hasn’t collapsed.

Mark-to-Market
Mark-to-Market accounting requires companies to value financial assets at their fair value – the price they can fetch in the market. That has led companies to take big write-downs on traded securities, even if the underlying assets are not severely troubled. For example, desperate sellers lower prices to make a quick sale, thus forcing prices down even though the securities themselves have not changed. The write-downs have put pressure on prices of financial firm stocks and forced many firms to sell assets to raise money in order to stay well above the capital requirements that have been set by regulators.

Many financial institutions want to see this mark-to-market rule changed, claiming that these paper losses are significantly higher than they should be. In fact, the banking lobby has argued that financial institutions have been forced to write off as losses still-valuable assets because the market to sell them had dried up temporarily, creating a spiral of reduction in asset values and exacerbating the crisis of confidence in the financial system.

Despite the arguments above, the Securities and Exchange Commission recommended against changing these rules. However, the FCC did acknowledge that the current financial crisis has shown that finding a market price is not always easy, and it recommended that “additional measures” be implemented to clarify how a company should value these assets in times of crisis.

Lack of Confidence
The U.S. is experiencing a crisis of confidence. The Conference Board’s Consumer Confidence Survey fell to an all-time low of 38 in September, lower than the 38.2 level in 1980 when inflation rose above 14% and unemployment was surging. This is irrational, but understandable when you realize the survey was taken immediately after the President of the United States went on national TV and said people could lose their pensions, jobs and homes.

Stocks have been in a decline for over a year now, and the severity and the scope of the decline may have scared many individual investors away for a long time to come. Small investors are frustrated that even diversification isn’t working—nearly every corner of the stock market is down significantly and much of the bond market is in the red. Unfortunately, that lack of confidence in the worldwide financial system has severely constrained credit and capital flows, resulting in a series of bank failures in the U.S. and Europe, which only served to further erode confidence! And when institutions that are household names fail—Fannie Mae, Freddie Mac, Lehman Brothers, AIG—that also has a dramatic effect on confidence.

Investors gave the U.S. Government 0% financing and the yield on Treasury Bills fell below 0% during December, with investors in effect giving their cash to the Government for safe-keeping for a few weeks. This, too, is an example of lack of confidence in the financial systems, but also shows reliance on the U.S. Government as one of the more conservative places available in which to invest.

The global financial system is grinding its gears because, from big banks to small investors, the essential confidence required to buy, sell or invest seems to have disappeared. Except for cash-and-carry deals, every capitalist transaction requires a certain amount of faith: faith that an asset to be purchased has some genuine value, faith that the party borrowing money will survive to repay it. Right now, that basic element of trust is gone, or at least sharply reduced, and until we get it back, the financial markets will probably remain skittish and economies around the world will suffer.

“What we are scared about is not the bad news. It is rather the news that we haven’t gotten yet. And human imagination is nothing if not limitless in its ability to create disastrous scenarios,” said Andrew Lo, a finance professor at MIT’s Sloan School of Management. “Right now, everyone’s imagination is working overtime.”

Panic in a downturn, much like over-confidence in good times, is a sign of social contagion, says Dr. Robert Leahy, professor of psychology at Weill Cornell Medical College. “People just begin listening to each other, and they feed off the bad news, just as they fed off the overly positive good news about housing prices going up 4 years ago,” Leahy says.

It is not all in our heads, however. There have been plenty of good reasons to worry about the health of Main Street and Wall Street over the last 12 months. Unemployment has risen and retail sales have dropped. Each government effort to plug the market’s holes seems inadequate. Stock rallies (in October the Dow enjoyed 2 or its 6 biggest one-day percentage gains in its 113-year history) repeatedly run out of steam. The banking system and housing market still show little sign of returning to normal.

Stocks usually rebound sharply after a bad fall, but the trick is figuring out when they are done falling. They may have hit bottom in November, when stocks hit multi-year lows and then began an upswing. Others think stocks will drop again and won’t bottom out until later. Whether stocks indeed turn up in 2009, as is widely expected by many economists, depends in large part on how successful policy makers are in stabilizing the economy in credit markets, and getting banks to lend again.

Over the past 10 years, stocks as a broad group are down. The chart to the right illustrates how the U.S. benchmark indexes have remained relatively flat over the past 10 years (although it is necessary to look at rolling periods of time to accurately determine how well a specific index has performed over a longer period). The performance of stocks as a broad group trails that of almost every other asset class, including Government Bonds, gold and even real estate, according to data from Morningstar Inc. So while many investors hear the advice that now is the time to buy stocks, they often have trouble following it. In fact, the avoidance of any element of risk by professionals and amateurs alike helps explain the current demand for U.S. Treasury Bonds

If anything can restore consumer and investor confidence, a look at the historical resilience of the U.S. economy should do it. Difficult as it has been, 2008 is not without precedent. For example during the 1973-1974 recession, the Standard and Poor’s 500 Composite Index declined for 21 months and some investors wondered if the market would ever recover. In the early 1980s, short-term interest rates exceeded 20%, inflation was in the teens, and the stock market lost 27%. In 1987, the market lost 20% in a single day. In the beginning of this century, the technology bubble burst and the S&P 500 lost 49% and the NASDAQ Composite Index lost 78%. Each time, our economy has not only recovered but gone forward into new periods of prosperity. And while past performance is no guarantee of future results, we feel confident that staying the course is the best way to ensure you’re well positioned to participate in the eventual recovery.

Keeping a long-term perspective won’t make it easier to get through this, but it should reassure you that we will get through this! Many Governments around the world have essentially said: “We are going to do whatever it takes to get this economic system running smoothly again.” But investors must be patient since it will take time for stimulus packages to have an impact. After all, just because you have a blueprint for the construction of a building does not mean it is going to be completed in 24 hours!

Interest Rate Changes
The severity of this downturn has been extreme, and market forces have led the U.S. Government to take far-reaching measures during this crisis.

Interest rates fell sharply in 2008. The Federal Funds Rate has been reduced to 1% from 4.25% a year ago, and the Prime rate has declined from 7.25% to 4%. The goal was to provide cheaper credit to every part of the economy, starting with housing; however, only Government bonds rallied in 2008. Even the highest-rated corporate bonds were hurt by credit concerns, and investors in high-yield corporate or municipal bonds or emerging debt have seen losses of more than 20%.

Another major reason to reduce interest rates to such a low level is to influence investors to take a longer-term approach, since the returns on long-term investments are usually higher than the return on short-term investments. Right now, investors seem to be drawn to short-term investments. Demand for U.S. Treasuries increased during 2008 to the point where 90-day T-bills ended the year yielding just 0.07%–essentially nothing. Investors were willing to accept that low rate just to be sure they at least had a return of their principal in the future. However, once the economic stimulus plans start to revitalize the economy, there is a very good probability that many investors will reposition these lower-yielding investments and put the proceeds into long-term investments.

One upside? Mortgage rates have also declined, allowing a flood of refinancing by mortgage-holders.

Inflation and Deflation Concerns
Deflation, or fallen prices, is an insidious process that first attacks asset values and then commodities, migrates to goods, and ultimately hits wages. Let’s take a look at how this played out in our current crisis.

The U.S. housing market peaked in 2006 and then began falling. The stock market began its tumble one year later. As these asset prices sank, many financial institutions found themselves with insufficient collateral. They responded by cutting back on lending. This credit contraction, combined with the effects of sinking home and stock values, caused consumers to pull back. Speculators, sensing the weakening economy, sold economically sensitive commodities, such as oil and copper, driving their prices lower. In fact, the recent drop in the price of oil is one of the most breathtaking commodity-price collapses in history. When gasoline prices tumbled, car dealers, retailers and other companies stepped up their discounting to move goods and sell services. With further reduced consumer spending, businesses started cutting back employment, putting downward pressure on wages, salaries and bonuses, which only served to lower consumer spending even further. If this vicious cycle is not stopped, the real value of debt, such as mortgages, loans and bonds, will go up, increasing the burden on both consumers and businesses. (This scenario played out in its most vicious form from 1929 to 1932, when consumer prices and real gross domestic product dropped by about 25%.)

So, what has the actual effect on our workforce been so far? In December, unemployment climbed to 7.2%, bringing the total number of jobs lost during 2008 to just over 2.5 million—the most since 1945. Many Americans have been out of work for months and are resorting to lower-wage or part-time jobs to make ends meet. The number of workers out of a job for more than 27 weeks (considered long-term unemployment) doubled last year, according to the labor department, and the Obama economic team has begun to worry that parts of his plan could be delayed by this worsening problem.

The good news is that the U.S. Government is taking various steps to prevent this destructive decline, including reducing interest rates, extending guarantees and enhancing deposit insurance, just to name a few. The bad news is that if we get out of this deflation cycle, it’s hard to imagine a scenario where the Fed injects so much paper money into the system ($1 trillion or more) and the end result is anything but hyperinflation, which would drive up the price of everything from gasoline to college tuition and erode the value of fixed-rate investments like bonds.

Emotional Factors
These are challenging and troubling times for investors. The global economy and the world’s stock markets have experienced swift and dramatic changes. Many companies that once stood as pillars of the financial community have collapsed. It’s no wonder that emotions are running high! But we’ve said it before and we’ll say it again—emotions can drive investors to behave in ways that are potentially detrimental to their long-term goals.

If most people followed their emotions, they would end up buying high and selling low! Keep in mind, though, that periods of turmoil in the stock markets have often proved to be the best times to invest. For example, Friday, October 10, 2008, ended one of the worst weeks in Wall Street’s history. In 5 trading days, the Dow Jones Industrial Average had dropped 18.2%, the biggest one-week decline in the Dow’s 112-year history. Panic and fear reigned as the press speculated about the possible collapse of the world’s financial system. However, on Monday, October 13, the first trading day following that Friday, something unexpected happened—the stock market soared! The Dow gained 936 points, its largest point gain ever. The 11.1% advance represented the biggest percentage gain since March 1933 and the 5th biggest ever.

Another emotional factor to be aware of it called “recency bias.” This is when investors overreact because they attach more significance to a recent event than it deserves. It’s important to keep your sense of perspective. This isn’t the first time the world’s financial system has seemed to be in jeopardy. Just take a look at the chart to the left! For more than a century markets have endured wars, recessions, assassinations, bubbles and busts, and they have always come back. Investors who sell stocks in a decline may do real damage to their long-term finances by (1) liquidating their portfolios after a significant drop in value, thus locking in losses, and (2) trying to time a market that has historically shown a tendency to turn rapidly after hitting bottom.

The chart to the left details bear market lows and recoveries beginning on June 1, 1932 (the day the S&P 500 hit its lowest point since the 1929 stock market crash). Just 3 months after reaching a low, the median increase of the S&P 500 has been 18.7%. (Source: Standard and Poor’s 500 Composite Index)

No one knows when the market will go up after this recent downturn, but evidence suggests investors may be best served by ignoring the bad news.

Turmoil in the markets can inspire powerful emotions, and lead to very human, but ultimately destructive, investment decisions. In 2002, Daniel Kahneman received the Nobel Memorial Prize in Economic Sciences for his work with Amos Tversky showing that investment decisions were affected by a variety of issues, including herd mentality, overconfidence, pride and regret. They also found a human tendency to respond much more strongly to losses than to gains—a tendency that drives many investors out of the market during acute declines. Unfortunately, emotion seems to trump reason a majority of the time.

Some people take no comfort in historical performance. Despite the fact that equities have historically rebounded quickly, even from sharp downturns, do you fear the recovery may take longer than the days you have left on earth? Or do you worry that history is irrelevant in this unprecedented global crisis, fearing that stocks may have entered a new phase in which they simply stop performing? What should you do if your gut is telling you to save what’s left and get the heck out of stocks right now?

Before you do anything, read this. I have a number of reasons why you shouldn’t make this major change:

1. You cannot trust your gut right now. Many investors have strange feelings and sometimes it feels like a “knot the size of a golf ball” has started to grow in your stomach. However, this is usually how markets feel before they rebound. A market bottom is usually at the point of maximum pessimism – which is not, by the way, a point at which you usually make good judgments.

2. Ask yourself if your urge to get out of the market is a result of everyone you know getting out of the market. We tend to see safety in the herd, but it’s an illusion. Pay better attention to your own judgment. It’s hard to hang onto stocks when everyone you know is selling, but history suggests that you won’t regret it.

3. Some investments are irrationally cheap, as the chart shows. The prices of many individual securities are hard to explain except as a once-in-a-decade opportunity. When the market plunges, so do price/earnings ratios—even those of many solid, reputable companies that appear to be able to weather this current economic crisis.

4. You cannot argue with arithmetic. If you went into 2008 with a portfolio split of 70/30 between stocks and bonds, your portfolio has probably decreased about 30% during 2008. If you decide to sell now and switch into 10-year treasuries, which are currently yielding about 2.2%, it will take you 14 years for your portfolio to recover back to the value it was at the beginning of 2008. The irony is, at nearly 50% off their peak, stocks are far less risky than they were a year ago, when you bought them without hesitation.

5. Check out the dividend yield on various stocks. The dividends on the S&P 500 stocks are currently paying at 3.4% as of December 31st, up from 1.1% earlier this decade. The dividend rates are significantly higher than the yield on Treasuries at this time and therefore offer a rare opportunity to purchase stocks that have a significantly higher return, but also offer the ability to participate in the potential appreciation of these stocks in the future.

6. Stop obsessing over every bit of stock market news. If you do this, the odds are that you are over-estimating your risk, according to behavioral economist Richard Thaler of the University of Chicago. In fact, he found that the more often you check your stock prices, the greater you perceive your risk to be. The truth is, because stocks do involve risk, stock prices move up and down constantly, so if you watch them closely your brain may exaggerate the actual risk and the market may appear more dangerous than it really is. If this describes you and you’re ready to change your ways, Thaler’s experiment showed that the subjects who perceived the least risk were those who checked their investments no more than once a year! (Remember—if you’re overestimating the risk of being in stocks, you’re probably underestimating the risk of being out of stocks!)

Finally, here is one last thing to keep in mind when you’re feeling skittish:

Stock market declines historically begin prior to the arrival of the recession, although past performance cannot guarantee future results. Our stock market began to decline over a year ago. But the flip side, according to the National Bureau of Economic Research, is that the rebound usually begins while the recession is still underway, and when that happens, you want to be invested so you can fully participate in the potential upside. It’s better to be a little early than a little late getting back into stocks, as in the past, the upward move at the beginning of a bull market has been larger when compared with the vacillations late in the bear market.

Stock Market Recovery
The stock market appears to have started its recovery on November 20th. Isn’t this a bit perplexing? Many investors are baffled at the notion the stock market should be climbing at a time when employment is declining. However, if you look at the pattern in past stock market recoveries, the combination of a bull market and a recession will not seem so strange.

The stock market is not a barometer of the current state of the economy, but a guess about what the economy (and corporate profits) will be 6 to 24 months in the future. When we all know that the economy is deteriorating, that is already reflected in stock prices. The September-to-November crash anticipated the announcement in December that the economy is in a recession. Now stocks are starting to climb in anticipation of an economic recovery that probably won’t begin until the second half of 2009.

Many of the markets that were battered in the second half of 2008 are staging rebounds, sometimes at 10% or more from their low points. For example, the Dow has gained 19.3% from its November low point and the S&P 500 is up 24.2% through Tuesday, January 6th. Though major indexes’ gains from the November lows so far fit the traditional definition of a bull market (up 20%), few investors are interpreting them that way. Many investors say the market’s recent rebound is a short-term bounce in a broader bear market that still remains underway.

Don’t expect any real economic improvement or good news in the labor market for a long time. In history the evidence is overwhelming: stock market bottoms happen, and then stocks jolt upwards while the economy keeps getting worse – sometimes by a lot and for a long time.

Take for example the bear market preceding the roaring 1920s. Global stocks bottomed in June of 1921. The global economies didn’t hit bottom for nearly 2 more years. Or the 1973-74 bear market, when stocks bottomed in October 1974, but the U.S. kept sliding through March 1975.

Despite the current economic crisis, the global economy still retains enormous strengths. Between the early 1980s and 2007 the global economies grew at an unprecedented rate. Never before have so many people advanced so far economically in such short of period of time as they have during the past 25 years. Until the current credit crisis, 70 million a year were joining the middle class.

In addition, the world is currently flush with cash. Unfortunately, it appears to be frozen because of fear, but the cash is there. According to JPMorgan Global Wealth Management, the estimated Central Bank’s reserves of the Global Economy stand at $5.7 trillion, up over 1/3 in just the last year to a level never seen before. This unprecedented hoard of money must eventually go somewhere else and it is hard to see it going into bonds yielding such low interest rates.

Another interesting observation during 2008 was the price of oil. Please see the chart which illustrates that the price of oil per barrel started at lower than $100 on January 1, 2008, then increased to nearly $150 per barrel in July, and then plummeted down to $38.60 as of December 31st. This is a perfect example of how volatile commodities can be and how unusual the year 2008 ended up to be.

With the price of oil down to these levels, this will certainly help the average consumer with their fuel costs. Economists at UBS note that because U.S. households buy about 100 billion gallons of gas per year, a dollar-a-gallon drop in pump prices (which we saw from July to December) frees up some $100 billion for consumer spending, which is the approximate amount generated by the economic stimulus that was provided through tax rebates in 2008.

Impact of President Barack Obama
Since November 5th, many investors have discussed the impact, both positive and negative, that Barack Obama will have on various sectors of the economy on January 20th. For example, Obama’s victory has already boosted some health-care plays, because his insurance proposals should increase the demand for generic drugs and companies that manage drug benefits. Another example is that the securities of coal companies have encountered declines because Obama has hinted he is against increased use of the dirty fuel until there is proven clean-coal technology.

Mr. Obama and democrat leaders announced on Monday, January 5th, that they are working on a 2-year stimulus package which could be as large as $775 billion, including infrastructure investments, and up to $300 billion in income tax cuts.

Mr. Obama appears to have his hands full as he starts outlaying his strategies on how to tackle the nation’s many problems once he is sworn in as President on January 20th. Mr. Obama has his work cut out for him, but we should all hope that he will be able to manage the presidency as brilliantly as he managed his election campaign.

Lessons to Learn From the Economic Downturn of 2008
2008’s volatile market environment provided a number of lessons for shareholders:

1. No investment will continue to rise in value forever. For example, many homeowners were so confident that housing prices would continue to rise that they signed up for adjustable mortgages with low “teaser” interest rates and – in some instances – chose a “no down payment” option. Unfortunately, when home prices fell in 2007 and mortgage rates were reset, teaser rates were no longer available in many circumstances. As a result, homeowners with little equity couldn’t meet their inflated mortgage payments and were often forced to sell their property.

2. Don’t take on more risk than you can handle, and be prepared for the time when assets will decline, which they most likely will at some time in the future.

3. Don’t try to time the market. The problem with timing the market is that you have to make 2 perfect decisions: to get out at the right time and to get back in at the right time. In light of the housing slump, credit crunch and rising commodity prices, the market is likely to remain unsteady, which in turn will make market timing even more difficult.

4. Diversification can usually help smooth volatile periods. Many investors spread their risk by selecting a mix of commodities, real estate, and other investment vehicles with the idea that they were supposed to diversify their portfolio and help cushion the shock when stocks and bonds took a dive. That is the theory, anyway. As the market crashed last year, investors learned a hard lesson: strategies to cushion losses don’t always work. Even diversification is not a fail-safe strategy and proved unsuccessful in 2008, when almost all of the investment alternatives decreased in value.

The question still remains – does a “buy and hold” investment strategy still make sense? The point of sticking to sound fundamental strategies, after all, is to keep you from making big mistakes in moments of crisis. And abandoning the stock market now could turn out to be a very big mistake.

All of us are left with questions and uncertainty. How far will prices drop? How much damage will the unwinding of the housing and credit bubbles ultimately inflict on the economy and capital markets? How long will the pain last this time?

In addition to these legitimate questions, many older clients are asking, “Will I outlive my income during retirement?” You can take some comfort from the fact that most investors do not spend 100% of their net worth during their lifetime. A significant portion is usually inherited by beneficiaries, who will most likely invest this money over a long period of time. Although individual situations vary, older clients should probably stay invested for the long term.

Steps an Investor Should Take at Times Like These
There are a number of strategies to help investors deal with market volatility more confidently:

1. Recheck your risk tolerance level. It may have changed since the last time you checked your comfort level with the Asset Allocations in your portfolios.

2. Ask yourself whether you are up-to-date regarding significant life events that may affect your risk tolerance. Are you more concerned than usual about perserving your capital?

3. Review your personal financial goals. Have they changed due to the current stock market?

4. Consider keeping additional liquid funds. Money that you expect to need within the next 2 years should be invested in short-term liquid vehicles such as bank accounts and Treasury Securities.

Conclusions
Many Americans have been shocked and baffled by the speed and severity of this financial crisis. Investment and commercial banks have received much of the blame. Basically, too many people borrowed too much money and spent or invested well beyond their means. We indulged our desires for faster cars, bigger houses, smaller cell phones. What we are living through today is a painful, protracted, but ultimately healthy rebalancing.

And on a hopeful note, it appears that Americans are starting to save again rather than relying on capital gains and home equity to do their savings for them. The Government says that Americans set aside $260 billion from their disposable incomes in October, up from $70 billion a year earlier. That is a step in the right direction for the long term, even though it intensifies the short-term downward pressure on the economy because consumers are not spending as much.

But the long term is just what we need to focus on right now. If you focus on the short term as an investor, you might be tempted to add to your losses by selling stocks with the thought of moving your money to T-bills and FDIC-insured bank accounts. If Treasuries continue to yield 0.01%, do you know how long it would take to double your money? Seven thousand years! You can’t even count on preserving your capital. After you adjust for inflation, your yield would actually be negative.

One of the biggest questions for investors who have decided to stay in stocks is whether to put more into the stock market now or wait for prices to drop even further. Caution appears to be appropriate as the global recession tightens its grip. However, as mentioned earlier, these bleak earnings outlooks and economic lows have already been factored into many share prices. Stocks are available at a discount right now, but we must emphasize patience. We may be towards the bottom of the market, but there’s no guarantee that we are! Therefore one strategy is to buy back into the stock market over a period of time using dollar-cost averaging. Periodic investment plans do not assure a profit or protect against a loss in declining markets. By doing this, you will reduce your risk of investing a significant amount now only to find out that the market still has a long way to go down.

Right now most people just want to know what is in store for the coming year. Although no one knows for sure, the consensus from a poll of nearly 50 economists was that our economy would continue to shrink minimally in the first quarter and then start sluggishly growing again, thanks primarily to the unprecedented policy stimulus from the Fed, Treasury, and Congress. Unfortunately, this recovery might not feel much like one at first, because fiscal policy efforts will only slowly work their way into the economy and the Fed’s moves will need time to unclog the financial markets. And, of course, these are only estimates, and opinions can change overnight.

So be patient! And be careful of what you read. Remember, journalism is about what happened yesterday. The stock market is always about tomorrow.

And just as each recession or downturn has its own unique characteristics, so does each investor. We understand that you each have your own specific concerns and worries that we may not have been able to address in this letter. That is why we will put together a course of action tailored just for you to help you deal with this economic crisis both emotionally and financially.

Our goal is to keep you informed and to attempt to reduce any unnecessary stress that you may have! We will be seeing you soon and we thank you for the trust and confidence you have placed in us.

Yours Truly,
Jerry Lynch CFP®, CLU ChFC

P.S. “We had a bad ten years, so now we’re going to have another bad ten years? I’m overwhelmed by the emptiness of that idea. The history of the market is precisely the opposite. If you have a bad ten years, you’re likely to have a good next ten years.” Jeremy Siegel

P.P.S. “Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year – from now. What is likely, however, is that the market will move higher…well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.” – Warren Buffett, October 2008

Note: The views stated in this letter are not necessarily the opinion of Comprehensive Asset management & Servicing Inc.. and should not be construed, directly or indirectly, as an offer to buy or sell any securities mentioned herein. Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. With any investment vehicle, past performance is not a guarantee of future results. Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs or expenses. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. Rebalancing a non-retirement account may create taxable events that may increase your tax liability.

Sources: Wall Street Journal (10/10/08, 10/11-12/08, 10/18-19/08, 10/27/08, 11/1/08, 11/8/08, 11/11/08, 11/15/08, 11/24/08, 11/25/08, 11/29-30/08, 12/15/08, 12/18/08, 12/31/08, 1/1/08, 1/6/09, 1/8/09, 1/10/09, 1/11/09), Investor Magazine (November 2008), Barron’s (11/10/08, 12/8/08, 12/29/08), Business Week (9/29/08, 10/6/08, 10/13/08, 11/3/08, 12/15/08, 12/29/08, 1/5/09 1/12/09), Business Week Small Biz (December 2008/January 2009), Bob LeClair’s Finance and Market Newsletter (12/6/08, 12/7/08), American Funds Insights 2009, Dow Theory Forecasts (11/3/08), Investment News (10/13/08, 11/3/08, 11/10/08, 11/17/08, 12/8/08, 1/5/09), Profitable Investing (October 2008, November 2008, December 2008), U.S. News & World Report’s (11/17/08), The Economist (10/18/08, 11/22/08, 12/20/08), AARP Bulletin (December 2008), On Wall Street (December 2008), Journal of Financial Planning (December 2008), Forbes (11/10/08, 12/8/08, 12/22/08), Fortune (10/27/08, 11/10/08, 12/22/08, 1/19/09), American Funds The Flyer (January 2009), Money (September 2008, November 2008), Registered Rep (November 2008), Money Advisor Consumer Reports (December 2008), CNNMoney.com (3/12/08), Worth (December/January 2009,) USA Today (10/31/08), Kiplinger’s Personal Finance (February 2009), Research Magazine (September 2008).