Racine Journal Times, WorkLife Section, August 26, 2007

Goldilocks, where are you?

Goldilocks has officially skipped out of town.  The not-too-hot and not-too-cold, but just-right economy we’ve enjoyed for quite some time was chased out by the Bear family.  Like many financial woes, the current problems stemming from a liquidity crises seemed to come out of nowhere.  But did they?  Warning signs have been flashing for 12 to 18 months, but perpetual optimists got complacent and went on with business as usual.

The turmoil in the bond market is unprecedented.  Billions of dollars worth of exotic financial securities were bought by those who never really understood them, which are now toxic waste.  Furthermore, financial strategies that are kissing cousins to those created by the geniuses at 6-feet-under Long-Term Capital Management, which required a major bailout in 1998, are proving that seemingly minor flaws magnified by leverage and arrogance is not a tasty recipe.

No one, including myself, can accurately predict whether this crisis will end up being a minor flu strain or one resembling the 1918 pandemic.  Either way, it’s not going to end well.  But that doesn’t mean it has to turn out badly for you.  If you have money invested in the financial markets, here are a few things to ponder:

Don’t get too close, and Papa Bear can’t bite.  Most folks want risk when the stock market is rising, especially toward market tops, so it’s only natural if your equities are taking up more space in your portfolio.  If a news report of a 300-500 drop of the DJ Industrials Average makes your stomach do a few somersaults, it’s time to reassess your stock holdings – both quantity and quality.  How would, for example, your stocks and overall portfolio perform if the stock market continues sliding?  How sensitive are your investments to interest rate fluctuations, or the need to refinance current debt or finance future growth?

Fight the urge to chase performance.  When reviewing mutual fund performance, keep in mind that hefty (or lousy) returns represent what’s already happened – not necessarily what’s going to happen.  If economic conditions have deteriorated, is it wise to invest in a fund showing good returns earned in and dependent on a more favorable environment? For example, many funds are, and have been for many years, heavily exposed to financial stocks, which boosted their returns while interest rates were declining and money was loose.  With the winds of change blowing from both directions, you can probably expect returns sported by funds tilted toward financials to take a beating for awhile.

Expect the unexpected.  Many of Hurricane Katrina’s victims suffered a double dose of tragedy because they believed that the levees would protect them.  And if those broke, at least their home-owners (or hazard) insurance would protect them, right?  For too many, both proved to be worthless.  That’s why a false sense of security is so damaging.  Many may be facing a similar situation with their bond investments.  Your bond investments might hold up in the current environment and help temper your stock losses, but they might not. 

On the domestic front, high yield (junk) bonds are most at risk.  Even bank loan funds, some short-term bond funds and commercial paper – typically low-risk investments – are suffering.  To make matters worse, bond-ratings firms such as Standard & Poor’s and Moody’s were slow to recognize the extent of the risk bondholders faced, and are now catching up with increased downgrades.  As such, bond managers required to meet certain mandates such as holding only high-quality corporate bonds may be forced to sell any downgraded bonds.  Such a scenario would only exacerbate an already weak situation, which will take more than a few days to correct.

Trust, but verify.  While our financial system is quite sound and the Federal Reserve can be expected to do its job as lender of last resort, be wary of any commentary that seems a little too rosy.  Less than three months ago, Chairman of the Federal Reserve, Ben Bernanke, said that the risks of the sub-prime mortgage mess were largely contained.  As of this writing, the Fed has injected more than $38 billion into the banking system, and other global central banks are doing the same – a sign of financial stress all around the world.  Furthermore, 117 major U.S. lenders have either filed for bankruptcy or temporarily ceased operations, with 14 more teetering on the same cliff.  All the while, market pundits addicted to the Greenspan Put are pounding the table for the Fed to rescue the day.  Again.

Jim Rogers said it best:  “People should be more concerned with the return of their principal than the return on their principal.”  It’s easy to forget such sage advice when markets keep reaching for the moon, and risk control is so old school.  It’s important to understand that a large component of healthy long-term investment returns is avoiding significant losses.  With that understanding, you’ll be better prepared to invest prudently in any economic environment.

What does that mean?  It means being proactive rather than reactive.  It means being calm rather than panicked.  It means having faith in our markets, but not blind faith.  It means patience.  It means being confident, but not arrogant.  It means having clarity rather than confusion.  It means seeking truth.  These are some of the characteristics that investors would be wise to consider, for with them, you can eat your porridge and sleep sound in a bed just right for you, with or without Goldilocks or the Bears.

Michelle Ouzounian, CMFC, is the founder and President of Verity Investment Counsel, Inc. (www.verityinvcounsel.com), a fee-only, independent registered investment advisory firm in Racine. Michelle can be reached at 262-898-8400, or m.ouzounian@verityinvcounsel.com.

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This article contains the opinions of the author, but not necessarily those of Verity Investment Counsel, Inc.  Such opinions are subject to change without notice.  This article is provided for educational purposes only.  The information contained herein does not suggest or imply and should not be construed, in any manner, a guarantee of future performance and/or investment advice.  Information contained in this article was obtained from sources believed to be reliable, but not guaranteed.  No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Verity Investment Counsel, Inc.