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By Carrie L. Coghill, CFP
Based upon the dismal performance of the stock market over the past two years, many investors are looking at their portfolios amazed at how quickly wealth can diminish. Prior to the year 2000, we had become accustomed to double-digit market returns. Some of us, during 1999, even benefited from triple-digit returns. Five years of good stock market returns, along with a “new economy” was all it took for investors to utter the unfortunate words, “this time is different.” When it comes to investing, the words, “this time is different” is usually the kiss of death. It is not realistic to extrapolate five years of investment performance and assume that a new long-term trend has been created. Many investment cycles and trends occur over decades. On the flip side, it is not prudent to extrapolate the past two years of negative performance and assume the stock market no longer makes sense.
Asset allocation is much different than market timing. Asset allocation is a long-term strategy. The proper mix of investment classes are diversified to work together over time. As business cycles change and economic conditions vary, your investments should complement each other in order to achieve long-term positive results. Inherent with most asset allocation strategies is the fact that all of your investments will not move in the same direction and the same time. Hence, there will usually be investments within the strategy that have achieved less than desirable results, in the short-term. Even though investors understand the concept of asset allocation and that it is a long-term strategy, it is emotionally difficult to hold onto investments that have under-performed in the short-term.
The best way to employ a sound asset allocation approach, while keeping your emotions in check, is to review your expectations. Gaining an understanding of how investment sectors have performed historically is the first step. The second step is to take a look at how investments and sectors may be affected by our current economic conditions. This process will prevent you from making emotional mistakes with your money. Realistic expectations will not only provide you with peace of mind but are also the basis for enabling you to achieve your long-term goals. In the late 1990’s, investors expected 20 percent-plus from their portfolios. If savings strategies were created assuming such inflated numbers, then it is now time to re-evaluate these projections using more realistic numbers. Otherwise, those dreams of sending your children to college, or retiring early (or ever), may never come to fruition.
Current Economic Landscape
Our country’s economy officially fell into recession in March, 2001. Economists define a recession as a period during which real Gross National Product (GNP) declines for two or more successive quarters. Due to increased awareness of “investing” throughout the 1990s, this is the first recession that many investors have experienced. The word “recession” has scared these people into thinking the party is over and “investing” no longer works. In order to ease those fears, some facts may help. This is our 11th, post WW-II recession. On average, these recessions have lasted 12.4 months, with an average stock market decline of -28.4 percent (as represented by the Dow Jones Industrial Average). The average 12-month increase following the market’s lowest point has been +22.3 percent. This current recession was fueled by higher interest rates, higher energy prices and a dramatic slowdown in business spending.
The events of September 11th complicated the economic picture. However, this country has once again responded with such resilience to these fears. I recognized this first hand when I took my 12-year-old daughter to New York City over the holidays. The streets were packed with people, the stores were filled, Broadway shows were sold-out and hotels were at full capacity for New Year’s Eve. As a society, we have bounced back. As an economy, Alan Greenspan has done a wonderful job aggressively reducing interest rates and Congress has responded, as well. In addition, we have seen energy prices plummet since last year. Not only does this put additional dollars in the individual investor’s pocket, but corporate earnings will be positively affected by this reduction in energy costs, as well.
The process of getting through a recession involves re-evaluating our economy and re-adjusting our expectations. It appears as though most of the bad news is out and downward re-adjustments have been revealed. It’s important to continue to monitor economic data in order to get a gauge on what type of recovery to expect. This data includes unemployment numbers, consumer confidence and business spending. The best we can hope for is that these numbers are close to the “expected numbers.” Wall Street hates surprises. Even if they are good surprises, it can be a sign that the economy is not being managed properly.
Fixed Income Assets
Fixed income assets are represented by investments that offer a guaranteed source of income. Certificates of deposit, individual bonds (municipal, government, corporate) and fixed annuities all fall into this category. During a recession, we tend to see interest rates decline in order to stimulate spending. We’ve all seen the incentives for zero percent financing throughout the automotive industry. When we look at the impact declining interest rates have on fixed income investments, we need to break them down into two categories: existing investments and new investments.
If you own high quality bonds (government, corporate) going into a recession, you should benefit from interest rates declining. This is because existing bonds become more valuable, as interest rates decline. For example, if you own a bond paying seven percent, and rates go down to five percent, your bond becomes more valuable. If you wanted to sell it, you would get a higher price than the five percent bond. With the Fed cutting interest rates 11 times in 2001, it is no mistake that many high quality bond funds have posted double-digit returns. However, do not let these double-digit returns sway you into thinking you will make more money in the bond market than in the stock market. High quality bonds, especially government bonds, react negatively as interest rates rise. As soon as this economy gains some ground, which we are already hearing rumblings of, the focus of the Fed will be back to managing an expanding economy and raising interest rates. This will be a negative influence on the bond market.
The one aberration from the positive performance of bonds throughout recessions is with high-yield bonds. High-yield bonds, or junk bonds, are bonds that receive a lower than investment grade rating or are not rated at all. The high-yield sector tends to under-perform going into recession and throughout recession. This occurs since a slowing economy puts additional pressure on corporate earnings, which increases the fear that these bonds will default. However, coming out of recession, these fears are alleviated and this sector tends to perform very well. As an example, let’s take a look at the performance of the Federated High-Income Bond fund. During our last recession in 1990, this fund had negative performance of -12.80 percent. In 1991, the fund was up +60.34 percent. Although past performance is no guarantee of future results, this gives you an idea of how this sector has responded to recession.
Although lower interest rates are good for consumers and businesses, it is not good for individuals who have new money to invest into fixed income. With 1-year CD rates at approximately 2.7 percent, you are losing money after taxes and inflation. Although most fixed income investments offer no risk to your principal, the risk of lower interest rates becomes challenging, if you’re living off of the income. One of the best places to look for the most competitive income yields, at this time, is with corporate bonds.
The Stock Market
Based upon historical stock market data, as it relates to recessions, we’ve begun to recover. The question is “what kind of recovery will this be?” Will we have slow growth or, will the recovery be accelerated? The answer to this question is very difficult, if not impossible, to accurately forecast. Therefore, in order to understand how your stock investments are affected by recession; let’s take a look at some various industries:
• Consumer Discretionary. This is a tough section when consumer spending is slow. Tax relief and lower energy prices are temporarily offsetting rising unemployment. The key is to stick with quality and companies that have solid revenue growth.
• Consumer Staples. Without the ability to increase prices, consistent unit growth is essential.
• Energy. The supply/demand imbalance in the energy markets is bullish for domestic natural gas companies. Slowing demand has temporarily put pressure on these stocks, but balance sheets and cash flows are very healthy.
• Finance. Fed rate cuts and a steeping yield curve are positive, but be on the lookout for corporate and consumer credit problems.
• Health Care. With rising cost, Medicare woes and falling margins, stay out of managed care. Look instead to companies with products that will thrive, regardless of government policy. Key word is pipeline. Pick quality companies to avoid volatility.
• Industrials. Very economically sensitive. Focus on companies with strong generic growth or growth via acquisition. Defense spending may surprise on the upside.
• Information Technology. Focus on companies that are involved with building and enhancing the global communications infrastructure. Companies that bring strong productivity improvement to consumer/enterprise are also emphasized. Avoid extremely high P/E’s and areas of over investment. Some areas are extremely oversold.
• Materials. Very difficult sector in a low inflation environment. Focus on revenue growth. Merger & Acquisition activity remains a catalyst.
• Telecom Services. Rapid technological change and the insatiable need for increased bandwidth has made this a dynamic sector. Government regulation and over investment has slowed the process of change. Emerging telecom is extremely oversold and may be explosive, when psychology changes.
• Utilities. Deregulation has invigorated competition, with the spoils going to independent power producers without legacy. Fears of excess capacity are overblown.
Regardless of economic conditions, there are always profitable companies to be uncovered. The key is to focus on market trends and strong fundamentals.
Gaining knowledge about the economy and historical investment performance is an essential element of taking responsibility for your money. If you are managing your own investments, you must have an understanding of this in order to make appropriate decisions and prevent your emotions from taking over. On the other hand, if you work with an investment advisor, this knowledge will help you communicate with that person and provide the peace of mind that you are working with an experienced professional that can be trusted.
Carrie L. Coghill, CFP, is president and co-founder of D.B. Root & Company, a financial planning firm based in Pittsburgh.
