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Financial crisis or a full-fledged panic?
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The failure of so many large financial institutions in such a short period has been a shock to the overall economy. Whether the U.S. government’s $700 billion rescue plan will be enough to return the credit markets to health remains to be seen. In the meantime, the credit crisis has spilled over into the corporate bond market, the municipal bond market, the commercial paper market and credit markets overseas.
We believe this is a financial crisis, which is a severe disruption in financial markets that can spill over into the overall economy. A financial panic is characterized by intense fear and can become a self-fulfilling prophecy. For example, if too many people believe a bank won’t be able to pay depositors, they’ll all attempt to withdraw their money at once. This in itself will ensure that the bank can’t pay, and it will go bankrupt. Panic can spread as lenders and investors hoard cash and sell anything that carries risk.
The following actions represent an extraordinary effort by the federal government to prevent the financial crisis from turning into a financial panic:
• The $700 billion rescue plan
• Insurance of money market accounts
• Nationalization of Fannie Mae and Freddie Mac
• Efforts to lend money to arrange the mergers of large financial institutions
Whatever it’s called, we believe it’s important to understand the nature of the crisis and have a strategy to survive it. But first, a little history.
Panics Are Rare
True financial panics are nearly unheard of in the modern era. However, they did occur in the U.S. in 1837, 1857, 1873 and 1897. J.P. Morgan met with bankers for eight weeks to resolve the Panic of 1907. This led to a near 50-percent decline in share prices, rattled the gold and municipal 0bond markets and nearly bankrupted New York City.
One of the reasons the Federal Reserve (Fed) was established in 1913 was to provide a means for avoiding future panics. Unfortunately, during the Great Depression, the Fed moved to protect member banks but didn’t help nonmember state institutions. This oversight, along with the lack of FDIC insurance, was the primary reason about 10,000 banks failed during the Great Depression. The Banking Acts of 1933 and 1935 gave the Fed more supervisory powers, in large part to avoid another depression.
Previous Financial Crises
While panics have been largely absent during the past 70 years, crises have been more common.
1980s — Interest rate volatility led to trouble in the savings & loan industry. By 1985, many were all but bankrupt, and a run on S&Ls began in Ohio and Maryland. The U.S. government insured many of the individual deposits and therefore was financially liable when they collapsed. It set up the Resolution Trust Corporation to take over and sell any S&L assets that it could, including repossessed homes. The cost of the bailout eventually totaled about $150 billion.
When the market fell 23 percent in a single day in October 1987, regulators introduced “circuit breakers” to limit computerized trading activity and allow authorities to suspend all trades for short periods. 1990s — The collapse of hedge fund Long-term Capital Management (LTCM) occurred during a financial crisis that began in Asia in 1997, spread to Russia in 1998, and required a Federal Reserve-led rescue plan. Concerns that large banks might fail led the Fed and other major central banks to lower interest rates sharply.
Lessons from the Past
Each crisis has unique characteristics. Some last longer and are more severe than others. The overriding lesson from history is this:
• Investor panic can destroy investor wealth. Without a well-designed strategy, emotions can take over and lead to financial disaster.
• However, a crisis also can provide the opportunity of a lifetime for investors who know what to do. So here we offer a checklist for not just surviving but possibly even benefiting from the current crisis.
• Close your ears, but open your eyes.
• Forget about the “experts” who are feeding the crisis with predictions of doom and gloom. The people telling you what will happen next probably didn’t warn you that this crisis was coming. No one has a crystal ball. Things are bad, but they’ve been bad before, and historically the economy has always bounced back. Ignore the pundits by closing your ears, but keep your eyes wide open. What should you be watching? Prices. As fear spreads, stock prices drop.
• All else being equal, investors who buy at lower prices are more likely to earn higher returns. Investments priced for perfection, as they were in 2000, provided miserable returns. In the past, quality investments that were priced for disaster tended to provide good returns in the future.
Avoid extreme thinking
The world has received invitations to end before but has always turned them down. Are we headed for the next Great Depression?
Anything’s possible, but it’s doubtful. The Great Depression was preceded by a tremendous decline in the stock market, but it was caused by a series of policy blunders.
• The Fed actually raised interest rates in an effort to support the dollar and failed to save nonmember institutions.
• The Revenue Act of 1932 raised taxes in order to balance the budget.
• Protectionists in Congress raised tariffs on imports with the Smoot-Hawley Tariff Act, which invited retaliation from other countries and led to a broad decline in world trade.
• We didn’t have today’s shock absorbers such as FDIC insurance, unemployment benefits and Social Security.
A deep recession is certainly possible, but hopefully our leaders have learned enough from past mistakes to help avoid another Great Depression.
Look forward, not back
Job losses, mortgage foreclosures, bank failures, government bailouts and large investment losses can all be pretty scary. But those things have already happened. Chances are this bad news is already reflected in stock prices. If the news gets worse, stock prices will likely move lower, but the opposite is also true. One thing that probably hasn’t been reflected in current stock prices is an economic recovery, which would likely push the stock market higher.
Remember, investing is not as easy as buying when you feel good and selling when you feel bad. Avoid the tendency to overreact to things that have already taken place.
Don’t fear the bear, embrace it
Listen to this advice from survivalist Peter Kummerfeldt: “When faced with a real bear, keep a cool head. Try to stay calm. Do not yell, scream, kick or fight. Don’t panic. Make no sudden moves.
Stand your ground. Never try to outrun a bear; it will only make matters worse. The injuries that occur are more a function of what the human does to resist than what the bear is capable of doing.”
That’s good advice for investors, too. We also believe bear markets provide an opportunity to buy good investments at a better price.
Of course, we can’t predict future performance, but in 10 years, it’s likely that there will be two types of investors: those who say,
“I’m glad I did,” and those who say, “I wish I had.” Which category you’re in depends on how you handle yourself during this crisis.
Focus on what you can control
Remember, panic is not an effective investment strategy. During a crisis, investors are hit with a seemingly endless stream of bad news.
Your success depends on your ability to stay calm and focus on the things you can control. You can’t control bank failures, the direction of the economy or the actions of our leaders in Washington. The most important things you can control are the quality of the investments you own, the diversification of your portfolio and your own emotions, by maintaining a long-term perspective. Let go of everything else.
Today investors are asking questions such as, “When will it end?”, “How much worse will it get?” and “Who’s next?” The bad news is we don’t have answers to these questions. The good news is we don’t have to answer these questions to know how to invest, because our advice is based on investment principles, not predictions. Predictions change every day. Principles are constant. Before we recommend a long-term investment, we assume there will be short-term setbacks along the way. That’s why when the economy hits a rough patch, our advice, for the most part, doesn’t change.
Review and rebalance
Chances are some of your investments have declined more than others. In order to maintain good balance in your portfolio, review it with your financial advisor and take advantage of opportunities to rebalance by adding money to asset classes that have fallen the most. If you have money to invest, use that first. If you don’t, consider selling some investments in one asset class and reinvesting the proceeds into another type of investment within your retirement accounts to help reduce taxes. Ask your Edward Jones financial adviser if rebalancing makes sense for you.
Upgrade your portfolio’s quality
“Buy and hold” doesn’t mean “buy and ignore.” Things change, and the outlook for even the best companies can suddenly and unexpectedly change for the worse. Crises are often characterized by the sudden collapse of companies once thought to be invincible.
Also, if the economic downturn lasts longer than expected, companies with a weak financial condition or whose business is especially sensitive to the economy may fare worse than investors expect. Therefore, you may want to focus on stocks and bonds that are stronger financially and have higher credit ratings. Also realize aggressive equity investments typically fall more than growth-and-income investments in a market downturn, so make sure they represent a smaller portion of your portfolio.
Review your tolerance for risk
Investment decisions should be based on your goals and risk tolerance rather than what’s happening in the market. When you think about your tolerance for risk, is it the same when the market is rising as when it’s falling? Most people are aggressive after the market has risen and conservative after the market has fallen. But being too aggressive when times are good and too conservative when times are bad can cause you to buy high and sell low.
Instead of jumping into and out of the market, determine what mix of investments you can live with in good times and bad. Then stick to that regardless of the economic outlook. The short-term outlook changes all the time. Your risk tolerance and asset allocation shouldn’t.
Diversify completely
During this latest market decline, one investor said, “I’ll never look at diversification quite the same way again.” That investor understands the need for complete diversification. Owning five stocks and three bonds is not complete diversification. Complete diversification means owning enough stocks and bonds so you won’t be tremendously impacted if one or two companies declare bankruptcy. Diversification doesn’t guarantee a profit or mean you can’t lose money, but we believe it’s the best strategy to help reduce your risk.
Review how you own investments
We used to say asset allocation is the most important decision you can make. We don’t say that anymore. Asset allocation is the second-most important decision. We believe the most important decision is how you own investments. Are you a do-it-yourselfer who feels confident when the market is rising but panicked when it falls? Are you watching television or surfing the Internet and confused by conflicting advice? If so, talk with your financial advisor about the different ways to own investments.
You can invest your money in a variety of ways. To help determine which may be appropriate for you, consider how much time and energy you want to spend. The more involved you want to be in making decisions and reviewing your investments, the more complex your investment approach may be. Can it be appropriate to own stocks and mutual funds? What about a few stocks and funds and a variable annuity? There’s no single answer for everyone. Any number of combinations can be an appropriate strategy.
Be patient
No one can pinpoint a market bottom. Historical studies can show how long the average decline lasts, but not all downturns are average. Some are worse than average, and bear markets can wear down even the most disciplined investor. Don’t let that happen. Remember, history is on your side. Although past performance is not an indication of future results, bear markets have always been followed by bull markets. If history is a guide, the longer this one lasts, the closer you may be to the end. While no one can forecast when a downturn will begin or end, it’s likely that the moment of maximum panic and bad news is right at the bottom. So be patient and, if appropriate, buy quality investments that are available at good prices.
Be courageous, but be smart
Mark Twain once said, “Courage is resistance to fear, mastery of fear — not absence of fear.” While courage is good, a little fear is OK, too. Some investors don’t survive a panic because they get clever, greedy or overly aggressive. Investing too much in one stock or bond, or buying with borrowed money, can lead to disastrous results. In the stock market, there is no such thing as a sure thing. You can be brave, but don’t forget to be careful, too.
Most dangerous phrase in Investing: ‘This time Is different’
How do we know for certain the economy and the financial markets will recover? We don’t. No one can see the future. Our optimism is based on our faith in the future of capitalism and America. Each day, 150 million Americans get up and go to work in spite of our current troubles.
While capitalism is the best economic system we know, it’s not perfect. One of its enduring characteristics is the boom-bust cycle.
Each time there is a boom, many believe it will last forever. The same can be said for the bust. Since you can’t predict the boom or the bust, you must be prepared for both. The best way to prepare is to focus on quality investments, be completely diversified, be patient and don’t lose hope. We’ve experienced crises before, and each time we have eventually recovered. Each time the stock market has moved on to new highs.
Nicholas Murray Butler, author, educator, recipient of the Nobel Peace Prize and advisor to seven presidents, once said, “Optimism is the foundation of courage.” As you watch the events unfold in the weeks and months ahead, our advice is to remember those words and stay the course. In our opinion, we’ll get through the current crisis. We always have.
(Alan Skrainka is the CFA and chief market strategist for Edward Jones)
(Belfanti, AAMS, is available for free consultation at the local Edward Jones office, 106 W. Main St., Bloomsburg. Call toll-free, 1-877-784-9001)
We believe this is a financial crisis, which is a severe disruption in financial markets that can spill over into the overall economy. A financial panic is characterized by intense fear and can become a self-fulfilling prophecy. For example, if too many people believe a bank won’t be able to pay depositors, they’ll all attempt to withdraw their money at once. This in itself will ensure that the bank can’t pay, and it will go bankrupt. Panic can spread as lenders and investors hoard cash and sell anything that carries risk.
The following actions represent an extraordinary effort by the federal government to prevent the financial crisis from turning into a financial panic:
• The $700 billion rescue plan
• Insurance of money market accounts
• Nationalization of Fannie Mae and Freddie Mac
• Efforts to lend money to arrange the mergers of large financial institutions
Whatever it’s called, we believe it’s important to understand the nature of the crisis and have a strategy to survive it. But first, a little history.
Panics Are Rare
True financial panics are nearly unheard of in the modern era. However, they did occur in the U.S. in 1837, 1857, 1873 and 1897. J.P. Morgan met with bankers for eight weeks to resolve the Panic of 1907. This led to a near 50-percent decline in share prices, rattled the gold and municipal 0bond markets and nearly bankrupted New York City.
One of the reasons the Federal Reserve (Fed) was established in 1913 was to provide a means for avoiding future panics. Unfortunately, during the Great Depression, the Fed moved to protect member banks but didn’t help nonmember state institutions. This oversight, along with the lack of FDIC insurance, was the primary reason about 10,000 banks failed during the Great Depression. The Banking Acts of 1933 and 1935 gave the Fed more supervisory powers, in large part to avoid another depression.
Previous Financial Crises
While panics have been largely absent during the past 70 years, crises have been more common.
1980s — Interest rate volatility led to trouble in the savings & loan industry. By 1985, many were all but bankrupt, and a run on S&Ls began in Ohio and Maryland. The U.S. government insured many of the individual deposits and therefore was financially liable when they collapsed. It set up the Resolution Trust Corporation to take over and sell any S&L assets that it could, including repossessed homes. The cost of the bailout eventually totaled about $150 billion.
When the market fell 23 percent in a single day in October 1987, regulators introduced “circuit breakers” to limit computerized trading activity and allow authorities to suspend all trades for short periods. 1990s — The collapse of hedge fund Long-term Capital Management (LTCM) occurred during a financial crisis that began in Asia in 1997, spread to Russia in 1998, and required a Federal Reserve-led rescue plan. Concerns that large banks might fail led the Fed and other major central banks to lower interest rates sharply.
Lessons from the Past
Each crisis has unique characteristics. Some last longer and are more severe than others. The overriding lesson from history is this:
• Investor panic can destroy investor wealth. Without a well-designed strategy, emotions can take over and lead to financial disaster.
• However, a crisis also can provide the opportunity of a lifetime for investors who know what to do. So here we offer a checklist for not just surviving but possibly even benefiting from the current crisis.
• Close your ears, but open your eyes.
• Forget about the “experts” who are feeding the crisis with predictions of doom and gloom. The people telling you what will happen next probably didn’t warn you that this crisis was coming. No one has a crystal ball. Things are bad, but they’ve been bad before, and historically the economy has always bounced back. Ignore the pundits by closing your ears, but keep your eyes wide open. What should you be watching? Prices. As fear spreads, stock prices drop.
• All else being equal, investors who buy at lower prices are more likely to earn higher returns. Investments priced for perfection, as they were in 2000, provided miserable returns. In the past, quality investments that were priced for disaster tended to provide good returns in the future.
Avoid extreme thinking
The world has received invitations to end before but has always turned them down. Are we headed for the next Great Depression?
Anything’s possible, but it’s doubtful. The Great Depression was preceded by a tremendous decline in the stock market, but it was caused by a series of policy blunders.
• The Fed actually raised interest rates in an effort to support the dollar and failed to save nonmember institutions.
• The Revenue Act of 1932 raised taxes in order to balance the budget.
• Protectionists in Congress raised tariffs on imports with the Smoot-Hawley Tariff Act, which invited retaliation from other countries and led to a broad decline in world trade.
• We didn’t have today’s shock absorbers such as FDIC insurance, unemployment benefits and Social Security.
A deep recession is certainly possible, but hopefully our leaders have learned enough from past mistakes to help avoid another Great Depression.
Look forward, not back
Job losses, mortgage foreclosures, bank failures, government bailouts and large investment losses can all be pretty scary. But those things have already happened. Chances are this bad news is already reflected in stock prices. If the news gets worse, stock prices will likely move lower, but the opposite is also true. One thing that probably hasn’t been reflected in current stock prices is an economic recovery, which would likely push the stock market higher.
Remember, investing is not as easy as buying when you feel good and selling when you feel bad. Avoid the tendency to overreact to things that have already taken place.
Don’t fear the bear, embrace it
Listen to this advice from survivalist Peter Kummerfeldt: “When faced with a real bear, keep a cool head. Try to stay calm. Do not yell, scream, kick or fight. Don’t panic. Make no sudden moves.
Stand your ground. Never try to outrun a bear; it will only make matters worse. The injuries that occur are more a function of what the human does to resist than what the bear is capable of doing.”
That’s good advice for investors, too. We also believe bear markets provide an opportunity to buy good investments at a better price.
Of course, we can’t predict future performance, but in 10 years, it’s likely that there will be two types of investors: those who say,
“I’m glad I did,” and those who say, “I wish I had.” Which category you’re in depends on how you handle yourself during this crisis.
Focus on what you can control
Remember, panic is not an effective investment strategy. During a crisis, investors are hit with a seemingly endless stream of bad news.
Your success depends on your ability to stay calm and focus on the things you can control. You can’t control bank failures, the direction of the economy or the actions of our leaders in Washington. The most important things you can control are the quality of the investments you own, the diversification of your portfolio and your own emotions, by maintaining a long-term perspective. Let go of everything else.
Today investors are asking questions such as, “When will it end?”, “How much worse will it get?” and “Who’s next?” The bad news is we don’t have answers to these questions. The good news is we don’t have to answer these questions to know how to invest, because our advice is based on investment principles, not predictions. Predictions change every day. Principles are constant. Before we recommend a long-term investment, we assume there will be short-term setbacks along the way. That’s why when the economy hits a rough patch, our advice, for the most part, doesn’t change.
Review and rebalance
Chances are some of your investments have declined more than others. In order to maintain good balance in your portfolio, review it with your financial advisor and take advantage of opportunities to rebalance by adding money to asset classes that have fallen the most. If you have money to invest, use that first. If you don’t, consider selling some investments in one asset class and reinvesting the proceeds into another type of investment within your retirement accounts to help reduce taxes. Ask your Edward Jones financial adviser if rebalancing makes sense for you.
Upgrade your portfolio’s quality
“Buy and hold” doesn’t mean “buy and ignore.” Things change, and the outlook for even the best companies can suddenly and unexpectedly change for the worse. Crises are often characterized by the sudden collapse of companies once thought to be invincible.
Also, if the economic downturn lasts longer than expected, companies with a weak financial condition or whose business is especially sensitive to the economy may fare worse than investors expect. Therefore, you may want to focus on stocks and bonds that are stronger financially and have higher credit ratings. Also realize aggressive equity investments typically fall more than growth-and-income investments in a market downturn, so make sure they represent a smaller portion of your portfolio.
Review your tolerance for risk
Investment decisions should be based on your goals and risk tolerance rather than what’s happening in the market. When you think about your tolerance for risk, is it the same when the market is rising as when it’s falling? Most people are aggressive after the market has risen and conservative after the market has fallen. But being too aggressive when times are good and too conservative when times are bad can cause you to buy high and sell low.
Instead of jumping into and out of the market, determine what mix of investments you can live with in good times and bad. Then stick to that regardless of the economic outlook. The short-term outlook changes all the time. Your risk tolerance and asset allocation shouldn’t.
Diversify completely
During this latest market decline, one investor said, “I’ll never look at diversification quite the same way again.” That investor understands the need for complete diversification. Owning five stocks and three bonds is not complete diversification. Complete diversification means owning enough stocks and bonds so you won’t be tremendously impacted if one or two companies declare bankruptcy. Diversification doesn’t guarantee a profit or mean you can’t lose money, but we believe it’s the best strategy to help reduce your risk.
Review how you own investments
We used to say asset allocation is the most important decision you can make. We don’t say that anymore. Asset allocation is the second-most important decision. We believe the most important decision is how you own investments. Are you a do-it-yourselfer who feels confident when the market is rising but panicked when it falls? Are you watching television or surfing the Internet and confused by conflicting advice? If so, talk with your financial advisor about the different ways to own investments.
You can invest your money in a variety of ways. To help determine which may be appropriate for you, consider how much time and energy you want to spend. The more involved you want to be in making decisions and reviewing your investments, the more complex your investment approach may be. Can it be appropriate to own stocks and mutual funds? What about a few stocks and funds and a variable annuity? There’s no single answer for everyone. Any number of combinations can be an appropriate strategy.
Be patient
No one can pinpoint a market bottom. Historical studies can show how long the average decline lasts, but not all downturns are average. Some are worse than average, and bear markets can wear down even the most disciplined investor. Don’t let that happen. Remember, history is on your side. Although past performance is not an indication of future results, bear markets have always been followed by bull markets. If history is a guide, the longer this one lasts, the closer you may be to the end. While no one can forecast when a downturn will begin or end, it’s likely that the moment of maximum panic and bad news is right at the bottom. So be patient and, if appropriate, buy quality investments that are available at good prices.
Be courageous, but be smart
Mark Twain once said, “Courage is resistance to fear, mastery of fear — not absence of fear.” While courage is good, a little fear is OK, too. Some investors don’t survive a panic because they get clever, greedy or overly aggressive. Investing too much in one stock or bond, or buying with borrowed money, can lead to disastrous results. In the stock market, there is no such thing as a sure thing. You can be brave, but don’t forget to be careful, too.
Most dangerous phrase in Investing: ‘This time Is different’
How do we know for certain the economy and the financial markets will recover? We don’t. No one can see the future. Our optimism is based on our faith in the future of capitalism and America. Each day, 150 million Americans get up and go to work in spite of our current troubles.
While capitalism is the best economic system we know, it’s not perfect. One of its enduring characteristics is the boom-bust cycle.
Each time there is a boom, many believe it will last forever. The same can be said for the bust. Since you can’t predict the boom or the bust, you must be prepared for both. The best way to prepare is to focus on quality investments, be completely diversified, be patient and don’t lose hope. We’ve experienced crises before, and each time we have eventually recovered. Each time the stock market has moved on to new highs.
Nicholas Murray Butler, author, educator, recipient of the Nobel Peace Prize and advisor to seven presidents, once said, “Optimism is the foundation of courage.” As you watch the events unfold in the weeks and months ahead, our advice is to remember those words and stay the course. In our opinion, we’ll get through the current crisis. We always have.
(Alan Skrainka is the CFA and chief market strategist for Edward Jones)
(Belfanti, AAMS, is available for free consultation at the local Edward Jones office, 106 W. Main St., Bloomsburg. Call toll-free, 1-877-784-9001)
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