Market Comment Q3 2011

Originally published on October 7, 2011

Perspective

The market has posted a significantly negative quarter. The summer produced a political spectacle in Washington, D.C.  An extremely divisive debate regarding an increase to the debt ceiling produced a demonstration of the dramatic dysfunction of the US Federal Government in it’s current state. The markets spent the summer in an increasingly volatile pattern. The dramatic swings have been a reflection of the lack of confidence in government and lingering fears from the financial crisis if 2007-2009.

Markets Driven By Politics

The problems posed by growing debt and aging populations are not easily addressed. The process of political negotiation in the US has become increasingly ugly as the endless election cycle seems to suppress any real plan for the dilemma of Social Security, Medicare and Military spending. The market recognizes that there are solutions to these challenges, but the leadership in the executive and legislative branches seems to be mired in extreme ideology instead of actual plans or solutions. The disorder in Europe seems to get progressively worse.  The currency union that makes up the Euro has no effective mechanism for crisis management. The dire fiscal situation in Greece has been dragging on for over a year. While it is obvious that the Greek debt will need to be restructured, there is no process yet put forth that allows for losses to be taken.

Sovereign Defaults and Debt Restructurings

The markets have been overly focused on European debt. Each day has been driven by comments by politicians and financial institutions in Europe. Market volatility has gone up dramatically. The trading has been divorced from economic trends that seem to be emerging that show a gradual recovery in the global economy. There is a pervasive fear that the debts of the peripheral European countries will place negative stress on major banks in Europe and drag the world economy back into crisis. The forecasters of gloom are having a field day predicting grim visions of the future. Peter Schiff, Harry Dent, Nouriel Roubini are all notable media figures that have made predictions that have turned out to be correct in the past. The problem with predicting the future is that it is likely to be impossible to do consistently. History is the guide by which I try to keep a consistent philosophy as an advisor. An investor who attempts to follow sage forecasters of the future is likely to be whipsawed by short-term swings in the market that are very difficult to manage and trade through. The history of sovereign defaults (countries that default on their debts) is quite illuminating. An interesting pattern here is that it has happened throughout financial history. Here is a selected list of past government bond defaults in the modern era.  

Country      Year of Default

Poland       1981 Romania    1981 Serbia        1983 Turkey       1978 Argentina   1982, 2001 Brazil                   1983 Chile          1983 Ecuador     1999 Paraguay  2003   Source:

Debt Defaults and Lessons from a Decade of Crises

, Federico Sturzenegger and Jeromin Zettelmeyer examine the facts, the economic theory, and the policy implications of sovereign debt crises.   It is a very important perspective that we need as investors to see that small and mid-level players in the world economy have defaulted before. The bond holders take write-offs and losses, but the world does not end. The inflexibility of the Euro has caused the Greek default to happen in slow motion. This creates uncertainty throughout the European economic and banking system and rattles the entire world economy.  The fears of disorderly default are very stressful for investors in the short term. The ultimate resolution and losses created by Greek default is unlikely to create long-term changes to the prospects of growth in the in Europe and the US.

Patience and discipline

Now is the time to remember that is easy to invest, but very tough to succeed. When we look at a year that has a negative result of 8-10% it is very tempting to make changes. Clients often ask me to “please move to safety now, and we can get more aggressive when things look better”. Sounds nice, but very difficult and most likely impossible to execute in reality. There is always going to be challenge and fear facing us as investors. It is this very perpetual uncertainty that causes the results of the average investor to be so poor. Using the Dalbar Study  data   http://finance.fortune.cnn.com/2011/05/26/retirement-guide-2011-take-control-and-win/   mentioned in my last letter, the costs of being average are quite severe.

Let’s take an example of $10,000 from 1991 to the end of 2010:

S&P 500 Result           $57,081 Average Investor Result       $21,083   If it was easy to succeed, the average investor would not be in such terrible shape.   Stay calm. Stock prices are becoming more attractive as they decline. That is what drives buying to come back into the markets. This too shall pass.