By Joe Smalley, Accredited Investment Fiduciary® 

Over the past few years, the phrase “it’s different this time” has probably been overused.  Usually the phrase was referring to the tech bull market, or the Baby Boomer demographic bull market, or the housing bull market.  And often, it was a way to justify making sector bets, overweighting an investment class, or picking winners.  I have always shied away from it, thinking that it is very difficult for us to know in real time whether or not this time is different than previous epochs.  Being a proponent of Harry Markowitz, I’ve instead thought that asset allocation, diversification, and investing for the long term have been better than trying to time the market.

And while that is all still true, 2008 came along and hit all of us very hard.  The entire financial system was on the brink of imploding.  Asset allocation did not provide any shelter.  Stocks and bonds both went down in value.  Gold and oil were hit.  Real estate and emerging markets suffered.  The only asset class to come through unscathed was cash. 

Keynesian government intervention became the norm.  The Federal Reserve turned their very large balance sheet into our safety net.  Lo and behold, asset prices rose again.  By the spring of this year, most investment accounts were back to where they were before the debacle that was 2008.  Long term investors were rewarded for not abandoning their diversified portfolios. 

But at the end of June, the Fed ended their Quantitative Easing program.  This coincided with a nasty debate about the country’s debt ceiling.  The pendulum had swung hard, and a vocal minority in Washington demanded that fiscal restraint be not only restored, but that the government must vigorously cut spending.  While likely beneficial in the long run, these cuts in the short term may have serious unintended consequences.  With the divided political power in D.C. likely to continue until the elections in 2012, the largest rating agency downgraded the long term debt of the U.S. for fears that our elected officials will be unable to solve the difficult challenge of fixing our structural deficits any time soon.  Although many Congresses from years past have pushed off addressing the mathematical problem of too many people utilizing Social Security, Medicare, and Medicaid at the same time, this Congress does not have that luxury.  The time to fix this critical issue is now.  Unfortunately, Congress has not been this divided in my life time, which makes this all the more daunting.

And because ours is now a global economy, what happens here impacts countries far across the oceans.  But more importantly, what happens there, also impacts us.  While we are minding our knitting, the European Union is struggling mightily to address the very serious issue of debt and default of a handful of their member countries.  They are able, in large part because of the financial strength of Germany, to bail out several of these countries (Ireland, Greece, Portugal), but as more populous countries continue to need assistance (Italy & France), the political will – and more importantly, the financial ability to backstop these countries will be tested.  It is challenging, to say the least, to have a common currency for multiple countries with different financial systems.  I would not be surprised if the EU splits apart, the Euro is put out to pasture, or if financial systems converge.  Whatever happens in Europe, however, will directly impact not only the U.S. economy, but the world’s economy.  All eyes are on Angela Merkel.

I need not tell you that over the past several weeks the stock market has been volatile.  As I write this, the Dow Jones Industrial Average is experiencing the 13th straight day of 100+ point moves.  The Volatility Index is at a three year high.  Investors both large and small are having a difficult time digesting all of the news, and with the memory of 2008 so fresh in our collective minds, many are just opting to sit this one out.

All of this brings me back to my earlier premise.  Is it different this time?  Well, for me it is.  While I still strongly believe in asset allocation, diversification, and investing for long term goals, I also think that protecting a portfolio is now an important consideration, as well.  Not that it wasn’t before, but with technology as advanced as it is, and with the news cycle constantly reminding us of all of the challenges that we face every ten minutes, it is much easier for investors to hit the sell button, or clear an entire position that they’ve built up over the past decade in a shorter period of time than it takes to read this commentary.  The velocity of the market on the downside is considerably faster than it has been before, so in that sense, yes, it is different this time.  We have seen that in a blink of the eye severe volatility can erode a portfolio.  And the fact that today’s investors have 2008 ingrained in their minds makes this time different.  With S&P downgrading the U.S. debt, it is hard to believe that they won’t downgrade France’s debt, and then when that happens, a whole host of domino downgrades, as well.  For these reasons as well, yes, this time is different. 

You may be getting the impression that I’m less than bullish in the near term.  You would be correct.  So what do we do now?  Simply put, we re-tool. 

We review our goals, our time horizons, and our risk tolerance and we adjust our portfolios accordingly.  We invest in models that are linked to our risk so that positions can be easily and quickly transacted when market movements demand changes.  And we use hedging strategies that reduce our exposure to risk assets and can even profit from declining markets. 

The past few weeks, I’ve been talking with clients, adjusting portfolios and watching what is happening in Washington, Rome, Athens, London, and Berlin, and how all of that impacts trading on Wall Street.  My conclusion is that we must construct our client portfolios so that when the velocity of the market dictates that we make changes, we can do so quickly and across the board. 

Because of what we see in Europe and here at home, we have added gold to our model asset allocations and brought in alternative investments.  We have increased our active bond allocation and modified our equity exposure.  All in all, we have completely revamped our models due to the change in sentiment and the prospects for the short and intermediate term.  As things evolve and hopefully improve, we will update the asset allocation of our models accordingly. 

The Chinese have a saying, “may you live in interesting times.”  I think we can say with certainty that we are indeed living in interesting times.  In fact, in my mind, we are in the midst of a game changer.  This time things are different and in an effort to make sure we keep up, we are making some changes, as well – in how we do business, in how we implement strategies, and in how we manage risk.  Because of these changes, our staff will be touching base to schedule a meeting so we can talk about your situation.  Feel free to contact us, as well.  Prior to coming in, please take a moment to fill out a quick meeting form and send it back to our office.  This will help me as I prepare my recommendations for you. 

While this time may be different, the best thing we can do is to help keep your long term financial goals in sight.  Bull markets and bear markets run in cycles.  Part of the difficulty in investing is to keep focused on the long term, while getting through the short term. 

Thank you for your trust, your business, and your time.  If you have any questions about any of this, please do not hesitate to contact me directly.

Joe

P.S. If you are looking for an interesting read on the history of financial crises, be sure to check out “This Time is Different: Eight Centuries of Financial Folly,” by Carmen Reinhart and Kenneth Rogoff.  In it, they take the opposite theory, that this time things really are not different – but that over the past 800 years all financial crises have occurred because of sovereign debt problems and the subsequent currency issues that arise from them.  When looked at it from that point of view, maybe things aren’t so different after all.

All investments carry risk.  No strategy can guarantee a profit or protect against a loss.  All strategies should be used to help you accomplish your overall long term goals.  Past performance is no guarantee of future results. Not all equities offer a dividend and dividends are not guaranteed. Real estate investments are subject to a high degree of risk because of general economic or local market conditions; changes in supply or demand; competing properties in an area; changes in interest rates; and changes in tax, real estate, environmental, or zoning laws and regulations. REIT units/shares fluctuate in value and may be redeemed for more or less than the original amount invested. The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income. International investing involves risks not inherent with domestic investments, such as currency fluctuations, differences in accounting methods; foreign taxation; economic, political or financial instability; lack of timely or reliable information; or unfavorable political or legal developments. Investing in alternative investments may not be suitable for all investors and involves special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, and potential illiquidity.  Investors must meet specific suitability standards and understand these investments are for a long-term investment horizon. Investors should note that diversification does not assure against market loss and that there is no guarantee that a diversified portfolio will outperform a non-diversified portfolio. 

Joseph D. Smalley is a financial advisor practicing at 2900 West Rd., Suite 222, East Lansing, MI 48823.  He offers securities and advisory services as a registered representative of Commonwealth Financial Network®, a member firm of FINRA/SIPC and a Registered Investment Advisor.  He can be reached at (517)487-4850 or at smalley@smalleyinvestments.com.