A Word From The Advisor
We Hear You

Warren Buffett admonished investors to “Buy American. I am.” on Oct 17, 2008. Since then, US equities have retreated an additional 15%, with the S&P 500 down over 48% from its peak in October 2007. Needless to say, it’s been a rough period for shareholders all around the world.

Oakwood clients are justifiably apprehensive, and we spend a great deal of time listening to your concerns. Our goal, as always, is to assess your needs in order to design the most appropriate strategy for your particular situation.

During difficult times, the value of solid financial advice becomes even more important. When times are good, investors are happy, even if their portfolios may in fact be underperforming customary benchmarks. When markets turn, however, the discipline and rigorous analysis provided by the best advisors causes them to stand out from the crowd.

For this quarter’s Word from the Advisor, we thought it would be appropriate to highlight the key questions we’ve been hearing from clients and share with you our thoughts and responses.

Q: Did you see this market debacle coming?

A: We did see it coming, but certainly did not anticipate the magnitude. Over the past few years, as equities have appreciated in value we took steps to position clients appropriately to manage through this period.

For example, we advised clients to shift their allocation away from over exposure to increasingly expensive US equities and toward a more stable balance of equities and fixed income. We also encouraged clients to expand into Oakwood’s structured global DFA portfolios as a way to further diversify their holdings.

In our US equity strategy, we moved towards more defensive positions and higher cash balances. While we are not market timers, when values move outside of long-term trend lines, we become more conservative. In order to maintain a reasonable balance of risk and reward, we use bonds to counter balance equity risk, and we have been moving clients in this direction where appropriate.

Historically, the lack of correlation among major global markets provided diversification benefits to investors. However, this time most markets moved downward together. Unlike the bear market of 2000-02, where global market exposure offered an effective buffer to US equities, there has been little refuge from the storm. As we look ahead, we believe global markets will once again offer attractive diversification opportunities.

Regardless of your investment structure, it is very important to maintain a reasonable time perspective. As we discussed last quarter, it is essential to focus on asset allocation. Remember, that as an Oakwood client, you are guided through a comprehensive wealth management process that assesses your needs, risk tolerance, expectation of return and time horizon. We continue to implement this wealth management process to provide appropriate risk-adjusted returns over the course of market cycles.

Q: When will it be over?

A: It’s impossible to know exactly when an individual market will find its bottom and turn positive, although we may already have begun to see this happen with the US equity market rise in March. After falling nearly 50% since October of 2007, US stocks certainly appear undervalued. However, just as share prices exceeded underlying value on the way up, our study of market history suggests that share prices tend to overshoot on the downside. Alternatively we could have a period of steady prices while earnings catch up.

What is crucial to understand at this juncture is that equity prices are more attractive on a normalized earnings-per-share basis than they have been in the past ten years. This means that investors stand a vastly greater likelihood of strong positive returns over the coming years.

Most economists are predicting a slow recovery beginning in 2010. Typically, equity prices lead an economic turn by six months or so. Economic recovery will depend on the effectiveness of government policy, particularly the impact of the fiscal stimulus package, focus on the financial system and mortgage and housing market issues. It depends even more crucially on the elusive quality of ‘investor confidence’.

We may see new lows and continued volatility. We are consequently caught between the two fears of putting money into the market either too early or too late, i.e. missing the bottom. A practical solution is to shift money into equities slowly and carefully and to rebalance holdings conscientiously. The conservative nature of our firm benefits our handling of this difficult process. We are thoughtful in reinvesting in the market and we hew to the more cautious approach. We are fully prepared for the possibility that the testing of lows and volatility will continue.

Market recovery will eventually come. There is something in the American character that always finds a way to make money. Corporations will take fundamental actions to find profitability and ultimately reward investors. They will do what they must to survive, however objectionable it may be to lay people off in difficult times. In addition, the federal government’s new initiatives could benefit corporations.

Q: What should I be doing? Should I move to cash to avoid further pain?

A: In last quarter’s Word from the Advisor we discussed the need for disciplined asset allocation. This message is equally true today. While we consistently focus on asset allocation tuned to your individual risk tolerance and time horizon, we also recognize that your circumstances can change.

With the market stumbling, and with the possibility of further declines, some clients naturally ask about the safe haven of cash. In doing so, they tend to ignore the crucial fact that, beyond minimal interest income, there is no investment return on cash. Bear in mind that a balanced portfolio (20% stocks / 80% bonds) delivered positive returns in 11 of the past 12 years; with the only down year being a modest decline in 2008.

Cash is an unattractive investment choice over time. Without taking some risk, cash will surely disappoint. For longer term investors, only proper asset allocation will get you to your goal.

Q: If we believe that the economy will continue to go through a rough period, what returns should we expect from the markets?

A: The market has already fallen sharply. This decline in market prices combines two effects: lower current and expected future profits, and higher risk and rewards for expected future profits. The discount rate, in turn, has increased because uncertainty about future profits (in other words, risk) has increased and, apparently, because investors have become more risk averse. This may sound unpromising, but in fact higher discount rates for expected profits translate into higher expected stock returns.

The bubble burst and the economy has slowed. Not only are corporate profits weak, but investors are not willing to pay the same price/earnings multiples as before. As that persists, the markets will remain stagnant. But corporate profits will recover and right now prices are more reasonable than at any time since the 1980s. You have every reason to think you will have good returns in the coming five to ten years.

Q: How long will it take to recoup my losses?

A: The answer may not feel satisfying, but it’s best to think about it in the aggregate. Since 1926, bull markets in the S&P 500 Index have lasted longer than bear markets and have delivered disproportionately greater price gains than the bear market losses.

Moreover, fluctuating performance within each trend illustrates that volatility and uncertainty occur even within established market cycles: that is, bull markets may have short-term dips, and bear markets may have short-term gains. This illustrates the difficulty of accurately predicting and timing market cycles.

It also validates the importance of maintaining a disciplined approach that views market events and trends from a long-term perspective. Investors who react emotionally to short-term movements are at risk of making ill-timed decisions that compromise returns.

Q: Is it different this time?

A: We believe that the forces behind the markets decline are essentially cyclical and not permanent, but that the impact is magnified by several forces converging at once: deflation, highly leveraged institutions and households, illiquid financial assets, and social demands. What’s different now is that in the past, government involvement was traditionally limited to fiscal and monetary policy, but now government is contemplating intervention in our economy on an unprecedented scale. The risk is a misallocation of resources, or government nationalization of assets. Alarmingly, the administration is seeking to take healthy assets and invest them in inefficient entities. What differentiates the current decline from prior recessions, therefore, is the degree to which wealth is being redistributed. Taken to an extreme, this policy could remove the incentive for capitalists to invest. Indeed the need to monitor markets closely, given this difference, makes the most compelling case for professional portfolio management. Our job is to not rely on the most promising scenario, but rather to anticipate the full range of possible outcomes, and to position you most effectively given your specific time horizon and risk tolerance.