“History doesn’t repeat itself, but it does rhyme,” goes the old saying. In that regard, the pattern of the sovereign debt crisis in Europe, its effect on the Euro currency, and the impact on the stock market is a familiar tune from the 1997-98 foreign debt and currency crisis that roiled world markets. While every crisis has its unique elements, I think it’s a valuable lesson to revisit how that crisis played out, and how the stock market responded before, during and after the crisis resolved.

The first jolt to world markets began in 1997, when investors began fleeing the currencies of many developed and emerging Asian markets after a real estate bubble burst (sound familiar?). While foreign stocks suffered big losses, U.S. stocks held up well, and in short order calm returned to the capital markets when the International Monetary Fund (IMF) moved in to prop up currencies from Korea to the Philippines.

Heading into the summer of 1998, the U.S. stock market had enjoyed strong gains for the year. But the Asian currency crisis had caused commodity prices to plummet – taking oil to an unthinkable $8 a barrel – and soon commodity-dependent Russia was teetering on the financial brink. Fear again swept world markets as investors obsessed over whether Russia would devalue its currency and default on its debt. Stocks around the world began to move steadily downward.

Those fears were realized in mid-August, when Russia succumbed to market forces and defaulted on its debt. The country’s stocks, bonds and currency collapsed, and panic swept the world stock markets. The S&P 500 index plunged more than 12% the last week of August 1998, including a staggering 7% drop on August 31.

But that wasn’t all. In mid-September, famed hedge fund Long-Term Capital Management was revealed to have had huge positions in the Russian markets that had gone sour. The fund, which had deep ties to all of Wall Street’s large investment banks, announced losses of nearly $4 billion, all incurred in a month’s time. The Federal Reserve was forced to step in and broker a deal with the Wall Street banks to prop up the fund and keep its losses from spiraling through the financial system.

By October 1998, U.S. stocks had seen their gains for the year evaporate into thin air. The S&P 500 index had fallen 14% since the turmoil in Russia began, and the Russell 2000 index of small stocks dropped almost twice that amount, plunging 25%.
Stocks were finished, many pundits said. The market had seen huge gains going back to 1993, and the run was over. It was time, investors were told, to “move to the sidelines” and “get liquid.”

Then, just as dramatically as the downturn began, it ended. With all the bad news already priced in by the market, an unexpected rebound began in November. Over the last two months of the year stocks recovered all of their lost ground and more, gaining about 30% during the last eight weeks of the year:
 
For the round trip – from the beginning of the crisis in Russia through the end of 1998 – the S&P 500 finished up more than 10%. At the end of it all, the S&P 500 finished 1998 with a 20% gain, but many investors experienced losses for the year because they bailed out during the downturn.

Will the current sovereign debt crisis in Europe play out the same way? While the exact path of this crisis will no doubt have its own unique set of circumstances, the parallels are hard to ignore. When countries get themselves into fiscal trouble, the capital markets react. The ironic thing is that it is the very act of reacting by the markets that eventually forces the changes that need to be made. Sovereign governments and the politicians that run them are all too happy to maintain the status quo and allow the hard, politically unpopular decisions to be kicked down the road to another administration. But ultimately investors force action to be taken, lest they refuse to continue to underwrite that country’s fiscal activities in the equity, debt and currency markets.

It’s what happened in the Far East in 1997 and Russia in 1998. And it’s what is happening in the smaller economies of the Eurozone today. Eventually markets will force the fiscal policies that sovereign governments need to adopt in order to allow for future economic growth. For long-term investors, it’s not an enjoyable process to be a part of, but it is a necessary function of the markets that clears the detritus from the financial system and allows for the kind of economic growth necessary for stocks to thrive.

And once the system is cleared, history shows that a powerful market recovery often follows soon thereafter.

Recently we met with a prospective client in our office who offered an opinion that surprised us.

“I don’t really believe in asset allocation,” he said. “It certainly hasn’t worked for me.”

This particular individual is a savvy investor who sits on a large block of concentrated stock. He understands the inherent risk of being so heavily invested in the fate of a single company, but he didn’t see a lot of benefit to diversifying, either. He viewed both situations as equally risky.

On the surface, this didn’t make sense. How could diversifying one’s assets across dozens of market sectors and thousands of securities be equally as risky as having everything riding on the fate of a single company?

When we pressed this gentleman for more information, however, we quickly understood where he was coming from:

He had been the victim of tactical asset allocation.

Tactical asset allocation is a strategy in which an investment manager diversifies his clients assets across a wide variety of asset classes and investment styles and then – herein lies the problem – shifts the money around periodically according to the advisor’s opinions about where the “opportunities” and “dangers” lie.

Those opinions are invariably based on market trends, economic forecasting, timing systems, or just plain hunches. But whatever the underlying rationale, the result of tactical asset allocation is the same: It introduces a huge risk into the equation – the risk of bad guessing.

That’s what happened to the aforementioned investor. His advisor had diversified his assets and then set about guessing which sectors to “overweight” and which sectors to “underweight.” Unfortunately, he guessed wrong, and it cost his client plenty.

This is not unusual; in fact, it is quite common, especially in times of extreme volatility. Consider this: How many investment professionals correctly called the financial market meltdown of 2008 and moved their clients’ assets into the correct market sectors to avoid that meltdown? Perhaps there are a few, but they certainly are keeping a low profile.

And how many of those same professionals saw, in March 2009, the beginning of one of the greatest market recoveries in the last 100 years and correctly overweighted their clients’ assets in the highest gaining asset classes? Did anyone really have the guts to overweight REIT and emerging markets value stocks in March ’09, with those two asset classes down more than 70% over the prior 12 months? Anyone? Hellllooo…?

Tactical asset allocation is the evil twin to strategic asset allocation – the cornerstone of our investment philosophy at Capital Directions. Strategic asset allocation advocates combining poorly correlated asset classes together in a portfolio to diminish unnecessary risk as much as possible. It is pure common sense – “don’t put all your eggs in one basket” – with a strategic foundation.

An advisor who adheres to strategic asset allocation would never shift around a client’s assets according to past or predicted future market conditions. Instead, changes to the allocation are based on changes in the client’s life situation.

Strategic asset allocation isn’t a panacea. It can’t keep you from experiencing market volatility, although it can certainly diminish unnecessary volatility. But the real benefit of strategic asset allocation is that it removes the risk of bad guessing and keeps the client invested so that he is there when the market makes its sudden and unexpected moves upwards. Like the 70% gain the S&P 500 has logged in the past 12 months.

When an advisor touts the virtues of “asset allocation” or “diversification,” that is really only the opening statement. It is vitally important for investors to then drill down and ask that advisor whether he practices strategic or tactical asset allocation. Or, at the very least, whether he shifts his clients’ assets around based on his beliefs about where the market is heading.

The answer to that question will tell you whether you want to continue your discussions with that advisor – or run screaming in the other direction while you still have your wealth intact.

The stock market in 2009 has put investors through just about every kind of emotion possible: frustration, fear, elation, hope, depression and relief come to mind. I’m sure there are more, but you get the picture. When the market starts the year by diving 30% in a little over two months, as it did through March 9, and then turns around and gains north of 60% the next eight months, there aren’t many emotional stones left unturned.

Now, as the Dow has stalled out in recent weeks north of the psychologically-important-but-fundamentally-irrelevant 10,000 threshold, it seems the dominant emotion amongst investors today is trepidation. A general malaise that the market has come too far, too fast, and we are therefore destined for another steep downturn. The media is teeming with so-called experts who subscribe to this worldview and help keep this feeling of trepidation front-and-center in the investor psyche.

I think all of this handwringing requires deeper analysis, because there are two points to consider that are being glossed over in the discussion:

First is the obvious: Of course the stock market will go back down, because, in the short-term, the market’s behavior resembles more a yo-yo than a straight path upward. The trend line of the market over the past year – a huge dive down and then a huge climb back up – is historically atypical. The more normal behavior for the market is a lot of short-term bouncing around within the longer-term march upward. Given that we have seen gains of between 60% and 80% in most major asset classes the past eight months, no one should be surprised if the market experiences a downturn in the months ahead.

That doesn’t mean, however, that the market is doomed to repeat its swoon from last year. Bear markets (defined as a 20% market decline) are a fact of life in the stock market, but the market panic that began after the collapse of Lehman Brothers in September 2008 is not. Such events are the equivalent of a 100-year flood in the capital markets. They are extreme events of rare frequency.

The second point that bears further analysis is the assumption that the gains we have seen are somehow “invalid,” the short-term result of another bubble that is doomed to burst. But the current psychology of the market is one of doubt and disdain, and bubbles aren’t born on skepticism. Remember back in 1999 when all you had to do to get rich quick was get in on a dot-com IPO? When making a triple-digit gain in a single day was not unusual? When the experts said we were in a “new era” when earnings didn’t matter anymore? That is what a bubble environment is like. Bubbles are born, not just on optimism, but on pie-eyed euphoria and a complete detachment from risk. And that is a long way away from the skepticism and doubt many investors have today about the sustainability of the current bull market.

As we said in our client letter last month, perhaps history will show that the overreaction in all of this was not the recovery of the past eight months, but the end-of-the-world panic that preceded it. If that proves to be the case, then a return to the stock market levels prior to the collapse of Lehman is not only plausible, but actually just makes sense.

Back in July I was reading an article on the Wall Street Journal’s web site that I must admit I found amusing. It was an analysis of the sudden and dramatic rally the stock market had recently experienced, a period in which the Dow Jones Industrial Average gained 10% in only about a week.

The article was amusing because it contained lots of quotes from “experts” who were confounded by the rally. One trader, for example, remained steadfast in his contention that market sentiment on Wall Street was still negative, but said had no choice but to be buying because of all these pesky buy orders he was being flooded with. This is the kind of myopia that sets in when you work on Wall Street and believe it is the sentiment of a handful of traders, as opposed to the intentions of billions of people all over the world, that determines the direction of the market.

The comments from the experts, however, were nothing compared to the handwringing that was going on in the follow-up comments that readers had posted about the article. One woman was calling for a “supercop” regulator who could prevent these “bubbles” from forming in the stock market again. (Presumably she would like a government entity to approve who gets to buy stocks and who gets to sell them.) Another was haranguing all the “idiots” who were buying into the market when the economy is still in such bad shape. There were pages and pages of these comments, and almost all of them were communicating the same plaintive wail:

“The market isn’t supposed to be doing this! It doesn’t make any sense! All the news is bad – it’s supposed to be going down!”

For the past ten months, it’s been easy money to bet against the stock market. All those folks who did so looked like geniuses, and were quick to guffaw at those who were staying put in a market that was stuck in reverse.

Now they are experiencing the other side of the coin, and they are finding it none too fun. They are railing against a market that has taken off just when things seemed the bleakest, claiming it must be a temporary upswing on the way to fresh lows at some point down the road.

They look at the nearly 50% gain the market has logged in only a few months, which they have completely missed out on, and tell themselves the market is “overbought.” But they are unaware of the dramatic gains that occur on the other side of historic bear markets. Like the 47% gain the S&P 500 posted in only eight months coming out of the 1973-74 bear market. Or the 50% gain the market saw in the months coming out of the 2000-02 bear market.

I don’t pretend to know where the market is heading in the short term. But there are a lot of folks who did pretend to know and made their investment decisions accordingly. And right now they are paying a heavy price for their hubris.