I attended a symposium in Austin, Texas recently where the esteemed finance professor, Gene Fama, addressed our group. If you aren’t familiar with Dr. Fama, he is one of the pioneers of Efficient Market research, is often referred to as “the father of modern finance,” and has been a candidate for the Nobel Prize in Economics. So, to borrow the old E.F. Hutton line, “when Dr. Fama speaks, people listen.”

After his presentation, Dr. Fama took some questions from the crowd, and his response to one of them caught my attention. When asked for his perspective about the extreme volatility that has been plaguing the financial markets since August – and, really, since 2008 – he had an interesting response.

“The volatility we have seen is not unusual from a long-term historical perspective,” Dr. Fama said. “But it is unusual compared to the volatility we became used to over the past few decades.”

This may be hard for you to believe, but it’s easy to see looking back at the historical record. While volatility in recent years has spiked, it is consistent with other times of turbulence, notably the 1930s and ‘40s (and in truth, it has been a good deal less volatile than the Depression era). This may not exactly be comforting, but it is at least informing.

“But wait!” you say. “Why do I keep reading about the ‘unprecedented volatility’ we are seeing in the market today?”

The answer is that the media isn’t interested in perspective, it is interested in drama. Financial reporters love to focus on point declines in the market, because it draws people’s attention. And when reporters get to go on air and breathlessly tell us that the Dow experienced, say, its fourth-largest point decline ever, that makes for some captive viewers.

Point declines, however, are very different from percentage declines, and percentage declines are really the only logical way to judge volatility. After all, a one-day drop of 500 points at Dow 12,000 is not nearly of the same significance as it was at Dow 2,200, which happened in October 1987. At Dow 12,000, that decline was about 4%; at Dow 2,200 it was about 23%.

In that regard, consider the following list of the 20 largest one-day percentage declines in the Dow Jones’ modern history:

Notice anything interesting about this chart? That’s right – not one of the declines from recent weeks even made the top 20 largest percentage declines. And even at the height of the panic in 2008, only one day cracked the top 10. So I take exception with the argument that these swings in the market have been unprecedented.

This isn’t to say, however, that the recent swings haven’t been unusual. Referring back to the table, it is interesting to note that fully 50 years passed between the 1937 downturn (at #11) and “Black Monday” 1987, the mother of all one-day percentage declines that is #1 by a large margin.

Looking back at a timeline of one-day percentage swings of 3% or more in the Dow from 1928 – 2008, we can see this trend in which volatility took a long holiday during middle part of the century: So while we can’t say the market volatility we have seen in the past few years has been unprecedented, we really have to go back to the Depression era to find a time that rivaled our current market environment. This is consistent with a central reality: Financial crises lead to extreme volatility in the financial markets, and until the crisis is resolved, the volatility will likely remain. And we are in the midst of the worst financial crisis we have seen since the 1930s.

While politicians trade in rhetoric, markets deal with realities. And the reality the market sees right now is a heavily indebted developed world that can’t meet its obligations. And so, in its own heavy handed way, the market is forcing the issue by essentially voting on the policy moves that European and American governments are making to improve their balance sheets. The market is applying pressure to politicians by giving a Bronx cheer to any efforts it deems ineffective in getting our debt crisis under control, and the same thing is happening overseas in Europe. And this is serving to force our politicians to deal with things they’d just as soon kick down the road to the next crisis.

In the short- to intermediate-term, therefore, stock volatility may well be like the relative who drops by and then just keeps hanging around, wearing out his welcome. In the long run, however, issues and crises have a way of resolving themselves. As the old economic saying goes, “If something can’t continue, it won’t.”

This is where long-term investors need to be extremely careful about the dangers of, as financial writer Nick Murray refers to it, “Volatility Fatigue.” After years of enduring wild swings in the market, it can be easy for investors to throw in the towel and flee the market “until things calm down.” But the stock market is a leading economic indicator, and things turn decisively upward in the market long before crises resolve themselves.

We saw this coming out of the bear market lows in March 2009, and no doubt we’ll see it again as events in the developed world resolve themselves in the years ahead. Alas, just as we saw two years ago, most of the investing public will be on the sidelines when it happens.

One of the most painful things about my line of work is watching the investing public commit one grievous mistake after another and being unable to do anything about it. I can help my clients avoid the emotional, reactionary missteps that are so tempting in times of turmoil, but there is nothing I can do for the masses who seem predestined (hey, I’m a good Presbyterian) to destroy themselves in every conceivable market cycle. No matter what the situation, the majority of investors do the wrong thing every time. It’s like being forced to watch a horror movie in slow motion, over and over and over again…

So, as I look at the recent happenings in the municipal bond market, all I can think is: “Here comes A Nightmare on Main Street, Part 214.”

First, for some context, here is a brief review of the average American investor (we’ll call him “John Q. Public”) and his experience over the past 15 years:

• In the late 1990s, John Q. Public loaded up on technology stocks, especially “dot-com” stocks. When the bubble burst in the spring of 2000, he lost about 80% of his investable assets.

• After the tech bubble burst, Mr. Public took whatever funds he had left and fled to the “safety” of cash investments. And he did indeed feel safe there for awhile, until the market suddenly took off in the spring of 2003, gaining 50% in 12 months while he earned 1% in money-market funds.

• In the mid-2000s, Mr. Public then tiptoed back into the risk pool, but he was still wary of stocks from his frightening experience in the 2000-03 bear market. So he split the difference and went mostly into bonds, just in time for interest rates to go up, which caused his bonds to fall in value. He lost money here, too.

• With the stock market back to record highs by 2007, John Q. Public realized what a fool he had been. The recovery was complete and all was safe with stocks! And, oh, what returns those financial and real estate stocks had delivered! He loaded up on rock-solid banks and financial service companies. Then the subprime financial crisis hit. The Dow fell nearly 60% over the next two years, and many financial stocks went under entirely. By early 2009, Mr. Public was once again completely fed up with “losing money in stocks” and went back to cash, locking in catastrophic losses.

• Right on cue, the market enjoyed its strongest gain in 80 years. From its March 2009 low, the Dow gained 90% in 18 months, but Mr. Public missed it. By late 2009 – fed up with making literally nothing in cash – John Q. Public went, not to those risky old stocks, but back to bonds. Safe, secure bonds. Except the safe, secure bonds weren’t delivering returns much higher than cash. So Mr. Public went searching for “yield”, moving farther out on the yield curve and lower down in credit quality. He invested in the supposed safety of municipal bonds, but opted for the higher-yielding, longer-term variety – never stopping to wonder why those bonds were producing such high yields in a low interest-rate environment.

And that brings us, inevitably, to today’s “muni bond crisis” that has been heavily touted in the headlines. Last fall, famed analyst Meredith Whitney issued a dire forecast for municipal bonds, and small investors panicked en masse. Municipal bond funds were swamped with redemption requests, forcing many of the funds to dump their bonds on the market at discounted prices to raise cash. That created a huge glut of bonds on the open market, and prices dropped accordingly.

Most experts believe that the muni bond market overall remains extremely secure. In a report last month, ratings agency Standard & Poors noted, “We believe the crises that many state and local administrators find themselves in are policy crises, rather than questions of governments' continued ability to exist and function… (The crises) are more about tough decisions than potential defaults." (See: Standard & Poor's, U.S. States and Municipalities Face Crises More of Policy Than Debt.)

S&P went on to say in the report that, for significant defaults to occur, state and local governments would have to face revenue declines roughly double to what they were during the Great Depression – an unlikely scenario to say the least.

Unfortunately, small investors have not grasped this reality and are selling muni bonds without regard to risk or return. That has forced yields higher because new issues coming to market must be competitive with the existing issues being sold at fire-sale prices on the secondary market. And that, in turn, has sent prices lower for all existing muni bonds.

What is lost on most investors is that municipal bonds come in almost as many flavors as Baskin Robbins’ ice cream. Consider this: While there are only about 8,500 publicly traded stocks in the U.S., there are millions of municipal bond issues in a wide variety of structures. There are general obligation bonds, revenue bonds, pre-refunded bonds, insured bonds, taxable muni bonds, escrowed-to-maturity bonds, and many others. The type of bond, the maturity of the bond, and the credit worthiness of the issuing municipality all play heavily into the risk and return characteristics of the bond.

Not surprisingly, therefore, the selloff in the muni market has not impacted all bond prices the same. Muni bonds of high credit quality, and with short- to intermediate-term maturities, have not been much impacted by the so-called crisis. Many of these are general obligation bonds, backed by the taxing authority of the municipality and insured against default. Some even have “pre-refunded” features in which Treasury Bills have been escrowed to ensure that the principal is there to be repaid when due.

The spread in performance between these types of bonds and the lesser quality, longer term bonds that enticed small investors with their higher yields has been eye-popping. For example, while the Pimco High Yield Muni Bond fund declined a whopping 9% from mid-November to mid-January, the DFA Short-Term Muni Bond fund only declined about 1%.

Unfortunately, most individual investors once again succumbed to return chasing and followed their quest for yield out to the edges of the yield curve, ending up in high-yield funds that they have now sold for 10% losses, or, worse individual issues like 30-year munis that have sold for losses of 20% to 30%. It has been a jarring realization for these folks that “safe and secure” bonds can be as volatile as stocks – perhaps even more so – if you are in the wrong bonds at the wrong time.

Alas, all of this pain could have been avoided if the investing public had subscribed to our philosophy about fixed income at Capital Directions: “Bonds are a risk-reducer – not a return-juicer.”

In other words, if you want “return”, let stocks do that for you. If you want “stability”, let short- to intermediate-term, high quality bonds do that for you. And never get those two objectives confused.

If only John Q. Public could get the memo…

The old adage in the journalism business is that "dog bites man" is not news, but "man bites dog" IS news. 

I thought of this recently when fund-research giant Morningstar – originator of the ubiquitous "star rating" system for mutual funds – published a study in which it found that fund expenses were actually a better predictor of future performance than were star ratings. Specifically, the study found a much stronger link between funds that had low expense ratios and high future performance than it did between funds with high star ratings and high future performance. 

To those of us at Capital Directions, this information is of the “dog bites man” variety. We have been trumpeting this point for more than 15 years now, often, it seemed, to deaf ears. What made this a “man bites dog” event is that the information came from Morningstar itself, the very firm that has made much of its living from touting the virtues of its star-rating system. It was as if the Wizard of Oz pulled his own curtain back.

Not surprisingly, the study garnered a huge amount of attention in the press (perhaps more than Morningstar bargained for), and no wonder: The notion that Morningstar would assert that fund fees would trump star ratings in doing fund research was something of a shocker. 

Yet that’s exactly what they said. According to Russel Kinnel of Morningstar, who authored the study, “If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

In an effort to protect the franchise, Morningstar then went on to assert that high-star funds tend to outperform low-star funds, but admitted the link wasn’t nearly as strong as the fee connection. 

The implications for those in the industry who use star ratings to sell past performance to prospective clients are thus clear: As far as predicting future performance goes, you are far better off looking for low-fee funds than high-star funds. The very group that compiles the rankings says so themselves. 

Alas, this presents a problem for all those brokerage firms, banks and insurance companies out there who love to sell the star ratings, because their fund fees are often…let me see if I can find the right word…unconscionable. Many times these providers’ funds have expense ratios well north of 2%, and high turnover ratios that bring total annual fund costs into the 3% to 4% range. 

When you have a fund family that consists of dozens or even hundreds of funds, as most of the large financial services firms do, then it’s easy to back into some high star ratings. If you have enough players in the game, you’re going to hit some home runs just by virtue of having a lot of different at bats. So every few months, these providers cull their top performers and roll out the marketing machine to tout what amazing star ratings these funds du jour have received. 

But if you force these firms to start touting their low expense ratios instead, then…gulp. Not what you would call a lot of fodder for an ad campaign there. Suffice it to say, then, that these firms are hoping the Morningstar study fades quickly from the investing public’s memory. 

Don’t let it fade from yours the next time a broker hands you a list of five-star funds and begins to tout their virtues. Likewise if you are a trustee of a retirement plan and the provider’s “recommended fund list” is heavily weighted toward star ratings. Ask them to show you a list of their lowest fee funds instead and see what their reaction is.

If big beads of sweat appear on their foreheads, then you know you are talking to the wrong people…

“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.