Third Quarter 2009 Letter to Clients

“Sometimes, then – very often the most important times – successful investing requires moving forward on nothing more than principle. When panic grips the market and investors are selling everything from Morgan Stanley to McDonalds to municipal bonds with the same disregard, you can’t know in real time when that mindset will abate. You can only know that such events represent a complete break with the way markets work, and that historically it will not be those who stay in the market that lose their shirt – it will be those who blink.

“It is our mission to make sure our clients are in a well constructed, prudently diversified investment portfolio suitable to their risk and return needs, so that they can stay invested and receive all the long-term benefits that the capital markets have to offer. We know that there will be times, such as the present one, in which that mission may seem out of touch, and we accept that as a necessary part of our refusal to succumb to the herd mentality in times of market turmoil. We strongly believe that our clients will benefit from this resolve over time.”

That was the perspective we were offering in our client letter exactly one year ago. It was in the midst of the worst financial panic the world had seen in a century, a jarring two-week period that saw this country’s financial giants fall like dominos, and saw the Dow Jones Industrial Average plummet from 11,628 to 7,773 (intraday). It was a period of time, as evidenced in the excerpt from our letter above, in which investors who stayed the course had little to reassure themselves but faith. Faith that, even in the face of complete pandemonium in the market, reason would ultimately prevail.

The hardy souls who kept their wits about them while most others were losing theirs weren’t rewarded immediately. As has been the case historically in times of turmoil, the stock market continued to experience wild gyrations in the months that followed the October panic, with intraday swings of 5% or more becoming commonplace. When the New Year commenced, things calmed considerably and the market swings became far less extreme. Unfortunately, the direction of the market became much more consistent as well: Downward.

But then in mid-March, just when Dow 5000 was starting to look like a real possibility, the stock market suddenly and unexpectedly reversed course and hasn’t yet looked back. In the past six months, large stocks have seen historic gains in excess of 50%, while small stocks have gained a mind-boggling 70%. As of this writing, the Dow sits just below 10,000, only about 10% below its pre-Lehman level (although still well below its 2007 high).

The swift and unexpected market recovery has cleaved the investment world into two camps: Those who stayed the course and were in the market when the rally commenced – and those who were not. The latter group is now squawking loudly that this is “the world’s biggest sucker rally” (we have seen this phrase so often someone should trademark it) and a return to the March lows, or lower, is inevitable.

As you run across these types of articles in the press, it is well to consider that those who are on the sidelines today are in a major pickle about what to do now, six months into a market that has gained back most of what it lost after the Lehman collapse. They didn’t believe such a recovery was possible, weren’t in the market when it happened, and now they are mightily peeved that they missed it. For that crowd, the only thing left to do is harrumph in the press that this is a “sucker’s rally” and hope they are right, because if the market continues to prove them wrong they will shortly be looking for a new line of work.

Unlike that crowd, we won’t be so vain as to presume we know what the market is going to do in the short term. Whether the March market low really was the culmination of the worst of times will only be determined with the benefit of hindsight. No doubt there is plenty of fodder around to make the case that the recent rise of the stock market is folly, from anemic earnings to the ballooning budget deficit to the specter of inflation on the horizon. But this is true of any market rally – hence the age-old investment adage that stocks “climb a wall of worry.” Perhaps history will show that the over-reaction in the market was not the recovery, but the panic that preceded it.

The more important point here is this: Those who mustered their fortitude and stayed the course in the face of the worst market panic since 1929 have been amply rewarded for their resolve and don’t have to lose sleep now wondering what to do next. At the other end of the spectrum are those who fled the market and now find themselves facing what we have always maintained is the hardest part about market timing:

When to get back in.

We do not envy them. 
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Several months back, Vanguard founder John Bogle penned a column in The Wall Street Journal in which he dubbed the financial crisis a failure of “ethic” proportions. (John C. Bogle, “A Crisis of Ethic Proportions,” The Wall Street Journal, April 21, 2009.) He placed much of the blame for the implosion of the credit markets on financial institutions that had juiced the system with mortgaged-backed derivatives, and on institutional investors who turned a blind eye to their tactics. He decried the huge investment banks and commercial banks for focusing only on the bottom line and embracing an “everybody’s doing it” mentality that became so egregious it nearly brought the entire financial system down. Finally, Mr. Bogle lobbied for establishing a fiduciary standard of conduct for all financial services firms.

We agree wholeheartedly with Mr. Bogle’s positions. The “capitalism” we saw in operation on Wall Street over the past decade was little more than glorified graft, and the reckless way that this country’s largest financial institutions gamed the system to their own benefit – and to their country’s great detriment – is unconscionable. As Mr. Bogle points out, much of this behavior was made possible because those firms were not required to adhere to a fiduciary standard of conduct.

Most investors don’t realize that the investment world is governed by two completely different Congressional acts: The Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. The brokerage industry is governed by the 1934 Act, which holds its members only to a “suitability standard” when investing other people’s money. In contrast, Registered Investment Advisors are governed by the 1940 Act, which holds its members to the much tougher “fiduciary standard” that Mr. Bogle advocates.

This may sound arcane, but it’s a critical distinction; one that allowed much of the securities industry to split hairs about the spurious investments they were selling during the height of the mortgage-backed securities bubble.

As an illustration, consider the definition of when a “suitability violation” occurs as noted in the Financial Industry Regulatory Authority (FINRA) glossary:

“A suitability violation occurs when an investment made by a broker is inconsistent with the investor's objectives, and the broker knows or should know the investment is inappropriate.”

Note that there is no obligation to act solely in the investor’s best interests – just to make sure the investment is consistent with the investor’s objectives. In such a scenario, a broker could recommend an S&P 500 index fund with a 5% front sales load and a 1.50% annual expense ratio over another S&P fund with no sales charge and a 0.15% expense ratio and still meet the suitability standard.

In contrast, Registered Investment Advisors are bound to a fiduciary standard – one that requires the advisor to place the client’s interests ahead of his own. As such, an RIA would be duty-bound to recommend the much lower fee S&P 500 index fund to his client.

There is a movement afoot to raise the bar for all financial services providers to the fiduciary standard of conduct. In our opinion such a move would take much of the systemic risk out of the financial system and bring much needed stability to the securities markets.

Alas, the brokerage industry is predictably working to thwart this effort: The Securities Industry & Financial Markets Associations (SIFMA) is advocating instead for a “universal standard” that would not make its members fiduciaries on behalf of their clients, but rather would only require its members to “observe high standards of commercial honor.”

One would have hoped that observing high standards of honor was already in place as a basic business practice for the securities industry. But given that this is a radical new proposal from the securities industry’s own lobbying group, we see now where the problem was to begin with, and we see that Wall Street, if left to its own devices, will continue to condone the behavior that created our current financial mess.

Congress is presently hearing testimony on both sides of this issue. If you have a moment and are so inclined, we would encourage you to drop your Congressman a line and let him or her know that you support the fiduciary standard for all financial services firms.