Commentary & Insight

Market Update — Ongoing volatility and advice for turbulent times

Ted Truscott, Chief Investment Officer
RiverSource Investments, LLC
September 8, 2008

Volatile markets continue to cause anxiety

Markets have welcomed the unofficial end of summer poorly, with plenty of intraday volatility and negative reactions to continued unpleasant news. Markets have also reacted strangely and with a perverse sense of logic to unfolding events. Throughout the spring and early summer, if oil prices rose, the market fell and vice versa. The logic was that high oil prices would be a source of inflation that would constrict the Fed's ability to further ease rates and fight off a recession. One would think that the decline in oil prices witnessed through the late summer would, therefore, be good news. No such luck. Now falling oil prices are seen as a sign that economic weakness is descending on most of the world and that recession surely is on the horizon if not here already.

There is plenty for investors to worry about, so let's start with the bad news. As we have said many times over the past few months, the housing crisis is not over nor will it be over anytime soon. Various pundits have predicted that we are close to reaching bottom or are currently at the bottom, but we do not see how this can be true. There is still way too much supply of new and existing homes, and prices will have to fall further for demand to begin to equal supply. As oil prices have shown, supply and demand do matter, and when there is an imbalance, prices must change to recreate the appropriate balance. There is no magic formula to make this all go away and no one should expect there will be. The government cannot and should not regulate the price of housing, so for the time being the pain must continue. Falling housing prices crimp consumers even if they have jobs because many people have been living beyond their means by borrowing from their homes.

It is hard to describe the magnitude of dislocation occurring in both stock and bond markets right now. Many of us here have been in the financial services business for over 25 years and some of what we are seeing is unprecedented. Its roots lie in the deep credit contraction, which has been in place for over a year and shows no signs of abating. Credit is the grease of any economic machine. If you restrict credit, then the machine does not function as well. When the machine is not functioning well, all kinds of other effects (many unforeseen) will occur.

Here's a basic example: Several weeks ago, a number of auto makers announced that they would either end or sharply curtail leasing as a way of selling cars to consumers. It is hard to think that this would ever have been possible and yet it has happened. Why?

Let's start with a simple explanation of how companies make money leasing vehicles. First, they make money on the difference between the lessor's borrowing cost and the customer's leasing rate. There are also tax benefits that accrue to the lessor. Finally the lessor makes money by selling cars in the used car market after the lease is over. This is called the "residual value" of the car.

So what has happened? First, auto finance companies (many captives of weak auto manufacturers) are paying much more to borrow money because of the credit contraction. This is problematic because higher borrowing costs make it tougher to make money on a lease. This is a problem but, in and of itself, not fatal. However, rapidly falling residual values due to higher oil prices have made it difficult, if not impossible, to make money on a lease. Auto vehicle sales are down to an annualized run rate of 14.2 million vehicles, a rate not seen since the early 1990s. Credit contraction has played a big role in these disappointing results.

Advice for turbulent times

The equity and bond markets have been so volatile and direction has changed so often, that it may not surprise you that even professional money managers are having a very difficult time in these markets. Managers who are properly focused on the long term have lost money, and while some traders made money on very short-term moves, many have lost even more money and some have been wiped out completely, including a number of large hedge funds. Recently, I was discussing the markets with some of our own portfolio managers who shared the pain they have been feeling of late. They have made many investments that they are confident will pay off in the long run, but are not doing well in the shorter term. If you have lost money in this market, it is clear you have plenty of company.

At the end of the day, the fundamental value (also known as price) of any security is the value today of all its future cash flows discounted at an appropriate rate. This is as axiomatic as the laws of supply and demand – the very laws that have resulted in a steep fall in house prices and the more recent decline in oil prices. We also know that fundamental investment value has little to do with price movements in today's markets. Price discovery has been extremely difficult for many reasons. First and foremost, the credit contraction has created a lack of liquidity particularly in the bond markets. Five and ten-point moves in one day for no fundamental reason have not been uncommon in various parts of the bond market. Second, investors are reassessing the future cash flows of many securities to calibrate with the new and more sober economic reality. Finally, many investors are simply chasing anything that looks like it will perform well. This has led to plenty of disappointment as outperformance of just about any investment has been short-lived.

The good news is that there is a great deal of fundamental value in today's markets. We see it and know it, but have also come to the sad realization that we will not be rewarded for purchasing fundamental value for many more months, perhaps the rest of this year. However, the patient investor knows that the rewards will be there and will stand by their conviction. Again, when I spoke recently with some of our own money managers they shared their commitment and belief that the bets they are making will ultimately pay off. Even with the short-term pain they may feel in their results, they know that by sticking to their guns and staying invested in the areas they believe will do well in the long term, they are taking the actions they need to win in the marketplace over time.

The situation for individual investors is the same. There are many securities on sale for a deep discount today and they are being purchased in our various portfolios. Just as we take advantage of this opportunity, so should you by dollar-cost averaging into this market. Fundamental value will eventually return to the marketplace and the investor that stays committed to their long-term objectives will be rewarded when it does.

For investors close to or in retirement, this advice may be of cold comfort. This is why we recommend a focus on product diversification as well as asset diversification. Annuities with embedded guarantees allow for exposure to the equity and bond markets and yet protect against losses. Fixed annuities, certificates, and high-quality bonds (including municipals) offer good value and a higher degree of safety. Finally, if you must sell long-term holdings in mutual funds, stocks, or bonds, to move into something safer, please make sure you realize losses in order to save on taxes at the end of the year.

Ultimately, the best defense an investor can have in any market environment, particularly in volatile markets like these, is to remain focused on their longer-term goals and remember the following five investing tips:

1. Review your investment plan - now is the time to make sure that your investment plan addresses the current volatility as well as your long-term goals, and to make adjustments if necessary.
2. Don't let emotions affect your financial future - market ups and downs will always occur and the turbulent markets we have seen are likely to continue in the near term. Keep your long-term focus in mind and don't let emotions drive your decisions.
3. Diversify, diversify, diversify - proper diversification and asset allocation is more important than ever during times like these. Don't forget the importance of product diversification along with asset diversification.
4. Be disciplined - over time, disciplined investment strategies like dollar-cost averaging can help smooth out market fluctuations and help you weather these volatile markets.
5. Avoid market timing - being out of the market for even a short time can cost you significantly. Trying to predict the exact times the markets will rise and fall is almost impossible and creates undue risk. Simply put, market timing does not work.

By remaining calm and sticking to your long-term plan for your investments, you will put yourself in a position to not only survive the current environment but have a much better opportunity to prosper than those investors who make ill-advised emotional decisions and suffer from the perils of trying to time the markets.