Commentary & Insight

Special Market Update

Ted Truscott, Chief Investment Officer
RiverSource Investments, LLC
September 15, 2008

"Such schemes [deposit/pension insurance] may breed a degree of complacency that there will always be someone around to fix any problems. The costs of that complacency are now becoming clear."

A Leaky Pool - The problems of insuring against systemic risk"
The Economist, Volume 388 Number 8596, Sept. 6-12, 2008

Moral hazard, or engaging in risky behavior on the assumption that someone will provide a bail-out, is the concept behind the U.S. government's refusal to rescue Lehman Brothers this weekend. It may also have been simple math: The government may call it a "conservatorship" but the rescue of Fannie Mae and Freddie Mac a few weeks ago will put taxpayers on the hook for billions of dollars of bad investments and failed mortgages. At some point the government needs to worry about its own books and the burden of its taxpayers. It may also have been shrewd political calculation: U.S. automobile manufacturers were making their way to Washington, D.C. recently to ask for loans in order to compete against Japanese and German manufacturers. The timing, some 60 days prior to a national election and on the heels of the Fannie/Freddie rescue, certainly looks suspicious. No matter which way you look at it, the government, after a year of trying to stem the financial crisis, has decided to let good old-fashioned capitalism work its brutal magic. This is not going to be pretty.

The landscape of financial services is being radically altered and bringing to a rapid end the golden age of financial services that has been in place for almost 25 years. Just two major U.S. investment banks remain independent today – Morgan Stanley and Goldman Sachs. Lehman Brothers is reorganizing under Chapter 11 and will be a shadow of its former self. Merrill Lynch will now become a part of Bank of America and Bear Sterns has already become part of JP Morgan. As we have written in earlier updates, the chief culprit is excessive use of debt or leverage in an attempt to turn low returns into high returns. It all works fine until it doesn't anymore. The merger of banks and investment banks brings us full circle – back to predepression era times when these two businesses were unified. While Citigroup started the trend a few years back, these more recent pairings are at best hastily arranged marriages.

There is more bad news on the horizon, barring the arrival of an unforeseen solution that comes out of nowhere – unlikely in our opinion. A major insurer is on the ropes and is in desperate need of capital. There is also more bad news to come for several commercial banks and thrifts.

What does this all mean from an investment point of view?

1. It is very clear that there will be additional mergers of financial firms. This is somewhat reminiscent of the early 1990s when many major banks merged in the wake of the commercial real estate and Latin American debt crises. While mergers may not salvage the value lost in the last year's downturn, they do make some sense. Vicious cost-cutting will be the source of future profits as firms rid themselves of redundant employees, back-office technology and businesses that no longer make sense. It is no secret that there are entire lines of business on Wall Street that no longer make sense, since there is no longer any funding to support them.
2. Credit will continue to tighten and be scarce. The Federal Reserve is likely to ease further tomorrow in response, but tight credit will continue for consumers and businesses. This will affect firms on Main Street as well as Wall Street. The strong and well-capitalized firms will prosper, while weaker firms will continue to fail. This is one reason that we do not recommend high-yield debt as an investment yet. Default rates are set to go higher and yields will need to go higher as well. When yields further reflect anticipated default rates, high-yield debt will be a very good opportunity.
3. Capital is in short supply. Those who have plenty of it will prosper, while those who do not will suffer. Those who can obtain access to capital will do better than those who cannot. It's always a good idea to invest where there are shortages and right now capital is in short supply and being priced at a premium. Legendary investor Warren Buffett has always had plenty of capital at his disposal. His companies and others like them will make a fortune buying businesses at distressed prices. This holds lessons for the individual investor and this is likely the only good news they will find. Financial assets are on sale! We are a remarkable society in that we will buy almost any good on sale, except financial assets. This is because we all fear financial loss and will do just about anything to avoid it. However, prices are much lower than they were one and two years ago. A patient investor will seize on this opportunity and profit in the future just like Buffett and his crowd. This is why we constantly reinforce that there is always opportunity in the marketplace. However, instant gratification is not part of this equation.
4. Markets will bottom at some point. As we have said in the past – everyone is always wrong at the turn. We cannot predict when this will happen but we are fairly certain that the government has decided to try and let markets settle without interfering any further. This may just be the beginning of that final "I can't take it anymore" sell-off that usually marks the bottom.
5. As stated previously, the housing crisis, which is at the root cause of many of today's problems, is not over and will not be over for at least another year. Look for an end to the decline of real estate prices as an indication that markets have bottomed.
6. Finally, we must emphasize that these are truly unprecedented times. It is fair to say that most people in the financial services business today have never seen anything like this in their working lifetimes. The lack of liquidity, dislocation in the system and general uncertainty will mean that stomach-churning volatility will continue until markets eventually reach bottom.

We will continue these updates as this situation unfolds. In the meantime, we also suggest that you meet with your financial professional to review your plan and make adjustments as a result of the last year's market declines, if needed. To some extent, we are all prisoners of what markets will give or take away from us, and just as we need to adjust to rising or falling paychecks, the same is true for rising or falling markets.

As always, the best advice we can give you is to stay focused on your long-term goals and objectives, and consider the following five tips for investing:

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.