Commentary & Insight

Market Update — Current conditions and what the future may hold

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

It's been a year since troubles first emerged in the financial system and there seems to be no end in sight as each passing month brings more bad news. There is no easy fix to the problems we face, as we have been postponing many necessary adjustments for years. The piper now needs to be paid, so here is a recap of the major issues, some thoughts about the future and a variety of suggestions on how to deal with the turmoil in markets.

Big problem #1 - housing

Falling home prices are the big driver behind our current woes. We have steadfastly held that the decline in housing prices is far from over and that this problem will take at least one year, and probably two, to work its way through the financial system. There is nothing that regulators can do to prop up the prices of homes and it's not a good idea anyway as any attempt to support prices only postpones the inevitable adjustment. We live in a mostly free-market economy where prices are set largely through the laws of supply and demand. Right now there are too many houses at prices that are still too high. Housing prices will only stop declining when supply and demand are equal and we are still far from that point. This week's Economist highlights the problem: Of the roughly 129 million housing units in the United States, 18.6 million are currently empty. Some of these are presumably second homes that cannot be afforded, but the current vacancy rate is 2.9% representing some 2.3 million homes that are vacant and on the market for sale. This is the highest level since this measurement began in 1956!¹

The fall in housing prices is enormously painful for two reasons. First and foremost, many consumers have lived far beyond their means by tapping into rising home equity to finance current consumption. As prices fall, that equity evaporates and consumers must adjust spending habits, which negatively affects a multitude of industries ranging from retailers and casual dining chains to banks and airlines.

Second and far worse, in our opinion, is that any borrowings against home equity must be repaid. If that home equity has disappeared, the hapless homeowner may find himself owing more money to the bank than their home is worth. For those in debt, deflation (the phenomenon of falling prices) is a big problem because debt payments are fixed – there is no adjustment in indebtedness for falling prices.

Big problem #2 - too much debt

There is too much financial leverage in our economy and the debt burden needs to be reduced through repayment, write downs and losses, and taxpayer-financed bailouts. Our debt burden has grown largely because many of the financial problems of the last two decades have been battled through lower interest rates, organized takeovers or rescues of financial institutions, and increased fiscal stimulus. Each time a crisis was averted, the proper adjustments were postponed and thus the problem became far larger and more difficult than might have been necessary.

The debt balloon has so many ramifications and causes that it is hard to explain in a short article. However, here are some highlights:

• Ironically the world is awash in savings, but almost all savings are in emerging economies and oil-rich nations. The United States saves very little and foreign nations have been financing our excess consumption for years. This is one reason why the U.S. dollar is so weak.
• Excess savings pushed down returns for financial assets leading to an increase in the use of debt to magnify returns. Investment banks pushed borrowings to levels of almost $30 for every $1 in capital. Private equity firms justified purchases because most financing was debt. At the height of the boom, according to one lawyer, private equity firms handed banks a term sheet on which debt was to be issued. This is notable because the financial world is not supposed to work this way. Banks are supposed to dictate terms, not the other way around!
• Banks loaned freely to construction firms, real estate development companies and consumers to build and purchase more housing. Easy money fueled excess consumption until the laws of supply and demand took hold in the housing market.

A lesson to be learned forever - reversion is mean

This is a play on words from a financial term known as "Mean Reversion." It is a law of gravity in the financial world that asset prices usually revert to their long-run averages. Despite a well-documented history of this truism, people still choose to ignore it. The technology bubble was supposed to teach people that price increases well above the norm result in a correction. It may take years, but a correction is coming and it may be long and painful if prices have risen well above historical averages. The bursting of the technology bubble was long and painful just as the bursting of the housing bubble surely will be as well.

And now, of course, we have the new mania – commodities. Despite ample evidence that demand is dropping for a wide range of precious metals and gasoline, prices keep rising and plenty of "experts" are now available to justify why prices will go higher still. Does this sound at all familiar? The converse, of course, is also true. Assets with returns below the historical averages offer future potential for profit.

The future

Stock prices are falling as are many bond prices. While this is distressing, any investor knows that falling prices eventually create an opportunity to profit. Simply put, when the expected return of a stock or a bond falls to a point where a good return can be earned (without the use of debt), prices will rise. This is exactly what happened in the 1980s and 1990s after the tough markets of the 1970s. Stocks and bonds were dirt cheap at the beginning of the 1980s and the long-term investor earned impressive rewards.

In the meantime, there is going to be a continued shake-out in multiple industries. There will be more bank failures. There will be increased bankruptcies among retailers, casual dining chains and other weak players. This the way our system works – it's not much fun to watch but survival of the fittest in our capitalist economy has always made our economy stronger in the long run.

Time - friend or foe?

In the world of investing, time is usually a friend but a lot depends upon age, financial circumstances, liquidity and a variety of other factors. For those with a long time horizon and some cash on hand, the fall in prices is a welcome opportunity. For those with a shorter time horizon, the fall in asset prices is very unwelcome. As such, the guidelines below need to be set in the context of each individual's circumstances. Your financial professional can help you assess your own situation.

Suggestions for the uncertain future ahead

1. Diversify your portfolio – as discussed in our last market outlook, portfolio diversification is absolutely necessary. A mix of financial assets has fared better over the last year than a single asset class, such as stocks.
2. Diversify your product suite – no single product can accomplish all that is necessary to cope with future obligations and challenges. A mix of financial products, including fixed annuities, annuities that offer guarantees, insurance and bank CDs/certificates, can create additional layers of diversification beyond asset allocation. A diversity of asset classes and products can help in this environment.
3. Maintain ample liquidity – many financial professionals suggest that clients maintain three to six months living expenses in cash or cash equivalents. This is sound advice. Cash is king in this environment. There will be many people who are forced to sell in this market. Profits accrue to those who can buy when others are forced to sell.
4. Utilize dollar-cost averaging – the long-term investor will celebrate falling prices by remaining committed to a dollar-cost-averaging program. By purchasing an asset at lower average prices, the investor may profit to a greater extent than those who sit on the sidelines waiting for the right opportunity. Market timing simply does not work.
5. There is always opportunity in the market – the attached chart from Empirical Research Partners shows a fascinating opportunity. In this study, stocks are ranked based on their valuation. Those with good growth potential and cheap stock prices are the top quintile in this study. These stocks have performed very poorly over the last year as indicated by the peak in the chart. These stocks could correct on the upside.
6. Hedging can help but be careful – hedging a portfolio effectively can be complicated and properly requires a holistic perspective on the portfolio and the objective, since any hedging strategy has the potential to disappoint in ways that are both clear and obscure in retrospect. Today's markets offer a wide variety of ways to protect portfolio downside. One way to do this is to purchase ETFs that bet against an index or asset class. Some ETFs offer the ability to gain 1% for every 1% that the S&P 500 falls. These strategies are inherently short-term in nature as it involves some judgment about market direction and their use should be confined to sophisticated investors.