As I walked into our lobby a little before 9 a.m., I noticed that Jim Kelly was already seated in the conference room. I'd had a long telephone conversation with this prospective client last week. It seems he's been fighting a losing battle with the stock market the last few years, and he is kicking himself for "staying with a bunch of losers." He was eager to see if I could help him get a new sense of direction.
As I pulled up a chair across the table from this lean, leathery man with pale blue eyes and thinning silver hair, I recalled our conversation. Jim is 76. He served as a Seaman aboard the aircraft carrier Wasp in WWII. When he returned from the service in 1946, he earned a business degree at night, courtesy of the GI Bill. By day he drove a delivery truck, which he financed with the $1,000 he had saved while Uncle Sam was paying for his food and shelter. By the time Jim retired in 1991, he was able to sell his trucking business for $500,000. That became his nest egg.
During the roaring nineties, this retired entrepreneur managed his own portfolio to a March 2000 peak value of $1.6 million; his memory is painfully fixated on this figure. Jim lost his first wife to cancer in 1992, but has since remarried; Nancy is 16 years his junior. Since Jim is vigorous, and since Nancy's life expectancy is about 25 years, the recent losses have made him start to worry about outliving their money, which has shrunk to $800,000.
More Than A Cycle
For our first five minutes together, I had the opportunity to practice silent compassion and work on my I-feel-your-pain facial expressions. Without even introducing himself, Jim had begun to recount first the glory days and then the depression and recriminations that have attended the halving of his portfolio in the last couple of years. I could tell Kelly felt humbled to contact an advisor after being self-sufficient and successful his entire life. But the shifting winds of the market and the economy were causing him such frustration and even fear that he had to seek outside help.
Jim was brimming with angst. He so wanted his portfolio to regain its former heights that I was not at all confident that he was going to be able to accept the prescription I knew I had to recommend. So I tried to put the medicine in a gelatin capsule that might make it easier to swallow.
"Jim," I said, "I'm really glad you came. A lot of men have recounted similar discouraging experiences at this table over the past year. (I hoped he would feel a sense of camaraderie with these anonymous, fellow-wounded members of our proud species.) Actually, you have survived this bear market better than many professional money managers." I pointed out a few technology funds that have melted down. After a few clicks on my HP-12c, I was able to tell Kelly that despite the terrible bear market, he had managed to earn 4.36% a year, beating the ravages of inflation. He should certainly feel good about that, I suggested; many have not done as well.
Jim knew I was sugar coating his recent portfolio disaster, but I think he appreciated that I wasn't taking some holier-than-thou approach. So I went on, not really sure where I was going.
"Jim, the turmoil we are living through now is more than a cyclical bear market; much more far-reaching. When the speculative balloon was pricked, a hundred-year storm was unleashed. That storm is still raging across the landscape of America two-and-a-half years after it began. The Middle East is a powder keg, and a stealth enemy threatens our own way of life here at home. Promising New Economy business models have dissolved like cotton candy in a summer squall. The storm has already leveled legendary stocks, exposed the avarice of respected business leaders, and shaken to their foundations institutions whose integrity we all depended on. This is really disconcerting stuff."
Get Over It!
"Sooner or later, the ground is going to stop trembling and the storm clouds will blow out to sea. But the clean-up of this mess, and the restoration of social stability and confidence in the future, is not going to happen overnight. I have no idea what our country or our world are going to look like when we have put Humpty Dumpty back together again, but I don't doubt for a minute that we'll be able to do it. Do you?
"We certainly cannot trendline our past into the future, because so much that we have taken for granted is up for grabs ... security, privacy, due process, the role and reach of government, our global relationships, the credibility of our leaders and our institutions. I am serenely confident that the good citizens of our free and entrepreneurial culture are up to the complicated task of rebuilding and 'normalizing' our way of life. But laying the foundation for a new era of peaceful commerce and true growth is probably going to take a long time; perhaps a decade, or even a generation. In the meantime, investors, especially retirees like you who have to live on the fruit of their investments for another 20 or 30 years, need a game plan for coping with an extraordinary degree of change and uncertainty.
"Lots of professionals are either thoroughly confused by the market turmoil or unaware of how deeply the foundation has been shaken in the past year. Some are waiting for the fallen soldiers to rise and fight again. (Cisco is owned by almost as many large-cap growth funds as owned it two years ago.) Some cling to a myopic brand of optimism. (Stocks are down 35%, therefore they are cheap and should be bought.) Still others believe that all that's going on is the usual rotation from large cap to small and back again.
"Jim, your portfolio is down; it's down a lot from the peak. But you still have enough money to sustain you and Nancy comfortably for your whole lives. Before we get into some ideas about how to make your investments productive again, I want to encourage you to forget about the $1.6 million. It's past, its over, give it a rest, fuggetaboudit! You have to stop beating yourself up and repeating what you should have done; one of the most memorable lessons my father taught me growing up is, 'You can't shoulda. Just decide what you can do today.' Stop hoping for the old names to stage a comeback, and stop dreaming about 14% returns. We don't need pie in the sky. Reasonable, normal returns will meet your needs.
Time For Defense
"Jim," I said, "One of the reasons you have lost so much ground the past two years, as I am sure you know, is that you have maintained an all-stock portfolio. Not only that, but you have stuck with technology and large-cap growth stories."
Jim was leaning his left elbow on the table and resting his chin on the open heel of his hand while his fingertips tapped on his cheekbone. This position forced him to speak through clenched teeth. "The gurus I read all say not to let short-term volatility drive you out of your positions. It's too late to get defensive, they say. Near the bottom, gonna get better soon. Don't wanna sell just before they turn up."
"I know," I said. And 'Over the long run, stocks earn more than bonds.' And 'You'll never get rich by diversifying.' And 'Technology is what America does best.' Right?" Jim nodded, still cupping his chin in his hand, yet raising his eyebrows and showing a faint, sheepish grin. He had heard all these mantras, and they had guided his portfolio strategy such as it was. I guessed he was opening up to a different approach.
"Jim, for nearly 20 years, U.S. investors didn't have to endure much more than a technical correction in stock prices. Most of today's professional money managers and media gurus never saw a bear market. They are from the "buy the dips" generation, and today they are either confused by the persistent weakness of stocks or they are still repeating the mantras that worked for a generation. Besides the fear of terrorism and the discouraging failure of many business leaders and institutions, we have a valuation problem in the stock market, the extent of which many people have not yet faced up to.
"Here's some interesting historical data as a frame of reference. In the 25 years from 1942 to 1967, stock prices grew at a compound rate of 9.6%. Considering that GDP and profits grew more like 7% a year, that was quite a tear for stocks! But by outrunning the growth of the economy, stocks became so expensive that for the next 15 years the popular stock market averages went nowhere! Worse than that, if you adjust for the loss of buying power to inflation over that period, a $1 million portfolio in 1967 shrank to $354,000 by 1982! That's how painful it can be to correct an overpriced stock market.
"To bring us up to date, in the 20 years from 1982 to 2002, stocks grew at a steamy compound rate of 13.5% a year vs. 6% for GDP. Valuations got way above where they topped out in 1967. If that last bull run of 9.6% a year was followed by 15 flat years in the market, doesn't it make sense that the even faster bull market of the '80s and '90s may give us even more grief before the payback period is over? Nobody knows the future, Jim, but I am convinced that there is still a lot of complacency and naivetÈ yet to be squeezed out of stock prices. It is not too late to start playing a little defense. Let me offer a few suggestions."
Time For Active Management
"The first defensive principle is diversification. We're not trying to get rich, just to earn reasonable returns on investment, so you can get this monkey off your back. We want to stop the bleeding, right? You need to sell the stocks and funds you own and buy some bonds. We'll spread your fixed income money across the maturity range, take on a conservative high-yield fund, add some high-grade corporates, inflation-indexed Treasuries and a preferred stock fund. We'll keep your next couple years' spending requirements in cash and short-term bonds. And maybe we'll allocate 30% to stocks.
"But we don't want to own the S&P 500 index. That's a broad-brush index that's still top-heavy with popular, over-valued stocks. The mutual fund industry hasn't had net redemptions yet, but they will by the time the valuation correction is over, and indexers will be hurting. We'd rather select veteran managers who are not locked into some narrow style definition; professionals who are seeking real returns, have demonstrated an eye for value, and whose shareholder correspondence indicates that they are aware that we are dealing with more than a cyclical correction. We want managers who are thinkers, who can adapt, who can size up the integrity and skill of corporate executives, and who don't base decisions on yesterday's mantras.
"We want your portfolio to include some good utility stocks, because this is an essential industry where the solid prospects of legitimate companies have been temporarily overshadowed by the shenanigans of a few. Secure sources of energy also deserve a place in your lineup, as do dominant, well-financed companies that are likely to gain market share in their respective industries during times of financial turmoil. When the economy is on the mend, they'll have pricing power and their profits will grow faster than sales. While the overall market has some correcting to do, I think we can do better with active management of the equity portion of your portfolio.
The System Is Working
"Jim, I know it's been frustrating for you the last couple years. It's been hard for the whole country. But the U.S. has been through financial crises, ugly scandals and military confrontations before, and we have handled them all. Free market capitalism is a powerful force for coping with change and for raising general living standards. However, as observers from Alexis de Toqueville to Michael Novak ("The Spirit of Democratic Capitalism") have observed, it only works well when its participants operate with a basic standard of integrity. Recent exposure of executive greed and deception and collusion by consultants, advisors and employees calls this essential component into question.
"But the really encouraging thing is that the system is working. Fraud is being exposed, and rank and file investors are outraged. The Justice Department, regulators, the media and the markets are all playing their parts to drive offending persons and companies from the marketplace, and to improve the transparency of commerce. As millions of consumers and vendors keep making decisions based on their own self-interest, we will all benefit from a rising level of integrity and continuing gains in productivity. One day, investor confidence will rise enough to spawn another roaring bull market. But you know, I think slow and steady will be a lot more pleasant!"