After a market calamity like the one we and our clients endured in 2008, it's sometimes surprising to find out that not all advisors had the same experience.
In fact, a handful of them actually dodged the bullet we now know as the stock market's 40%-50% decline. Talking to three such advisors, we might learn some lessons to help us do a better job of protecting our clients the next time around.
D.L. Blain & Co. LLC, New Bern, N.C.
David Blain's clients lost only 9%, on average, between March and November 2008.
"Actually," says Blain, "if I exclude clients who are retired and drawing money from their portfolios, that number drops to about 5%. The reason for this is that I wasn't anticipating the corporate bond disaster where 'AAA' paper like General Electric would be trading down 10% to 15%. So if we break out those clients who use corporate bonds for income, the remaining clients are down only 5%."
How did Blain achieve this performance? "Since October 2007, we've been cutting equity allocations. By January of this year, most of my 'models' were telling me to get out completely." Blain says he didn't go that far, but did move to a minimum underweighting by January. "We still had commodities and some emerging markets doing well into the summer of 2008, but anything having to do with financials we got rid of, moving into cash and Treasury bonds. We also did some shorting with short ETFs to hedge any remaining equities we had in client portfolios that we didn't want to sell, like low-cost-basis stuff. Also, I never want to be completely out of the market, so we always had at least 10% to 15% invested in [long] equity positions." Adds Blain, "It's a lot easier to add or remove one hedge position than to rebuild the entire asset allocation strategy for all clients."
What are the models to which Blain refers? "Stuff I've developed over the years. First, I use a simple moving average for each asset class to give me an overall reading. My other models-in which I've incorporated a lot of Ned Davis' research-are quantitative and deal with investor sentiment, equity valuation and the momentum factors in different markets."
Blain says he also looks for unusual trends that other investors might notice but not pay enough attention to. "Most measures of the credit markets were showing pretty smooth line or curve functions but, starting in October 2007, we were seeing record levels in variables like lending rates-especially commercial paper rates. And when the Fed started cutting rates, the cuts didn't affect longer-term securities at first.
That is, the Fed was cutting, but the markets didn't seem to be listening. When I see events that are multiple standard deviations away from what I would normally expect, I get concerned."
How did he deal with clients who might have resisted getting out of the markets before they'd peaked? "A lot of clients reacted, but not for the reason you might think. After the reduction in equities, clients kept wanting to buy back in because they thought they saw the bottom of the market ... or they wanted me to buy bank stocks. So they weren't complaining that we'd cut down their equity exposure, but that we weren't taking their suggestions to buy back in."
I asked how he would know when to get back in. "We'll depend on our models," says Blain. "As of the first week in December, we had a 'neutral' equity position, meaning 55% stock, 25% bonds, 6% TIPS, 6% gold and 8% real estate." Blain also made currency investments in some portfolios to play the dollar's rise during the summer. "That exposure provided a buffer to the portfolios," he says.
Eric Seff, Seff Investments,
"I've had a general foreboding about U.S. equities for several years," says Eric Seff. "We've had high budget deficits, high trade deficits; we have a declining educational system, an apparent lack of effectiveness by federal and state governments, and the U.S. has lost its economic and military leadership position."
Seff has also thought future corporate growth rates and profitability were way overestimated, and risk levels and risk premiums weren't reflecting reality. "Even before making a substantial move, I had people on a more cautious [equity allocation] than I would consider normal."
But when he really got disturbed was a year ago last August when the subprime mortgage mess became more obvious. "I thought, at that point, the market wasn't recognizing reality at all. The yields on risky securities were way too low vis-à-vis Treasurys, the market was way too high and market volatility was way too low."
That's when Seff began calling clients to discuss cutting back substantially on stocks to the tune of 6% of their then-current allocations. "If equities were 50% of their portfolios, we lowered their exposure to 3%. At that point, I was still quite concerned about inflation so I wanted money to go into money-market funds. Initially, any money market fund was OK, but later on we switched from traditional money markets to Treasury or federal money markets."
The result? For the 12 months ended November 30, 2008, the clients who took Seff's advice scored overall portfolio returns ranging from minus 2.2% to plus 1.4%. Family members (i.e., nonpaying clients) didn't always take his advice, and experienced sizable portfolio declines, prompting them to say they were sorry they hadn't listened. (Sometimes, lunches do come free, apparently.)
What's different about Eric's investment style? "I have a lot of friends in the industry who believe in efficient markets, so their idea of investing for their clients is essentially not to make any assumptions about the future. They reason that doing so is forecasting, which doesn't work if the market is efficient and has already discounted the future. But I believe you can't make intelligent short-term investment decisions if you're not thinking about long-term trends."
Although he says he tries not to forecast too much, Seff believes watching for "themes" is important and, based on his observations, he felt the market was the most pessimistic in early October 2008. "I sent out client letters to that effect, saying it was time to go back in-not because the future looked better-but because with all the central banks printing money, asset prices would rise. I still think that's the case.
However, I also still believe the political and economic systems of the world are inherently unstable and likely to remain so for an extended period of time." In addition, he says, we're in for a long, deep recession and we don't really know what the future holds now that government will be more involved in private businesses. "Let's call it 'the other shoe dropping," he says. "I'm extremely cautious."
In retrospect, Seff now believes his October re-entry into the market was a bit premature. "We went back in too early, but not to the degree we were in when we got out. If my fear about equities producing disappointing returns is correct, they may go out of favor for an extended period, creating fantastic opportunities eventually."
Bill Bengen, Bengen
Financial Services Inc., El Cajon, Calif.
What tipped off Bill Bengen to the market collapse?
"Earlier last year, the crisis was developing. I didn't believe the warning signs at first, but after Bear Stearns ran into trouble in March 2008 and things started happening very quickly, it became clear to me that no one really knew what this crisis was about." So Bengen decided to exit the market gradually. "I took clients to zero percent equities between March and October 2008, eliminating individual stocks, commodities, internationals, and even my old-line conservative mutual funds that weren't conserving capital as they should have been." He adds he'd never before gotten completely out of equities.
The effect on his clients? "My average client was down 10% to 11%. Today, their portfolios are about 75% cash in the form of U.S. Treasury money-market funds, some percent in gold [specifically ETFs directly investing in gold bullion, for example, the iShares COMEX Gold Trust and the SPDR Gold Trust], 10% to 15% in CDs, and the remainder in Treasury bond funds, which I'll probably sell in the near future."
Did any of Bengen's clients balk at his market departure beginning last March? "For the most part, clients loved that I got them out of the market. As a group, they're very concerned about what's going on [with the markets and economy]. A few clients were surprised we were selling equities and they had questions, knowing I would normally have stayed fully invested."
Bengen simply explained that we are in an extraordinary situation that demands extraordinary action. "As things deteriorated and I kept pulling them out, my clients gave me less and less resistance. There were always those who were concerned that, if we were going into a recession, stocks would bottom out and we'd miss the upswing. I said preservation of capital should be our top concern at this time."
Despite his current stance on equities, Bengen remains confident that he will re-enter the market on behalf of his clients. "We are going to get a chance to buy stocks at levels not seen since Warren Buffett was buying stocks back in 1974," he says. But when interviewed in late February he was in no rush to jump back, saying he would probably wait until the fall.
An independent financial advisor since 1981, David J. Drucker, MBA, CFP has also been a familiar journalistic voice since 1993. Drucker's entire body of work can now be purchased at www.DavidDrucker.com in 14 compendiums, by topic.