Madoff and the Mattress

Choosing the Right Course

Two stories in recent weeks drove home to us how truly difficult a period this has been for investors. No matter how sophisticated or naïve you are, it has been tough to avoid disaster. This week Bernie Madoff drew a sentence of life in prison for running the biggest financial fraud in history. People gave their life savings to one of the most sophisticated investors in the world, a pillar of Wall Street, and it all vanished. One of his investors was a university that gave him a big chunk of its endowment. Among the contributors was the estate of a single woman who had lived frugally and invested in Blue Chip stocks for 70 years. A career civil servant, she had given the university more than $20 million dollars. A lifetime of successful investing was squandered in one poor decision.

At the other extreme was the classic person who did not trust financial institutions at all. Instead she stuffed all her spare money, almost $1 million, in a mattress. So secretive was the elderly woman, that even her grown daughter wasn’t aware of her savings habits. That backfired when the daughter decided in early June to surprise her mother and replace the lumpy mattress with a brand new one. When they realized the next day what had happened, they scoured the local garbage dump but with 2,500 tons of new garbage each day, the missing mattress was nowhere to be found.

There are risks everywhere and it’s difficult for even the most sophisticated investors to strike a proper balance. We draw on our three decades of institutional investment experience to spot the pitfalls and help you achieve your financial goals and dreams.

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Starting Young

The Power of Postponement

Many people have heard of the power of compounding. But it’s another thing to take a fresh look at the actual numbers. Consider how money can accumulate in an IRA for someone who starts young and leaves the money untapped until retirement.

Right now, the maximum contribution to an IRA is $5,000 a year for someone under age 50 (your income must be at least that high; the source of funds can’t be a gift). Let’s look at what would happen if by the time someone turned 20, they had saved and earned enough to put $5,000 in an IRA as a one time only contribution. Now let’s invest that money in a broad stock market index and earn the average return of stocks over the last century, ten percent. After 50 years, the account would be worth $587,000 (remember this doesn’t factor in inflation).

Now if that same person waits ten years, until he’s 30, to invest, the total at retirement would be less than half, $226,000. At 40, it would be cut to $87,000. At 50, it would be $34,000 and waiting till 60, the total would be only $13,000.

These are, of course, average figures and the results generally would differ significantly from this illustration. But this does make a number of important points. First, the length of time you invest – whether it’s for yourself, your children or your grandchildren – is critical. The benefits of tax deferral make a huge difference. And achieving the returns of the broad stock market has been a great goal.

Stock Market Blues

It's So Bad

The stock market has been so bad this year -- and since mid-September -- that it seems like a tremendous accomplishment that the S&P 500 is now down only 12 percent year to date. Last Monday it was down 25 percent year to date. To keep these numbers in perspective, the S&P was down 38 percent last year and 22 percent in 2002. Other than that, you have to go back to 1974 for a year when the S&P was down as much as 12 percent. While the economy is terrible, the stock market has been discounting a lot. We will only know in retrospect when the bottom hits. But the results of past financial crises show that once the crisis passes, stock markets have had significant rebounds within the first two years.

Some Positive Signs

Harbingers of Spring

Like the flu, a recession is mostly bad. Like a recession, it's also hard to spot the good sides of getting the flu, particularly since it can be fatal. While it's easy to spot the misery of a recession, today I heard three positive things about this one. First, more people are planting vegetable gardens to save money. A side effect will be to have healthier food and some enjoyment. Traffic is down, leaving roads less congested. Finally, I heard an economist say today that because the job losses in this recession have happened so quickly, the recovery in jobs could be equally quick. He predicted that the recovery in jobs could start by late summer. He may not be right but after all the gloom recently, it's nice to hear an optimist.

The Last Stand

Guarding the Federal Treasury

The underlying assumption of all the economic rescue plans, is that the U.S. Government remains an unassailable credit. In the economic textbooks and financial theory, the interest rate on short-term Treasury securities is the "risk free rate." That is the bedrock upon which sits the world credit markets and indeed the entire superstructure of the global economy. There is no more powerful term of art in the financial markets than the guarantee that comes with "the full faith and credit" of the U.S. Government. As we spend voraciously to stimulate the world economy, this requires careful attention.

If for a second, this assumption is shattered, woe be to all of us. The last line of defense cannot be breached. This goes by different names: a dollar crisis, runaway inflation, a systemic crisis. It all boils down to the same thing. In a modern economy, everything depends on faith and confidence and most importantly faith in the U.S. Government to have the capacity and will to honor its debts. The remarks by China's Premier Wen Jiabao on Thursday were an early warning. When you owe someone $1 trillion, it pays to listen. Of course, he also needs to be careful or we won't be able to pay him.

Debtors generally lose their standing not when they have too much debt but when their liquidity runs out; they have no more capacity to raise additional funds to service their debts. The U.S. borrows for the long term, as long as thirty years, to finance highways and airports and all types of infrastructure -- many projects that won't pay off for years or decades. Over time those debts have always been paid but they cannot all be paid today. The danger is when the debts mount so high and rapidly and when funding dries up. Even the mightiest borrower can be brought down if they have not carefully planned for such a rainy day.

The U.S. must guard against this possibility in every available way. The U.S. Government balance sheet -- it's tally of cash and borrowings -- is the critical defense against the economic troubles spreading around the globe. If the Federal balance sheet is perceived as shaky, there is no saving the global economy from complete disaster. While this sounds dire, it is, but it is also highly unlikely if proper precautions are taken.

Part of the recklessness of this decade has gone largely unmentioned. While the Federal debt has roughly doubled, the average payment period has halved. This seemingly technical point is in fact a major risk factor that should be reversed as soon as possible. At one point early in the decade when debt was low, the Treasury briefly stopped issuing its longest bonds, 30 year maturities. The average debt maturity shortened to only three years. That means that every year the Treasury had to raise enough money to cover one-third of the debt. Between the shortened maturity and the rise in debt, annual funding needs more than quadrupled.

The Government's action was comparable to a homeowner putting his mortgage or car loan (typically four to seven years effectively) on their credit card, whose balance is payable in full on demand.

Why did this happen? Interest rates were historically low and short-term borrowing was a lot cheaper than long (the yield curve was historically steep). Now interest rates for the Government are even cheaper and it's still beneficial to borrow for short term -- months rather than years.

The Government should resist that temptation and step up the longer-term borrowing. One expert has even proposed 100 year borrowings to get us over the hump of baby boom retirements. In the short-term it will be more expensive to extend borrowings. But if we put too much pressure on the credit markets by constantly coming to market with tens of billions of dollars of short-term borrowings, it raises the likelihood of the credit markets balking. By taking precautions, that need not happen. Once it happens, there's no turning back so we should sacrific whatever is necessary to avoid that possibility.

Famous Last Words

Irrational Exuberance Anybody?

When Alan Greenspan gave his famous testimony to Congress and questioned whether the U.S. was in a stock market bubble characterized by "irrational exuberance," the Dow Jones Industrial Average was at 6,437. That level on Dec. 5, 1996 had climbed 24 percent over the previous year and nearly doubled in three years. It would double again before the next major bear market began in 2,000.

Now that we are back at that level of 13 years ago, does anyone feel irrational or any exuberance about the stock market or the economy?

More Bad Numbers

It's Bleak but not Hopeless

Boeing announced that in February they only received four orders for freight and passenger jets. The previous year they got 125 orders. That's a year over year decline of 97 percent. In good years, Boeing is the single largest U.S. exporter. So this is bad news for manufacturing jobs and our trade deficit. Orders are a forward looking indicator with new orders delivered years in the future, so this doesn't mean a collapse of current production. Anyway you look at it, it's not good. The only plus is that across the board, inventories are getting leaner and eventually people will want stuff again.