Notes, Views, and the Occasional Provocation January / February 2008  

On Martin Luther King Day, as the U.S. markets were closed, foreign markets apparently gave up on the American dream, at least temporarily, and declined significantly around the globe. The next day U.S. markets followed suit, and gloomy headlines are here again.

However, challenging economic conditions do not necessarily spell poor prospects for stocks. As "What to Do About A Recession?" explains, there is no consistent pattern to how stocks respond to economic downturns. Thus, while some market experts are glum about the market's prospects in 2008, others are predicting significant gains in the second half of the year.

Now is the time for exercising a consistent investment discipline, especially for portfolios designed to last decades, not just years. To help, we provide some context below for current events and the potential risks involved with abandoning well-conceived investment strategies when markets become turbulent.

First, however, we provide a brief review of significant economic events last year and how the markets responded. At the end, we note some exciting events at BFA and highlight some media mentions you may find interesting.

Please feel free to forward the newsletter to anyone who might enjoy reading it, and please send along any questions or comments you may have. We love hearing from you.

Warm regards,

Milo Benningfield




The Financial Markets of 2007
As usual, there were a number of economic and financial surprises during 2007. more

What to Do About A Recession?
The biggest non-surprise of 2008 may be an economic recession. more

BFA Notes & Media Quotes
A few notes on goings-on at the firm and recent media quotes. more





The Financial Markets of 2007
As usual, there were a number of economic and financial surprises during 2007:

Subprime-Driven Credit Crunch: for several years, there has been abundant capital chasing relatively few investment opportunities around the globe. This “liquidity” lowered yields on risky debt securities and fueled merger and acquisition activity, which, in turn, helped fuel rises in stock prices. Suddenly last summer, the party came to an end. Problems with subprime adjustable rate mortgages caused financial institutions to write down their financial assets, forcing them to restrict lending activities. A “credit crunch” was born and is still reverberating throughout the global markets.

Volatility Returned: Driven by the credit crunch, volatility returned to the markets. In November, after four years of relatively steady gains, the S & P 500 index experienced its first 10% decline – known as a "correction" – since 2003. In addition, the Chicago Board Options Exchange Volatility Index (VIX) – an option index that indicates implied volatility of stock returns – entered 2007 at a record low, then surged to its highest level since 2002.

Inflation Went Up: After initially declining during the first half of the year, the consumer price index surged during the fourth quarter as a big jump in fuel and food prices caused it to hit 4.3% on a year-over-year basis, its highest rate since 2005.

The U.S. Dollar Stabilized: The dollar did fall again in 2007 – an additional 9% on a trade-weighted basis against major currencies, including 10% against the Euro and 15% against the Canadian dollar. However, despite inflammatory news headlines, the dollar actually stabilized late in the year, suggesting there was still confidence in it. Also, the weaker dollar helped spur U.S. exports, producing the first meaningful decline in the U.S. trade deficit in years.

In response to these economic events, the major financial asset classes offered a few of their own surprises:

Treasury Bonds Outperformed U.S Stocks : Investors fled stocks during the second half of the year. This “flight to quality” boosted Treasury bond total returns to 9.0% in 2007, outpacing the 5.5% total return earned by the S & P 500 Index.1

U.S. Large-Cap & Growth Stocks Finally Outperformed Small & Value: After trailing small-capitalization and value stocks for the past seven years, large-capitalization and growth stocks finally came out on top – about five years later than most investment pundits had predicted would happen. U.S. growth stocks gained 11.4%, while value stocks lost 1.0% as financial stocks were hammered. U.S. large-company stocks were up 5.5%, while small-caps were down 1.6%.

REITS Fell to Earth: Real estate investment trusts (REITS) entered 2007 on an unprecedented hot streak, having posted positive gains for seven consecutive years and earning an annualized return above 23% for the past five years. However, the credit crunch put an end to their run in dramatic fashion and REITS declined 15.7%, trailing the S & P 500 index for the first time in eight years.

Emerging Market Stocks Soared: In the past, when the U.S. economy slowed, investors stampeded out of emerging-market stocks, fearing a hit to global growth would send them plunging. This time, however, emerging-market stocks outperformed most other equity categories and finished the year with 39.8% returns. It may be too soon to conclude the emerging markets have “decoupled” from developed-country economies, but their stocks certainly added some stability to globally diversified portfolios in 2007.

In retrospect, because of a well-documented phenomenon known as "hindsight bias," many of these events may now seem destined to have occurred. But it did not look that way even as late as the middle of last year. Rather, after a first half that produced significant gains, most investment experts were predicting a rosy second half. However, the analysts got it wrong again, particularly the bank analysts, proving once again why diversifying across asset classes is such a powerful long-term investment strategy.

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What to Do About A Recession?
The biggest non-surprise of 2008 may be an economic recession. The R-word has been on the covers of several major media publications recently. A number of economic indicators, including fewer containers arriving at U.S. ports, fewer rail-car loadings, and a lower trucking index suggest that the U.S. is either headed for or already experiencing an economic slowdown sufficient to qualify as a recession.2 Stock prices have been tumbling for several weeks now, perhaps pricing in the reality that a recession has already begun.

Since humanity did not survive 100,000 a years ago by standing around to ask whether a saber-tooth tiger was friend or foe, some investors are understandably asking, What should we do? More specifically, should we exit stocks or at least reduce our exposure right now? Unless something has changed recently in your personal circumstances, the answer is likely no.

Historically, stocks have not responded in any predictable fashion to recessions, so it's exceedingly difficult to try to time the market around them. For example, look at this data provided recently by the Wall Street Journal:



Wall Street Journal, January 14, 2008, "History Lessons: Past Recessions Yield a Few Clues."

The historical record suggests that each recession and the markets' response to it is different. Sometimes, as in the most recent recession of 2001, stocks drop before, during, and after a decline in economic activity. But during the recession of 1980, stocks never dropped, and in the six months afterwards, they galloped away.

Stocks are dropping now, you say, so maybe it's 2001 again, or 1970. Yes, but are we six months out from a recession, already in one, or heading through the other side? No one knows for sure, and the experts are divided. However, the stock market is an often accurate predictor of economic troubles, so, despite how things look, the worst may already be, or may soon be, behind us.

More important, just because the economic picture may be poor, stocks themselves may not be a poor investment. To be bearish on a security, you have to assume that conditions will be worse than what is already priced into the stock. As lower and lower earnings expectations have been "baked" into stocks over the past couple of months, they may well be positioned to resume growth going forward. This is why some experts are predicting as much as an 8% gain for the S & P 500 index in 2008.

Next, a big problem with abandoning stocks, even temporarily, is that much of their long-term returns occur over short bursts of time. It is enormously difficult to capture these short bursts while also trying to avoid the risks involved. For example, one of the worst days for markets in the past four decades was "Black Monday," October 19, 1987, when the U.S. and foreign markets dropped 20% in one day. However, just two days later, on Wednesday, October 21, 1987, the S & P 500 index experienced its best day in that same four-decade period. Similarly, the best one-month return for the S & P 500 index was October 1974, immediately after the worst one-year period. By exiting the market temporarily for even short amounts of time, investors risk losing the chance of a lifetime to recoup previous portfolio declines.3

Of course, all this presumes that you do not have a near-term need for sale proceeds from the stocks in your portfolio. A sound long-term portfolio has significant liquidity built into it through cash and safe, short-term government bonds in order to avoid having to sell other financial assets at fire-sale prices during volatile times. Investment in equities should be your patient capital set aside for at least a decade from now and preferably longer. If you’ve set things up correctly, you are not, as it may sometimes feel during market corrections, standing in a dinghy in the middle of the ocean with water gathering around your ankles. Rather, you are standing high on dry land, experiencing volatility and gloomy headlines as a distant squall on the horizon – fascinating, but of no great concern.

Finally, consider this: during the whole of the twentieth century, from 1900 through 2000 – in other words, through two cataclysmic world wars, a great depression, a presidential assassination, an oil embargo, rampant inflation and several major shocks to the U.S. financial system that rival current events – U.S. equities returned 10.1% per year. Safe, default-free U.S. treasury bills returned 4.1%. The 101-year difference between returns on stocks and treasuries – known as the "equity risk premium” – was thus about 6.0%.4

The 6% equity premium was the excess return required to induce investors to accept the risks of owning U.S. stocks over safer assets, and we might say that stocks in the twentieth century earned this premium despite an unsettling series of political and economic events. But that would be wrong. Stocks earned their premium because of such events, not in spite of them. Uncertainty, volatility, and the ever-present prospect of financial catastrophe are the very engines that generate excess returns expectations for stocks over other, safer financial assets. And for that, patient investors can be grateful. Because if such premium generators disappeared, then stocks' excess returns likely would disappear too, leaving us at the mercy of inflation.

To see this, we can look again at stocks versus treasuries in the twentieth century, but this time subtract out inflation, which was 3.2% per year. Between 1900 and 2000, after subtracting inflation, treasuries earned only 0.9%; stocks earned 6.7%. With stocks we would have doubled our money a little over every decade, but with treasuries, we would have needed a whopping eighty years to do so.

Cash, bonds, and stocks all have their proper role to play in a long-term investment plan. Altering long-term investment allocations can be a very appropriate move when done in response to some significant change in your life. But it is almost never the right move when done in response to short-term market fluctuations.

Indeed, switching investment strategies midstream probably represents an even greater threat to a portfolio than the equities themselves, since most strategies are sensitive to the business cycle. The risk is great that you will move out of one strategy when it is underperforming only to see it come into favor again a short time later. This is why the biggest risk to the equity portion of our long-term portfolios most often isn't the equities; it's ourselves.

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BFA Notes & Media Quotes
Benningfield Financial Advisors recently passed a major milestone by completing five full years of operations. We look forward to many more great years to come.

Due to significant growth, the firm also transferred its investment-advisor registration from the State of California to the federal Securities & Exchange Commission. BFA now manages approximately $38 million of investments on behalf of seventeen client families and individuals in addition to providing ongoing financial planning.

Finally, here is the most exciting news: after working for a year at BFA on a permanent part-time basis, last November Mr. Gilden Chung began a full-time position as the firm's Operations Manager. He handles a variety of administrative and client-service duties at BFA in addition to assisting with portfolio administration and financial planning.

Gilden earned a B.S. in Biology, graduating cum laude, and a M.A. in Education at San Francisco State University. Before coming to BFA, he taught high school science for the San Francisco Unified School District. He then worked for a decade with the Educational Opportunity Program at San Francisco State University, where he developed programs for, mentored, and instructed students from low income families who had never before sent a child to college. He is a lifelong resident of the Bay Area and lives in San Francisco.

It is terrific to have Gilden join BFA full-time, both for the extra capabilities he brings and for the camaraderie we now enjoy at the firm.

Recent Media Quotes
BusinessWeek Online, January 14, 2008
Milo was quoted in Ben Steverman's article "Risk: Smart Strategies for Tricky Times." Milo noted that many investors have been "paralyzed" by recent market volatility, with some having held mostly cash for the last two years. Addressing these fears, he said, "There is nothing wrong with risk. It just has to be calculated risk." He also cautioned investors against "suspiciously high" yields on certain bonds and other investments. Read the article.

Newsweek, January 14, 2008
Milo was quoted in Linda Stern's article, "When It's Quitting Time," which discussed how a couple could best make a transition from earning two incomes to one. Milo noted that the biggest challenge in such a transition is not the money, but the implicit contracts in the relationship. "If there are quid pro quos involved, it's important to make them explicit," he said. "Make sure each partner agrees on the reasons for the transition and acknowledges each other's efforts, sacrifices and good will in helping to make it happen." Read the article.

Dow Jones Newswire, December 7, 2007
Milo was quoted in Marshall Eckblad's article, "Affluent Boomers May Leave Heirs Little." The article appeared in numerous publications nationally, including the Wall Street Journal. In the San Francisco Chronicle, the article appeared on December 9, 2007 under the title, "Well-off Baby Boomers are Likely to Spend Their Kids' Inheritance." Noting that many baby boomers have ambitious financial goals for both funding a long-term retirement and leaving a legacy to their kids, Milo noted that "Invariably, their reach exceeds their grasp." However, legacies aren't the only or even best way to help our kids: "'If we’ve done our jobs,' Benningfield says, talking as a parent, 'we've invested in our kids early.'" Read the article.

That's it for now. Thank you for reading. Please look for our next newsletter in March. Until then, yours truly,

Milo Benningfield




1 Asset classes are represented by the following indices: Treasury bonds – Lehman Brothers Treasury Index; U.S. large-company stocks – S & P 500 Index; foreign developed-country stocks – MSCI EAFE Index; U.S. small-caps – Russell 2000 Index; U.S. growth stocks – Russell 3000 Growth Index; U.S. value stocks – Russell 3000 Value Index; REITS – NAREIT Equity-Only Index.

2 According to Wikipedia, a recession "is a decline in . . . gross domestic product (GDP), or negative real economic growth, for two or more successive quarters of a year. However, in the United States the official designation of recessions is done by the business-cycle dating committee of the National Bureau of Economic Research . . . . That Bureau defines a recession more ambiguously as 'a significant decline in economic activity spread across the economy, lasting more than a few months.'"

3 On the difficulty of timing the market, listen to what Jack Meyer said a few years ago, in an interview with BusinessWeek, when he was still managing Harvard University’s then $27 billion endowment:

BusinessWeek: To what extent do you time the market – by shifting your asset allocation in anticipation of a big move in stocks, for example.
Jack Meyer: As a practical matter, we don't do much of that. It’s the romantic thing to do, and it's what people like to talk about at cocktail parties. But frankly, we don't think anyone is very good at it. It's a very difficult way to make money.
BusinessWeek Online interview, excerpts in the magazine on December 27, 2004.

4 Triumph of the Optimists: 101 Years of Global Investment Returns, Dimson, Marsh & Staunton (2002 Princeton University Press) at p. 46.

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