Dion Money Management Blog   Money Management for Retirees and Their Families

Stocks fell for the second straight session on Tuesday as investors questioned whether the $700 billion bailout sought by Treasury Secretary Henry Paulson was the right prescription for the ailing financial sector. The Dow Jones Industrial Average fell 162 points, or 1.5 percent, to 10,854. Industrial conglomerate General Electric declined 4 percent after an analyst downgrade, and Bank of America slipped 2.5 percent. The broader market indexes also lost ground. The S&P 500 retreated 19 points, or 1.6 percent, to 1,188, and the technology-focused Nasdaq Composite Index was off 26 points, or 1.2 percent, and closed out the day at 2,153.

After the market close, Berkshire Hathaway, billionaire investor Warren Buffett’s holding company, revealed that it would invest $5 billion in Goldman Sachs. News of Buffett’s decision sent investors back into the market in after-hours trading and helped the S&P 500 recover nearly half of its Tuesday loss. Buffett, who is perhaps the world’s best-known and most successful value investor, looks for well-managed, undervalued companies with good cash flow and brand equity. Past investments have included large stakes in Coca Cola, Geico and Burlington Northern Santa Fe. But not all of Buffett’s picks pan out, particularly when it comes to the financial sector. Berkshire Hathaway’s investments in reinsurer General Re and Wall Street firm Salomon Brothers were less than successful. Nevertheless, Buffett’s move comes at a crucial moment for the financial sector and could change the psychology of the market.

Yesterday, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke testified before the Senate Banking Committee on the details of their proposal to bail out the struggling financial sector. The current crisis is one of liquidity, i.e., banks are reluctant to lend to one another for the very simple reason that they fear not being repaid. The problem, according to most economists, is that there is too much “toxic waste,” or mortgage-backed debt, still on the books of the big global investment houses.

Originally, the Treasury sought unfettered power to buy up to $700 billion worth of mortgage-related securities currently weighing down the books of Wall Street firms and large multinational banks. Because there is effectively no market for this paper, however, there is no real way to determine whether the taxpayer would be getting a fair price for this debt—or whether these securities would appreciate in value. The most controversial provision in Paulson’s proposal was a clause that would prevent Congress, the courts or any federal agency from reviewing or challenging the Treasury Secretary’s decisions.

Senators from both sides of the aisle were skeptical of the Treasury Secretary’s proposal, and it appears highly unlikely that Paulson’s plan will pass into law without dramatic changes, including the inclusion of oversight provisions. It’s not surprising that lawmakers are resisting the plan in its current form: Its principal advocate played a role in the excesses that led to the current state of affairs. In the mid- to late 1990s, Paulson was the chief operating officer of Goldman Sachs and later became its CEO before President Bush tapped him to head the Treasury Department.

While Congress contemplates how to address the meltdown on Wall Street, the situation on Main Street continues to deteriorate. The median price of an existing home plunged 9.5 percent in August, according to the National Association of Realtors, while the pace of sales slowed 2.2 percent to an annualized rate of 4.91 million. Economists were expecting an overall annualized rate of 4.93 million homes. There was a silver lining in the data. The inventory of existing homes on the market declined 7 percent, to 4.26 million. The number of unsold homes hit an all-time record in July.

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As the old saying goes, truth is the first casualty of war. Truth is also frequently the first casualty when things head south in the financial markets, as politicians attempt to assure voters that “the fundamentals of our economy are strong” on the same day that two of the nation’s oldest financial institutions—Lehman Brothers and Merrill Lynch—collapse and the Dow Jones Industrial Average loses 500 points.

Investors who follow the news know better. The economy has lost more than 600,000 jobs since the beginning of the year—and that is by the Labor Department’s own conservative estimate—and could tip into a recession as early as this quarter. The current financial crisis, despite the federal government’s aggressive and unprecedented intervention over the past several months, could very well get worse before it gets better. Unlike politics, the world of investing is still very much a “reality-based community.” To be able to profit from changing circumstances, investors must first understand—and face—the facts driving the changes.

While the current financial crisis is almost certainly more than a run-of-the-mill downturn, there is no reason for despair—or, even worse, panic. Below, we provide some simple steps individual investors can take to protect their wealth in the current market environment, maintain their peace of mind, and position their portfolios for future gains.

Check your federal coverage

The Federal Deposit Insurance Corporation (FDIC) is the New Deal-era program that backstops cash deposits at retail banks; the Securities Investor Protection Corporation (SIPC) is a similar entity that protects securities. While the two programs are indeed similar in many ways, there are some important differences.

The FDIC protects up to $100,000 per depositor, per bank. In other words, if you have several accounts containing a combined total of more than $100,000, then the excess may not be covered in the event of a bank failure. (In recent bank failures, however, the FDIC has covered depositors up to $150,000.) If you’re unsure whether your bank is covered by the FDIC, check your bank statement or give them a call. Note also that the FDIC only covers cash—not stocks, bonds or mutual funds. For the purposes of FDIC protection, money market funds are considered securities, not cash.

The SIPC protects up to $500,000 per investor, per firm, and coverage kicks in if your brokerage fails and cash or securities are missing from your account. Note that the cash coverage tops out at $100,000. While brokerage failures are extremely rare, they are not unheard of, and SIPC participation is something that all reputable brokerages should offer. Again, if you’re unsure about whether your brokerage is covered, check your latest statement or call your broker.

If your time horizon is 5 years or more, then buy equities

If you’re a contrarian with time to ride out the current volatility, then now may be a good time to buy—but don’t try to pick an industry sector or even a region. Instead, go global. The fact is that one of the broadest measures of the global stock market—the FTSE All-World Index—is off about 30 percent since last year. Vanguard’s Global Stock Index Fund tracks this index, and iShares has recently launched a host of global ETFs, including the Global 100 Index Fund, which tracks international mega-cap companies, and the MSCI ACWI ex U.S. Index Fund, which excludes U.S. companies.

Of course, there is no way to predict the future direction of the market, but we do know from ample historical data that the trend over the long term is upward. Even if the current woes in the U.S. financial sector ripple out to the global economy, it’s unlikely that the entire world wouldn’t have regained its footing within five years.

Factor a weakening dollar into your strategy

Will all the money the Federal Reserve and Treasury Department have been pouring into the financial sector lately (not to mention the giant budget deficits the federal government has been running); it makes sense for every long-term investor to factor a potentially weakening dollar into long-range forecasts. When the government has to print more money—or lower interest rates—the dollar tends to fall against other world currencies. For many years, economists have discussed the possibility that the euro, the currency of the 15-nation eurozone, could displace the U.S. dollar as the world’s preferred reserve currency and medium of international trade. While that is still unlikely, the current financial upheaval here in the U.S. is sure to spark renewed discussion of an ascendant euro.

Gold is a traditional hedge against a weak U.S. dollar. Keep in mind, however, that the futures market for this precious metal is volatile and funds or ETFs that invest in gold miners (or gold bullion) should only make up a small fraction of overall portfolio assets. Because foreign currencies by definition rise when the dollar falls, an international bond fund or ETF that invests in a basket of foreign currencies would also serve as a good hedge against a weak greenback while minimizing some of the volatility of a gold or single-currency investment. The PowerShares DB G10 Currency Harvest Fund tracks an index of nine foreign currencies as well as the U.S. dollar. The fund’s value has declined recently because of bets against the U.S. dollar.

Don’t forget tax-loss harvesting

For investors, particularly those with investments in the U.S. financial sector, this year may be a particularly good one for tax-loss harvesting, the practice of realizing capital losses to minimize taxes. You may apply an unlimited amount of capital losses to offset your capital gains. In addition, if your capital losses exceed your capital gains, you may apply of to $3,000 of that amount against your ordinary income; additional capital losses can be carried forward into future years. For more information, consult with your investment adviser.

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Stocks managed to gain ground yesterday as investors looked ahead to a federal bailout for troubled insurer American International Group. The Dow Jones Industrial Average finished up 142 points, or 1.3 percent, closing at 11,059. Shares of AIG swung wildly on enormous volume of 1 billion shares as rumors of a government rescue plan worked their way through the market. The S&P 500 gained 1.8 percent to finish at 1,214, and the Nasdaq Composite Index advanced 2.3 percent, ending the session at 2,208. The $85 billion rescue plan for AIG finally came through after the market had closed.

Fed watchers, for once, were divided on what Federal Reserve Chairman Ben Bernanke and his colleagues would do yesterday when they met to set interest rate policy. The central bank ultimately decided to leave the federal funds rate unchanged at 2.0 percent in the first unanimous decision of the year. The Fed’s restrained statement—it made passing mention of “strain” in the financial system—was belied by its actions throughout the day. The Fed and its district bank in New York flooded the banking system with nearly $100 billion in cash to keep things moving.

Central banks around the globe followed suit. The European Central Bank alone injected $100 billion worth of euros into the 15-nation eurozone in order to maintain suitable liquidity conditions. These drastic infusions were necessary in the wake of Monday’s global stock sell-off and the evaporation of almost all excess cash in the world’s capital markets. In the U.S., the federal funds rate—the interest on interbank overnight loans—soared to 6.5 percent as financial institutions began losing confidence that even these brief, 12-hour loans would be repaid. The Federal Reserve’s target for these loans is 2 percent.

Despite the government’s unprecedented intervention in the private (and quasi-private, in the case of Fannie Mae and Freddie Mac) over the past several months, investors are still wary. Stocks fell in early trading today as the Commerce Department reported that new home construction plunged 6.2 percent in August, to the slowest pace since the recession-plagued days of the early 1990’s. The current financial crisis, of course, has its roots in the U.S. residential real estate market, which entered what most economists now agree was a “bubble” phase in the late 1990’s, when home prices spiked far above their long-term average rates of growth. When that bubble burst earlier this decade, the giant mortgage-backed securities market that had been built around it also began to crumble.

One bright spot amid the wreckage on Wall Street has been the price of oil, which continues to slide, falling below the $100-per-barrel threshold on Monday for the first time in 6 months. Energy traders are betting that the current financial crisis could ripple out into the broader economy and decrease petroleum demand in the coming months. Helped by the slide in oil prices, the closely-followed consumer price index fell 0.1 percent in August, the first time in two years the gauge of retail prices has showed a decline. The core CPI, which strips out food and energy costs, rose 0.2 percent. Look for inflation to decline further in the coming months.

Today’s focus of investor anxiety is Washington Mutual, the giant thrift that is also one of the largest mortgage originators in the U.S. The Associated Press reports that federal regulators have been quietly pressing healthier private banks to throw Washington Mutual a lifeline. Shares of Morgan Stanley and Goldman Sachs, the only remaining independent Wall Street firms, are also trading sharply lower today as investors speculate on what the future holds for the storied firms. Both Morgan Stanley and Goldman Sachs posted quarterly profits earlier this week.

Dion Money Management offers managed account services for your IRA, Roth IRA, 401(k) and other retirement accounts. Call one of our Portfolio Strategists at 800-432-7447, ext. 191 to learn about the benefits of our managed account program.

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Oil prices plunged yesterday as traders unwound bets that Gustav—once a category 3 hurricane and now just a line of thunderstorms—would knock out energy production in the Gulf of Mexico. The drop in oil dragged down energy stocks, along with the broader market, and the Dow Jones Industrial Average slipped 27 points, or 0.2 percent, to 11,517. The major market gauges had been up around 1 percent each earlier in the session, but concerns over slowing economic growth squelched that early rally. The S&P 500 fell 5 points, or 0.4 percent, to 1,278, and the Nasdaq Composite Index gave back 18 points, or 0.8 percent, to close at 2,349.

The front month contract for the benchmark grade of crude oil fell 5 percent in New York trading yesterday to settle at just under $110 per barrel, but the sell-off in oil did little to cheer investors. While many analysts were predicting over the summer that oil in the $100 to $105 per barrel range would be bullish for stocks, investors now appear to be concerned that the steep drop-off is a sign that the global economy is slowing down too rapidly.

The Commerce Department said this morning that factory orders rose 1.3 percent in July, led by a sharp uptick in demand for commercial aircraft and heavy machinery from U.S. manufacturers. The July data follows an even stronger performance by the manufacturing sector in June, when the overall number of orders jumped 2.1 percent. The relatively weak U.S. dollar has made exports more competitive and helped offset sluggish demand in the domestic market for big-ticket items like automobiles and household appliances.

While the Commerce Department’s data has shown growth in factory orders for five consecutive months, another important industrial indicator, the Institute for Supply Management’s manufacturing index, fell slightly last month, from July’s reading of 50.0 to 49.9 in August. Any reading below 50.0 indicates contraction in the sector. Despite tipping into official “contraction” territory, there was some good news in the latest ISM data. The price pressure on manufacturers eased considerably last month, with the index that measures manufacturing inflation falling from 88.5 to 77.0. Although still inflationary, the decline in the price index for August represented the biggest drop since 2006. The reading primarily reflects lower energy prices. Additionally, the new orders index increased from 45.0 to 48.3.

The financial sector is still struggling. Fitch Ratings downgraded the preferred stock of Fannie Mae and Freddie Mac yesterday. Bailout rumors have swirled around the troubled government-sponsored mortgage giants since this summer, as investors grew concerned that Fannie and Freddie didn’t have enough cash to meet their short-term obligations. Lehman Brothers, which will post quarterly earnings later this month, is reportedly shopping its lucrative money management business around in a bid to bolster its capital cushion. Most analysts believe Lehman is the weakest of Wall Street’s remaining four investment banks.

On Friday, the Labor Department will report employment data for August. Payrolls have declined for seven consecutive months, and economists are calling for a loss of 75,000 jobs in August and for the overall rate of unemployment to edge up 0.1 percent to 5.8 percent. In addition, the Institute for Supply Management releases its service sector index on Thursday. Analysts who follow the so-called “non-manufacturing” index are looking for a reading of 50.0, a gain of 0.5 percent from last month.

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All of us have goals. Whether we want to be healthier or wealthier, or advance in our careers or our education, we need some way to keep track of our progress. When it comes to our investments, of course, we tend to pay the most attention to that all-important line at the bottom of our brokerage statements. When the markets are down, however, as they have been for much of the year, that monthly review can become an exercise in discouragement. It’s easy to get frustrated. Many of us may be thinking about heading for the safety of cash or bonds. Some of us may even be contemplating selling a primary residence or even putting long-awaited retirement plans on hold while we build up our nest eggs.

In a turbulent market, managing our expectations can be as important as managing our portfolios. By staying focused on our long-term goals and keeping the emotion out of our decision-making, we can avoid making costly and far-reaching mistakes.

It’s important during challenging markets to keep in mind that even the best professional investors in the world don’t always hit their marks. Consider the fact that Warren Buffett, the fabled “Oracle of Omaha” whose stake in Berkshire Hathaway—at $62 billion as of February 11, 2008—makes him the richest person on the planet according to Forbes magazine, trailed the S&P 500 for several years in the early 1970s. As recently as 2003-2005, Berkshire Hathaway shares underperformed when compared against the most widely-followed benchmark of U.S. equities. If Warren Buffett can lag the market, then all of us not only can—but inevitably do, too. In fact, the top professional money managers only beat the S&P 500 around 60 percent of the time.

As we know from the field of behavioral finance, it’s simply human nature for us to feel the pain of portfolio loss more acutely than we experience the joy of a gain. Researchers who have been able to measure these emotional responses with experiments have demonstrated that a pecuniary loss “hurts” about twice as much as the pleasure we derive from a growing bottom line. Behavioral finance has implications for better investing. To avoid losses, we tend to act in irrational ways, such as selling out of a stock or mutual fund during a period of underperformance—often just before the performance begins to improve. Armed with this knowledge, we may be better able to control the emotions that so often lead to poor investment decisions.

The first and most important step toward keeping overall investment performance in perspective is simply to acknowledge that portfolio performance is going to decline occasionally. From 1969 through 2007, for instance, the S&P 500 had an annualized return of 10.5 percent, although it actually lost ground in 9 of those 39 years. Investors who managed to hang on through those down years would have been rewarded with healthy gains over the long term. Selling during those down years would have locked in losses, triggered taxes and transaction fees and could have made it more difficult to recover lost ground later on.

If you manage your own portfolio, then it’s important to be realistic about what you can accomplish while also balancing work and family. Many of us who have underperformed the markets on our own often turn to professional money managers for help, thinking that they’ve got all the answers. But as the example of Warren Buffett above amply demonstrates, even the best investors in the world don’t always get it right. While there’s no doubt that the education and training of a professional can give investors an advantage in building an outperforming portfolio, perhaps one of the most valuable services a professional money manager provides is an emotional distance from our investments that keeps us from making the poorly-thought-out or hasty decisions that may “feel” right but end up costing us dearly down the road.

To paraphrase John Bogle, the founder and CEO of the mutual and exchange-traded fund company Vanguard, there is a difference between speculation and investing. Speculation means placing most or all of your money on a few risky stocks, timing the markets, and playing your hunches. In short, speculation is gambling with your future. Investing, by contrast, means staying diversified, remaining fully invested even when the markets are down, setting long-term goals and formulating a strategy to get there.

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