Source: Frontier Asset Management

History says stay the course, don't panic

By JOHN WYCKOFF

article created on: 2008-11-01T00:00:00

“These are the times that try men’s souls.” These words, written by Thomas Payne in 1776 in his series of pamphlets “The American Crisis,” seem apropos for today’s American financial crisis. The year has been difficult at best as we have lurched from one dramatic event to the next.

My advice to clients—even in the face of the headlines about plunging stock market indexes and massive credit crises is “Stay the course. Stick with the plan and don’t panic.”

Emotions such as fear and panic are not your friends in today’s markets. Even so, all of us feel out of control when what we face is frightening, inexplicable and important. This is totally normal.

A credibility gap
Fundamentally, our economy runs on cash (credit) and confidence. The current credit crisis began as millions of homeowners defaulted on their mortgages, some of them being the toxic debt that showed up on financial institutions’ balance sheets. Financial institutions holding these toxic assets were forced to write them down and suffered enormous losses, leading to an industry shakeout, some consolidations and government intervention.

In recent weeks, confidence has disappeared and banks have stopped lending money to each other—and to businesses who borrow short-term for operating capital. When you hear about credit markets freezing, that’s what they mean.

Many businesses of all sizes, even those on sound footing, rely on short-term loans to purchase inventory, make payroll, or otherwise operate while waiting for accounts receivables. This short-term lending takes the form of commercial paper and helps sustain cash flow.

When the market for commercial paper dries up, as we were starting to see, these businesses need to take other action such as layoffs, cutting back on investments or delaying expansion.

These actions have a more deleterious effect on the general economy. The Federal Reserve took action recently by agreeing to buy commercial paper, thus improving access for businesses to much needed short-term money.

The bailout

On Oct. 3, Congress passed the Emergency Economic Stabilization Act of 2008. The centerpiece of the legislation, The Troubled Asset Relief Program (TARP), is the $700 billion authority to purchase troubled assets from financial institutions. This takes direct aim at the root cause of the U.S. turmoil—bad mortgage assets that have choked off the flow of credit.

First, the program is designed to purge impaired assets from the balance sheets of lending institutions.

Second, it provides massive resources to facilitate a recapitalization of the financial system by government purchase of preferred shares in financial institutions.

Importantly, one of the stipulations in Treasury Secretary Henry Paulson’s plan for recapitalizing banks is that they use the new capital to make loans to get money moving around the economy again.

Other provisions are primarily focused on guaranteeing bank deposits and money market mutual funds, preventing foreclosures, providing oversight and minimizing the cost to taxpayers.

These are crucial steps to take in a time of economic crisis. Believe it or not, our current situation is not something radically new, nor is it unprecedented. Government-led financial rescues have happened many times, even though governments do not interfere lightly. That’s why these programs are temporary in nature.

The broad objectives of replacing troubled assets with an enormous infusion of money are consistent with the essential ingredients of past successful crisis-response programs.

Previous crises have shown us that when the financial system no longer functions properly, the quicker that public money is injected into the system to replace bad assets, the less painful the impact will be on the broader economy—and the faster a recovery can become possible.

There are plenty of historical examples that show that the faster we move to dispose of bad assets, the less likely it is that a financial crisis will become a decades-long catastrophe.

Be patient

But don’t expect the passage of the rescue bill to spur an immediate rally. We could see things get worse before they get better.

Recognizing market downturns as a normal part of the economic cycle is the first step to surviving market turbulence. Of course, it is human nature to forget downturns as soon as we can.

Let’s take a look to gain some perspective.

There have been 12 bull markets and 12 bear markets since 1942. Thankfully, the bull markets are typically longer and stronger than the bears.

Since 1942, the average bull market lasted 1,625 days and brought a 150-percent increase in the market. The average bear lasted 393 days, with a decline of 31 percent.

No one knows what the market will do when the current bear ends. But history shows that the market will eventually regain its footing and move forward. While it may be difficult to stay the course, the market historically rewards those who persevere with solid returns.

John Wyckoff (CPA/PFS, CFP®) responsibilities at StanCorp Investment Advisers include developing and implementing financial plans and managing investment portfolios for individuals and families. He has been providing personal financial planning and investment advice for the last eight years, and his experience includes more than 30 years as a CPA. John earned his Certified Financial Planner designation in 2002 and his Personal Financial Specialist designation in 2001. John has a degree in Sociology and an MBA from the University of California, Berkeley, and a Master of Taxation degree from Portland State University. John can be reached at 971-321-8090 or jwyckoff@standard.com.