| An eNews Update to our Quarterly Newsletter |
May 2008
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Recent financial headlines have been scary. Hundreds of billions of dollars melted away from bank balance sheets. Household names such as Citigroup, Bear Stearns and even National City have all been hit hard. The weakness in financial stocks has impacted the rest of equity markets. In times like these, balanced portfolios, and bonds in particular, become every investor’s best friend. Bonds are generally much appreciated for providing a dose of stability in uncertain times. However, not all bonds were up to the task of providing the stability investors expected. With liquidity drying up, various financial institutions were forced to liquidate even solid investment grade bond inventories. Municipal bonds also struggled, as their insurers suffered from the insolvent mortgage backed securities they were also in the business of insuring. How did our clients’ bond portfolios fare in the current financial storm? Our clients’ taxable bond portfolios actually did well through the crisis. We have continuously evaluated the main drivers of economic activity as part of the ongoing asset allocation process and have defensively positioned bond portfolios ahead of time. The ongoing analysis performed has uncovered some useful background information. The 2001 recession was short-lived. Consumers never stopped spending despite the burst of the dotcom bubble and stagnant wages. The main source of consumer resilience turned out to be mortgage refinancing - home prices started to rise, fueled by stubbornly* low interest rates. By 2006 we have become increasingly concerned with the speculative nature of rapidly accelerating residential property prices. We have evaluated the possible consequences of a potential unwinding of speculative residential real estate investments and concluded it could have a profoundly negative effect on the overall economy. As a result, we have taken the following defensive measures with clients’ bond portfolios:
As an example, one of the bond managers that earned our trust over the years established a proprietary “Housing Project” task force back in 2003. The task force quantified the disconnect between house prices and economic fundamentals, as well as the broader implication of a potential sub-prime loan meltdown. Additionally, the bond manager hired the consulting services of the former chairman of the Federal Reserve board, Alan Greenspan, for additional insights into the Federal Reserve’s potential action. As a result of these combined efforts, our clients’ taxable bond portfolios performed the job they were intended to perform without surprises. They were properly positioned to weather the current financial crisis. Where do we go from here? We believe the beginning of an economic turnaround to be imminent only once a price floor becomes apparent under residential property prices. The value of financial instruments based on insolvent mortgages ultimately hinges on the value of the residential property it was based on. While residential property values continue to sink in muddy waters and the bottom of the lake cannot be seen, the liquidity crisis will continue. How are we going to position portfolios in light of such developments? One of our primary responsibilities is to protect hard earned client assets. We will continue to rely on the fundamental values of the economy to guide us. We believe the unraveling of the real estate market and sub-prime mortgages has created good investment opportunities in many areas of the market. We will gradually shift assets from Treasuries into other high grade bonds that have been heavily discounted. Many such high grade bonds became the innocent victims of the current crisis. We will also reduce exposure to developed nations foreign currencies. We believe exchange rates may soon reach a cyclical point of inflexion, as interest rates in Europe and the US may shift direction at some point in the not so distant future. On a cautionary note, we currently view assets based on certain commodity prices as being in danger to follow a path similar to the dotcoms of 2001 and the sub-prime mortgages of 2008. Investors typically get in trouble by piling in investments that worked very well in the recent past. The implication that somehow last year’s good returns will be the driving force behind next year’s hopefully similarly pleasing numbers is often as false as it is dangerous. There is no causal relationship between past and future returns, with maybe the exception of the very last stage of a particular cycle. In these final stages of a cycle, investments are no longer supported by fundamentals – they become self feeding glorified Ponzi schemes. At Fragasso Financial Advisors, we work hard to keep investors away from the “Ponzi scheme” trap. * Fixed mortgage rates are based on 10-Year Treasury rates. 10 Year Treasury rates remained “stubbornly” low due to global market forces: surplus savings of exporting countries such as China or OPEC nations were invested right back into US Treasuries. The increased demand for US Treasuries pushed bond prices up and yields down.
This article is for informational purposes
only and not intended as financial advice. Consult your financial
advisor to determine what is appropriate for your situation. If you have any comments, questions or suggestions concerning this
electronic newsletter, please email us at fgi@fragassoadvisors.com.
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