This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Tuesday, September 8, 2009

Recession’s impact magnified by credit crunch

Debt. The very word by now should make your eyes water and the hair on the back of your neck stand on end.

We all know how it works; buying something today and paying for it tomorrow rather than saving today to buy tomorrow. And, most importantly, we know the disastrous effects it can have on a nation and a global economy.

For years leading up to the financial crisis of 2008, the United States’ consumer savings rate had been negative. That means that, in aggregate, more money was borrowed by Americans than was saved. It means that our country, from sea to shining sea, was running completely and totally on borrowed money — and borrowed time, as the saying goes.

The bill for all that debt finally came due in 2008, and in the blink of an eye credit tightened up tighter than a snare drum. When that happened, when the system couldn’t even get the credit to run on a day-to-day basis, the whole thing came crashing down.

Depressed yet? Well, don’t be. Despite the double-digit unemployment and daily headlines about protest after protest, topped off with a wave of bankruptcies, the truth is that this recession hasn’t been all that bad. Unfortunately, it has been magnified immensely by the credit crunch we experienced in the fall, and the ensuing financial crisis.

Now, months later, with the market having staged an excellent rally and the economic numbers starting to turn up, it has become apparent that the system is stabilizing.

After such a sharp decline, the U.S. economy and stock market are simply resetting, but at lower levels, since there isn’t enough debt left in the system to support the old highs in the market. The destruction of all that debt over the past year has just proven extremely … messy.

Living on a prayer

But have ye faith. The economy and the stock market — and your 401(k) — will return to their old highs. It may not happen for some time, so if you’re waiting for the Dow to get back to 12,000 so you can sell everything and move to Tanzania, you might not want to hold your breath.

The economy will recover — in time. And we can add a third line to that short list of things we know in life that are absolutely certain, right under death and taxes. That is this recovery will most definitely not be built on credit.

It may not even be consumer-led. With American consumers still in the process of getting back on their feet, it’s quite likely that, in this economy, consumers are going to take a backseat for a while, and let business drive. As discussed in the article, “Recovery in the making but danger still abounds,” nonfinancial U.S. companies are sitting on (hoarding) and unprecedented $14 trillion in liquid assets.

With a year’s worth of U.S. Gross Domestic Product in cash, this economy could be turned around in remarkably little time. Of course, that turnaround would be predicated on the right policies coming out of Washington and providing the necessary incentives – not penalties – for companies to invest some of that cash in expansion projects.

Those policies would include tax cuts (abatements at the local level simply won’t cut it), general deregulation (e.g. employment rules) and cheaper energy. Cheaper energy is a hot issue, especially with cap and trade coming up for a vote.

Priorities

Focusing for a moment on the economic climate, the most important objective in Washington should be making the United States self-sufficient for all its energy needs. This would contribute to the ultimate goal of keeping energy affordable, since energy dependence leaves this country at the mercy of energy providers, OPEC and the like.

Lately, it seems nearly impossible to check the headlines without noticing political turmoil, especially within this country. Between cap and trade and now health care reform, there seems to be a growing tension that there is somehow a battle waging between good and evil in this country. That President Barack Obama and Speaker of the House Nancy Pelosi want to bankrupt America, or that Rush Limbaugh and Glenn Beck want to burn down D.C. Neither of these could be further from the truth.

The bottom line is that liberal or conservative, Republican or Democrat, no group cares any more about America than the other. It’s just that when it comes to this country, each has a totally different vision of what the finished product looks like.

Conservatives want to save the economy through pro-business policies. The general feeling is that in order to allow the American working man to pull himself up by his bootstraps; the government needs to kindly step off his back.

Likewise, liberals tend to want desperately to help out the less fortunate, who have been made even more so by the current economy. They hope to capitalize on this opportunity to radically reform the role of U.S. government; to put systems in place to keep the little guy well-stocked on fish, rather than lifting regulations that make a rod and reel overly expensive.

Bottom line

The fact is that after the events of the last year, the current landscape — political, economic, and investment — is totally different from before. As an investment adviser, I can tell you with complete confidence that there are certain ideas, previously accepted truths that have been completely discredited over the past year.

First and foremost, the theory of buy and hold simply doesn’t work anymore. Today’s world sees major changes on a daily basis in both domestic and international politics, various sectors of the economy on various scales and with conditions constantly changing, the market is simply too dynamic for this system to work.

If that doesn’t throw enough of a wrench into your portfolio, the second change finally being acknowledged by the financial community is that diversification doesn’t work. Why this is a surprise, I simply will never know. Even the academics who conceived the idea of diversification stated that it was never meant for real-world implementation (Markowitz, Portfolio Selection: Efficient Diversification of Investments, page 275). As Warren Buffett once said, “Diversification is a hedge against ignorance.”

As you are undoubtedly aware, the world we live in today is vastly different from what it was a year ago. If you don’t understand how this impacts your investments, you better make sure your adviser does.

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