Tuesday, April 1, 2008

You Can't Fight the Fed!

From the Desk of Joe Rollins

As I am sure all of you are painfully aware, the first quarter of 2008 was a tumultuous one from an investing perspective. A great deal of the news regarding the state of the financial markets and the banking institutions seemed to be sensationalized, and so I was not completely surprised when it eventually took its toll on the stock market, impacting our returns for the first quarter of 2008. The purpose of this memo is to provide you with our thoughts on the financial events we are experiencing at the current time.

First and foremost, what is happening in the stock market right now is neither unusual nor unanticipated. From 2003 until 2007, we enjoyed extraordinary returns on our total portfolio under management of 108.1% before advisor fees. Remember that this percentage does not represent our best performing portfolios only; it is the average percentage of our total portfolios under management. For the same time period, the S&P 500 index return increased 81.6%.

Rollins Financial’s total portfolio under management has had five consecutive years of double-digit returns. It is not atypical for the stock market to decline after such a long period of positive returns. For the first quarter, our total portfolios have averaged a loss of 8.1% as compared to the S&P’s loss of 9.4%. The Dow Jones Industrial Average was down 7% for the quarter and the NASDAQ Composite was down 13.9% for the quarter.

The United States economy suffered severe economic blows during the first quarter of 2008, but the governmental agencies are certainly doing their part to nurse it back to health. Our Federal Reserve has taken remarkable and unprecedented swift actions to alleviate the liquidity issues due to the perceived credit problems. I believe we will see positive reactions due to those actions by the Federal Reserve.

Historians interested in the stock market quickly discover that it is unwise to invest against the Federal Reserve. The Fed is simply too big and too strong, and its impact on the economy cannot be ignored. The Fed’s cutting of interest rates over the last six months from 5.25% to 2.25%, and its injection of over $1 trillion into the economy, will have a hugely positive economic effect on our economy. While none of us know whether the country will ultimately fall into a recession, as an investor it is important that you understand that the Federal Reserve has already moved to stabilize and improve the economy. An investor would be ill-advised if he or she attempted to invest against the Federal Reserve.

With the government’s reduction of key interest rates, cash is currently an underwhelming performer. Over the last four or five years, the returns for cash have been a true competitor to stock market investing. In fact, in many cases, CD’s outperformed the S&P 500 index last year. No longer will that be the case. Interest rates are falling like rocks and investors will soon see money market rates in the 2% classification. As more investors realize cash is not earning enough to even keep up with inflation and can only provide negative returns, that money will migrate back into stock market investing.

The first quarter of 2008 was somewhat bifurcated in that virtually all of the losses were incurred during the first two and a half weeks of January. At the start of the New Year, there was a massive rotation of portfolios which essentially brought down all mutual funds. At Rollins Financial, we were also heavily trading on our portfolios during this timeframe. We reallocated the entire portfolio to remove some of the highly volatile mutual funds and instead invested in less erratic funds. Additionally, we moved out of many of the growth positions held in the portfolio and into more conservative investments that might gain during a net interest rate reduction. Our moves proved to be successful by the end of the quarter; our total portfolio actually wound up making some money from late January through the end of March.

The first quarter was also peculiar in that nearly all actively managed mutual funds incurred losses. In most cases, those mutual funds had losses greater than the S&P 500’s loss for the quarter – but losses were not isolated among stock mutual funds. High yield bond mutual funds in almost all types of high yield investments lost money this quarter. The only mutual funds that made profits during the quarter were mutual funds dominated by government-backed securities. However, even those gains were completely muted from an investment standpoint.

Fidelity Investments offers 41 diverse select mutual funds that allow you to choose the sector you believe will do well for the quarter. Interestingly, during the first quarter of 2008, only two of those 41 select funds actually had positive returns: gold provided a limited return of 4.9% and natural gas had a positive return for the quarter of 1.2%. The other 39 select funds all had losses, many of which had losses in the double-digits. Clearly, this illustrates that the first quarter, from an investment viewpoint, suffered broad-based losses and none of which were in any particular sector or asset class.

Even though the U.S. economy has slowed, the worldwide economy continues to boom. The economies of Asia, South America’s and many other economies in the world were bolstered by the world’s need for natural resources, and they continue to explode upward. While some economies will be influenced by the decline in growth in the U.S., it is highly unlikely that this decline will significantly affect their explosive growth. For that reason, we anticipate that we will continue investing in international funds for years to come.

I recognize that the first quarter has been difficult and frightening for investors. However, I do not believe that what we are experiencing is the first step in a long downward spiral. It is clear that the Federal Reserve is on the job and intends to solve the problems concerning the economy in short order. In my opinion, it is likely we will see the positive effects of the Fed’s moves sometime in the third quarter of this year, which will likely coincide with the Presidential election.

It is interesting to me that when stocks are cheap (as they are now), investors often ignore the buying opportunity. However, when stocks are expensive, investors seem to rush to participate. Right now we have some of the most amazing stock buying opportunities in history. I encourage you to look at your portfolio and add to it during the upcoming quarter so that you don’t miss the boat. This is also the perfect time to make your IRA contributions.

As always, if you would like to discuss this matter further or meet with any of us individually regarding your portfolio, please feel free to give us a call. Best regards.