What I'm Telling My Clients Now

A top advisor scopes out the contours of the impending market bottom, then reviews implications for the range of client-types he advises. Check his approach against your own. And tell us what you think.

Barring any near-term recoveries, 2008 will likely go down as one of the worst years for stocks, domestic and foreign, since the Great Depression. Unfortunately, the other asset classes—real estate, commodities, and even many bonds—have also performed poorly. None of this is news to our clients. The question is what do we as advisors do now, given the near-term uncertainty around when the market will bottom out.

Much depends on each individual client's financial situation and emotional constitution, of course. But here's what I'm telling my clients now.

Gaining perspective
The longest recession since World War II has been about 16 months. Assuming the present recession started early in 2008 and it matches or slightly exceeds the longest postwar recession, it might be late spring to late fall 2009 before economic recovery begins. Since a stock market rebound typically precedes economic recovery, the market could rebound before then; historically, it's turned up 60% of the way through a recession.

While it would be reassuring if we were at or near the bottom, we recognize the strong possibility that declines could worsen. The recent stock market swoon likely anticipated a significant drop in corporate earnings. But when revised earnings estimates and actual earnings reports come out over the next month or two, there may be further equity declines with these negative reports. Also, we know it's as normal for the stock market to overshoot on the downside as it does on the upside.

While no one knows for sure if we are getting close to a bottom, some of the more noteworthy market experts are beginning to see buying opportunities.

Bullish Buffett. The billionaire chairman of Berkshire Hathaway, Warren Buffett, has already started buying American stocks that he thinks are undervalued. In a New York Times op-ed piece on Oct. 17, he wrote that, "Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: 'I skate to where the puck is going to be, not to where it has been.'"

Of course, even the Oracle of Omaha can be wrong—or at least ahead of the curve.
Looking-Up Leuthold. Steve Leuthold, the usually bearish investment manager for the Leuthold Group, was recently interviewed by Barron's magazine. His firm looks at 28 different factors including price-to-earnings (P/E) and price-to-sales ratios, and they are quite positive, in his opinion. He notes that the P/E ratio is in the 15th percentile over the past 55 years, and that has been where markets have often bottomed out. He believes that on a valuation basis the market is cheap. He likes both domestic and non-domestic stocks.

Going-Global Grantham. Jeremy Grantham of the investment firm GMO is convinced that by October 10, global equities were as cheap on an absolute basis and cheaper overall than at any time in 20 years. In his two-part quarterly report, Grantham explained that while foreign stocks are even cheaper than domestic stocks, American equities were also cheap when the S&P 500 was at 900. Recently, the S&P dropped as low as 818. Lest you get too excited, he acknowledges that markets tend to overreact both on the upside and the downside. Thus, while the S&P might look cheap at 900, he thinks it could go lower. It's noteworthy that he is buying even though he thinks the market could go down significantly further in the short term.

Changing economic reality
In addition to market expectations, Grantham's quarterly report offered a number of predictions about the economy over the next few years. He believes that as we unwind from indebtedness, the economy will look more like it did 30 years ago, when people actually "waited until they saved some money before buying a new TV set."
As individuals and companies reduce debt over the next 10 years, the economy will experience further downturns in spending, which will depress prices—both in real and financial assets. "Topping off all the off-setting virtues of this ugly last year is the arrival of cheap assets," Grantham writes. He concludes that the S&P 500 will likely bottom out in the 600-to-800 range. If so, conditions may get worse before they get better. However, he is not trying to time the bottom, but rather is looking at this as the beginning of an opportunity to buy assets at attractive prices.

So what does this all mean to clients?

We can't lose sight of clients' time horizons and investment needs as we assess all this market-related analysis. With that in mind, University of Chicago professor John H. Cochrane, in a Wall Street Journal article entitled "Is Now the Time to Buy Stocks?," offered sage advice:
"If you're less leveraged, less affected by recessions, and have a longer time horizon than average, it makes sense to buy. If you're more leveraged (i.e., indebted), more affected by recession, or have a shorter horizon, it might be time to sell—even if you might be cashing out at the bottom. If you're about the same as everyone else, do nothing and relax." Easy for an academic to say.

Reassuring clients
Mark Berg, a financial planner in the Midwest, described the impact of this recent market trauma on his clients. Approximately 20% see this decline as a buying opportunity and agree with Warren Buffett's timeless advice to "be fearful when others are greedy and be greedy when others are fearful." But another 20% of his clients are terrified. These are the people who are retired or near retirement. Most of these clients simply wanted to hear a voice of reason that counters the doom and gloom of the media.
At my firm, Covenant Wealth Advisors, we have called all of our clients. A small percentage are frightened, many are anxious, and a few see this as a buying opportunity. Just as Professor Cochrane described different paths for different clients, we are helping our clients look carefully at their specific situation.

Are they retired?
Are their jobs secure?
Do they have any major upcoming expenses that can't be deferred?

While we don't expect most clients to relax, we do advocate patience, as tough as that can be during this time. Like most advisors, we consider "staying power" when developing an investment strategy. Before people should commit any money to the stock market, they need to have adequate reserves set aside for emergencies and financial commitments. The ideal investment time horizon should really be seven to 10 years. Or even better, the rest of a client's life.

If the client's financial situation is secure, we then turn to his or her emotional comfort levels, asking the following:
Has this downturn made you realize you aren't as risk tolerant as you thought?
If so, should you change your portfolio mix now?
Generally, if clients can wait financially and emotionally, we suggest not making any drastic changes.

What we're doing now
For many clients, we will temporarily hold off on further rebalancing. Thus, a 50/50 stocks-to-bonds portfolio that may have drifted to 45/55 or 40/60 due to stock declines will be left as is, effectively making it a little more conservative for now. For more aggressive clients who remain growth-oriented and still have a long-term horizon, rebalancing probably continues to make sense.

For conservative- and moderate-growth clients, we are tweaking the fixed-income investments and getting a little more conservative, giving up some longer-term potential benefits in exchange for reduced short-term volatility. For example, we will probably reduce or eliminate some of the exposure to foreign bonds.

We have looked at every client account for opportunities to harvest unrealized tax losses—losses that can be used to offset any gains or up to $3,000 or ordinary income. We are looking at opportunities to transfer funds from IRAs to Roth IRAs for clients who have little income or significantly less income than normal this year.

Reviewing client withdrawal rates
The clients most impacted by this economy and stock market decline are those that are retired. To the extent that clients' withdrawal rates exceed a prudent level (3%-5% depending on age), this will be a very challenging time. We have been reviewing client withdrawal rates.
One of the benefits of diversification is that many of our clients who are retired have 50% or more in fixed-income-type funds. While fixed income doesn't mean guaranteed income, fluctuation is much less than that seen in stocks. The best strategy for retirees drawing on their portfolios is to tap those assets that haven't declined significantly first. In other words, we draw from money funds, short-term bond funds, and longer-term bond funds.
We have run projections for all of our clients taking periodic or sporadic withdrawals to see how long they could tap fixed-income assets before having to sell equities based on the current withdrawal rate. We discovered that on average, our clients could tap their fixed-income investments to cover their monthly withdraws for 15 years before having to sell significant portions of their equities in a down market. Of course, this strategy will gradually make the remaining portfolio more aggressive as the fixed-income portion is a smaller component of the portfolio.

Clients who are withdrawing funds either periodically or sporadically should consider how the market decline has increased the rate of withdrawal. If they have been taking out more than 3%-5% before the market decline, that rate, as a percent of the current value, is now higher. If clients have exceeded our recommended withdrawal rate and have been taking out more than 5% before the recent stock decline, we strongly recommend that they look for ways to cut back on expenses, particularly any discretionary spending. For example, if they were taking out 7.5% per year and the portfolio has declined by 26%, their current rate of withdrawal is now more than 10%. This is not sustainable for a long life expectancy.
We have made a special point of contacting all our clients who are taking out more than what is prudent. We've also encouraged those giving money to adult children to carefully weigh the impact on their own finances. Our philosophy is Mom and Dad first, adult children second. (Not all our clients agree with us on this, but that's what we think.)
In a few cases, where a prudent withdrawal rate doesn't cover expenses, a retiree might consider putting a portion of the portfolio in an immediate annuity. An immediate annuity can provide a guaranteed income, with the downside being that when a client dies, heirs may receive less money. We are careful about which insurance companies to choose, since these policies lock clients in for life and some insurance companies aren't as financially strong as others.

In conclusion
We spend a lot of time discussing risk tolerance and time horizon with our clients. We try to anticipate potential downside risk so that clients aren't shocked when market declines occur, as they inevitably will. This decline is what is referred to as an outlier. It is likely to be in the worst 5% to 10% of market results, falling outside the normal range, with perhaps a one-out-of-20 probability.
We encourage clients to call us for an appointment before our annual review should they be overly concerned. We want to give them perspective during difficult times. We know that market declines take an emotional toll, and we let them know we're here to help them handle it.