CINCINNATI BUSINESS COURIER
October 26 – November 1, 1987
INVESTMENTS
Charles D. Vaughan
Wall Street – After the Crash
What to do Now
The earth rumbles an earsplitting roar, large stable objects shift and sway like toys in a tub; people are tossed about without violation, out of control. Large cracks in the most revered edifices and widespread casualties. The damage is massive, vertigo, nausea … finally, panic. EARTHQUAKE Richter 10! A major tremor in California? No but that’s what Wall Street seemed like on “Black Monday.” General numbness and disbelief how could it happen? As with any major disaster, the recovery process began, slowly and painfully. Regardless of ensuing market rallies, some of the damage is irreparable, and much of it is permanent.
The recovery is not unlike that in any major natural catastrophe. First priority is to protect life and property and to secure the essentials of living. Next comes sorting through the debris and assessing the damage. Then follows preparation for the inevitable aftershocks. Finally, recognition of the fact that life goes on and psychological healing begins.
Investors will need to go through these same stages to regain equilibrium of their financial plans. First is the need to cover outstanding margin loan obligations and assure that adequate cash flow continues. Next is the need to evaluate holdings to see what is left. Then comes the preparation for aftershocks and, finally, healing of memories.
Aftershocks from a stock market crash, based on historical precedent, can be many varied and long lasting. They generally come in two forms: loss of capital and loss of confidence. While they are interrelated, I will treat them separately. It is not my intention to add to the gloom of an already disturbing situation, but to provide some help by raising some potential problems and suggesting some possible solutions.
Loss of capital
Many hundreds of billions of dollars were literally erased from the asset columns in the world balance sheets in the past week. The tremor was felt not only in the U.S. markets, but in European and Asian markets as well. Combined with a huge drop of 25 percent plus in bond prices this year, enormous amounts of paper asset value have simply disappeared. The repercussions from this could be detrimental to the capital formation process in several ways.
The ultimate result might be a reduction of the economic growth rate to the further complication of the deficit dilemma. A slowdown in the inflation rate would bring about lower interest rates, but this, while comforting, could worsen commodity dependent Third World debt problems.
The damage to the equity markets may not be known for some time. But it is a cinch that some stock exchange floor specialists, over-the-counter market-makers and marginal brokerage firms took severe (possibly fatal) financial beatings. The ability to distribute and support new issues has undoubtedly been damaged. This might increase the cost of equity financing across the board, because even private placements are done on the basis of comparable public offerings.
Lending may become more stingy, as banks retrench on aggressive loans such as leveraged buyouts (LBOs), for two reasons. First, loan portfolios already precarious because of energy, farm and Lesser Developed Country (LDC) loans are now hurt by reduced values for stock exchange collateral. Second, a potential slowdown in the economy could threaten cash flows and debt service payments of existing borrowers.
Lack of continuing stock market profits would have a ripple effect on the economy, further reducing the amount of internally generated investment capital. The impact would be felt first in the area of high priced consumer and capital items. This could result in further layoffs in such industries as autos, which in turn could lead to a reduction in consumer spending generally. Should this occur, businesses in general might go into a cost cutting mode. The not result of this spiral could be a reduction in much needed tax receipts and a widening of the budget deficit. This would be happening at the very time a good Keynesian economist would look to increased government spending to stimulate the
economy.
Loss of confidence
The most lasting effect of the Crash of ’29 was in the minds of those who went through it. Much like those who experience a major earthquake, nobody who lived through it could ever forget it. No matter how solid the ground on which you stand at a given moment, you can never forget the time it went out from under you or the possibility that it could happen again. This time will be no different. Despite the amount of subsequent market recovery, the rules of the game have been permanently changed in the minds of all players. It could happen again!
For professional investors and institutional money managers, volatility and risk are interwoven. Increased volatility in the market universe increases overall risk in the equations. The net result is that many trust funds, pension accounts and other managed portfolios will make major reductions in their allowable commitment to equities, due to the increased risk level. Mutual funds likewise may have to brace for potential liquidations and switches out of equity funds.
A crisis tends to foster uncertainty, which in turn leads to increased caution. An attitude of “when in doubt, stay out” tends to become pervasive. Many investors will be looking for a rally to “get me even and get me out.” Even the most aggressive players will be alert for new tremors, a mindset toward protection rather than expansion in the markets could spill over into the total economy. Doubt is contagious.
What to do now
Look ahead, not back. What your portfolio was worth two months ago is not relevant. Playing “coulda,” “shoulda,” “woulda” is not only counterproductive; it can wreck your health! The key to solid financial planning is to prepare for the worst and be ready to accept the best. In repositioning assets, intelligent use of tax savings strategies is important, but only secondary to the total health of the portfolio. That means don’t be afraid to take a profit (or loss) if it is necessary to get your program into its optimum condition. In my opinion, the best ‘investment’ is a well designed and managed, diversified, balanced portfolio. This provides the best protection against unpredictable markets and performance acceptable to all but the most aggressive investors.
There are two basic types of investment: ownership (equity) and “loanership” (debt). You either own something and share in the profits (or losses) as with common stock, real estate and private business or you hold someone’s promise to repay borrowed funds with interest as with bank deposits, money market funds and bonds. There are some hybrid investments, but we will ignore them for now. Equity investments are usually valued on the basis of what other investors are willing to pay for them. So they tend to do well in expanding economies and usually grow with inflation. Debt investments, on the other hand, trade on the basis of their yield relative to their risk. They tend to do well in deflationary times (if they pay). The point of a balanced approach is to have a reasonable proportion of both types to hedge against economic fluctuations.
The distribution of assets in a given portfolio is the primary business of an investment adviser. I tend to favor a 50/50 balance most of the time for conservative investors. In the current uncertain markets, I would consider a mix of 40 percent equity (only 20 percent stocks), 40 percent debt (mostly five to seven-year maturity) and 20 percent cash assets preferable. This is because both bond and stock markets have reacted sharply after large gains, and uncertainty is great.
In the debt or fixed asset category, medium term, five to seven year bonds are worth considering, either U.S. governments or high quality municipals or corporates. In view of the current tax regulations, fixed rate annuities (and those with indexed adjustable rates) have strong appeal for those above age 50. Similarly, single premium whole life and single premium universal life policies can be very attractive under the right circumstances. Those who have IRAs or company pension plans that are invested primarily in common stocks might want to switch a portion of those funds into longer term fixed income ‘instruments’ as part of this segment.
On the equity side, solid mutual funds that have a historical record of holding against declines could be used. This would be especially attractive if the funds have switched privileges into other more and less aggressive funds for future possibilities. Another vehicle that has promise for equity commitment is variable annuities. Some have mutual fund type investments that can be made within the annuity shelter. The advantage is that the investor can control the switching from aggressive growth to fixed income to cash and back without current tax consequence. In buying annuities, it is important to examine the issuing company. An A.M. Best Rating of A plus is a must, and preferably from a company that has been around awhile. Other equity commitments could be placed in all-cash or low leverage real estate and well capitalized Real Estate Investment Trusts. Carefully selected convertible bonds could also be used if yields and conversion terms were satisfactory.
The cash portion could be in Treasury bills, money market funds or short term certificates of deposit (six to 18 months). If CDs are used, the institution behind them should be scrutinized, since they are not all created equal. The key here is to maintain a high level of liquidity and still maintain a decent return. During the 1970s, when both stock and bonds were performing poorly, cash type investments were the best performers. Similarly, those who had cash to buy in the dismal ’30s were able to build great fortunes.
After the dust settles, remember that wisdom is the art of learning from experience. We will never again be able to feel the earth vibrate without wondering, “Is this the big one?” Perhaps it’s time for a new building code for investment portfolios that assures withstanding a quake of 10 on the Richter scale.
NOTE: In last week’s column on fraudulent conveyance, the following Information was cut out In copy editing: (Jim Cunningham, a partner with Graydon, Head & Ritchey) “who has earned a national reputation In this field by conducting seminars for the Practicing Law Institute, provided the background Information for this article.”