Smart401k Blog

One of the top business headlines from the Associated Press at the end of the day on Friday read “Stocks Flat Ahead of Fed Meeting.” If you read any business news coverage over the past week, you may have noticed that many headlines were some variation on the theme of the approaching Federal Reserve meeting. Based on the amount of attention that the Fed gets in the news it’s obviously important, but let’s take a step back for a minute and take a look at what exactly the Fed does and why it’s important.

The Federal Reserve was established in 1913 to direct US monetary policy and helps keep the economy stable and running like a well oiled machine. Monetary policy refers specifically to the amount of money in the economy, and is important because the amount of the money available has a major impact on the interest rates that lenders charge.

Low interest rates tend to encourage borrowing and stimulate economic activity. While this is often a positive, low interest rates can also stimulate activity above the economy’s capacity and drive inflation. Inflation is a whole topic in and of itself, but when it is high and unpredictable it can have destabilizing effect on the economy and discourage economic growth.

So the challenge for the Fed is to adjust the US money supply so that the economy expands smoothly and at the same time maintains a low and stable rate of inflation. To do this, the Fed has three tools at its disposal: the discount rate, reserve requirements, and open market operations. Each of these tools allows the Fed to either increase or decrease the supply of money.

The most widely used and best known of these tools, open market operations, is controlled by the Federal Reserve entity known as the Federal Open Market Committee (FOMC). The FOMC has the ability to either buy government securities to increase the money supply or sell securities to decrease the money supply. The current policy of the FOMC is to set a target for the Federal Funds Rate and then buy and sell securities to try to pinpoint that rate.

Which brings us back to the news headlines and the importance of the upcoming Federal Reserve meeting. Typically, these stories refer to a meeting of the FOMC (there are eight at least eight FOMC meetings per year). At the FOMC’s meetings, the members, led by the Chairman of the Federal Reserve, discuss current economic conditions and decide whether there should be a change in the Federal Funds Rate target.

The current Federal Funds Rate target is 5.25% and it has been there since the FOMC’s meeting in July of 2006. The next Fed meeting is scheduled for tomorrow, and the turmoil that’s sprouted from the housing and credit markets have many expecting that the Fed will cut rates by a quarter or half percentage point to try to relieve some of the pressure.

Interpretations of what a rate cut would mean varies. Some believe that a rate cut would go a long way to help prevent the situation in the credit markets from escalating further and view a potential rate cut as a positive development. Others, though, focus on the fact that a rate cut — particularly one of a half percentage point — suggests that the Fed sees the problems as major threats to economic growth.

Of course, following tomorrow’s meeting we’ll have much more to analyze. So stay tuned for a look back at what the Fed had to say and what it means for the stock market.

For anybody that’s been following the financial news recently, you’ve likely noticed the upheaval in the real estate sector. We wanted to take the opportunity to explain how the downturn in the real estate sector may have affected your retirement plan and the market as a whole.

The real estate sector turmoil stems in large part from mortgage loans made during the market boom of the past few years. It turns out that some mortgage products that seemed to offer greater flexibility and accessibility offer little more than poor underwriting. Hot areas of the country where real estate seemed as if it couldn’t go down are now mired in a swamp of standing inventory of unsold homes.

The way that all of this finds its way into the stock market is apparent in some respects and less so in others. The most obvious effect is on the homebuilders who until recently couldn’t put roofs over buyers’ heads quickly enough to satisfy demand. Now, many builders are sitting on large levels of unsold inventory and in a number of cases are curtailing further development. In addition, the buyers (such as commercial banks and insurance companies) of the loans used to finance the real estate boom have had to decrease the value of loans on their books due to the rise in foreclosures and defaults.

Looking out a bit further, the real estate problems have the potential to fan out into other sectors via consumers that find themselves much more reluctant to spend money as freely as they have during the past several years. The perception of wealth created through a rising real estate market, as well as the actual cash that homeowners took out through home equity loans, helped grease the wheels of consumer spending. In simple terms, when people feel that they are wealthier, they tend to spend more.

The decline in real estate values has the potential to reverse this effect. As people feel the value of their house declining and are less able to finance spending through home equity withdrawals, they may be less likely to spend as much as they have over the past few years.

As a major component of overall spending in the US economy, a decline in consumer spending can have a significant impact on the economy. Over the coming months, economists, investors, and policy makers alike will be closely watching for signs of expanding economic weakness created by the problems in the housing market. As new data comes out for these groups to evaluate, it is very likely that the market will continue to see high levels of volatility.

The economy and stock market are highly complex mechanisms though. Similar to a biological organism, these systems have many interacting, moving parts that can and do rapidly change course and create outcomes that the consensus didn’t expect.  For instance, in the late spring of last year the market hit a rough patch and fell nearly 8% by mid-June. At the time, many said that it was time for the market to “correct” after the gains of the preceding years. But instead of continuing downward, the market regained its footing in late July and proceeded to run up 25% over the next year. Investors that hit the panic button prematurely missed some great gains. This example certainly isn’t to suggest that investors should expect another 25% between now and this time next year. Rather, it’s a good illustration of the fickle nature of short term forecasts for where the market is going.

In a bigger picture view of the situation, what’s going on is fairly typical of the cyclical nature of the markets. From time to time over-excitement in one area ends up sewing the seeds for a future correction. Corrections tend to begin with the industry that was experiencing the excitement, but eventually ripple out to the rest of the economy and can affect many different industries.

The silver lining to any kind of market correction, large or small, is that they can be very beneficial to some investors. Specifically, investors that have a long term perspective and intelligently allocate their assets can be in a position to take advantage of the market’s pessimism and reap the rewards when the correction is over.

Drilling down a bit further, here’s a look at how some of the recent market action has impacted small cap growth funds.

Asset Class Focus: Small Cap Growth In these turbulent times growth funds in general have been holding up better than most and small cap growth has not been an exception. Prior to Friday’s sell-off, Morningstar reported that total returns at its small cap growth tracking index were 9.8% for 2007 versus 5.6% for the S&P 500 index.

As many of the financial institutions and major builders that have been dead center in this tumultuous market are too large for most small cap growth funds, this category has managed to miss a lot of the resulting declines. This isn’t to say that they’ve dodged the bullet completely, though. Smaller financial institutions like investment banks Jefferies Group and Thomas Weisel Partners have been caught in the same crosshairs as larger banks like Goldman Sachs and are down 8% and 35%, respectively, since the beginning of the year. Property manager CB Richard Ellis has also had a tough run and is off 24% since early January.

Meanwhile, both the consumer goods and technology sectors have positively impacted the performance of many small cap growth funds. Crocs, the largest component of Morningstar’s small cap growth index, has been on an absolute tear, posting a gain of 164% year-to-date. That familiar name-your-own-price travel website, Priceline.com, has similarly bolstered small cap growth performance by jumping 77% so far this year. Dick’s Sporting Goods, O2Micro, and Foundry Networks have likewise driven the performance of some of the top small cap growth funds.

By Scott Revare

I ran into some very interesting facts regarding past market pullbacks that I thought would provide a good investing perspetive for our customers.  Most of these facts were pointed out by Paul Lim in a recent NY Times article. First, we should define the two terms typically used when the market drops significantly – bear market and market correction.  A bear market is defined as a drop in the overall market of 20% or more.  (note:  the overall market is usually measured by the S&P 500 – made up of 500 widely held US Company stocks).  A market correction is a market drop of between 10% and 20%.  Sometimes the industry fudges a little and starts talking correction once we hit a 7% or 8% drop, but the point is, that its a fairly significant drop from a market high.  Here are a few facts for you on bear markets and corrections (brought to you by S&P):Bear Market Facts:

• Number of bear markets since 1928 (80 years):  23
• Number of bear markets since 1946 (62 years): 10
• Statistics for the last 10 bear markets:
  • Average market drop:  more than 33%
  • Average number of days to drop that amount: 490 – (15 months)
  • Average number of days for the market to recover back to the previous market high:  669 (22 months)

Market Corrections:

• Number of corrections since 1928: 87 – or more than 1 per year on average
• Number of corrections since 1946: 16 – or about 1 every 3 1/2 or 4 years
• Statistics for the last 16 corrections:
  • Average market drop:  15%
  • Average number of days to drop that amount: 148 – (less than 5 months)
  • Average number of days for the market to recover back to the previous market high: 111 (less than 4 months)

In looking at these numbers, we can draw a few conclusions:

1.  The market has recovered from all drops, but it recovers from corrections more rapidly than bear markets. Historically, the average time from the start of a correction to full recovery is typically less than 9 months.  But recently, it seems that recoveries from corrections are even quicker.  Paul Lim points out that there were three corrections in row in the late 90′s (97, 98, 99) in which the average recovery was only 51 days.  Our two last “mini” (6-8%) corrections of late spring 2006 and in February of this year had recovery times of just 1-2 months.

If we put the market recovery times in the perspective of our retirement accounts, and think (average) worst case in a bear market situation – the average time from the start of a drop to market recovery is a little over 3 years.  Which means that it pays for us to position our planning outlook to make sure we have 3 years to let our investments recover from a potential market drop.  If you can’t afford to wait 3 years, your risk tolerance (and hence your Smart401k allocation) should be more conservative.

2.  Market drops are more likely corrections than bear markets.  Since 1946, official rcorrections (10-19% drops in the S&P 500) have outnumbered bear markets 16 to 10.  When we factor in “mini” corrections(5-10%), that ratio is significantly higher.

3.  Believe it or not, last quarter’s drop was not ever quite enough to be awarded the official label of “market correction.”  Just using market closing values as the offical measure, the market has at most been down 9.4% (July-19th to August 15th).  If we count intraday pricing, the difference has hit 12% – but that doesn’t count in the official measurement.

Our current assessment of the market is that we are in a market correction (for our reasons why, see our prior posting).  We are close to the low point of a typical market correction, which entails a rapid decline of around 10%, followed by a slower recovery that can take from 2 months to a year (it can often be a fairly rapid recovery).  While we don’t believe we or anyone else can predict the precise beginnings and ends of market corrections on a consistent basis, what is important to a long-term investor is to recognize that it is a correction.  Because all signs point us to believe we are in a market correction, our advice at the current time is to stay the course – we don’t believe a change to the recommendations we provided in July is required at this time.  We recommend that our customers ride this correction out.

That said, we’ve had quite a few of our customers call or email us to ask what to do with their accounts.  While its natural for anyone to be tempted to want to stop the bleeding, if you are losing sleep over fears of losses in your retirement account, or if you have actually pulled out of the funds we recommended for you, there may be an action you should take – adjust your investments to reflect a lower tolerance for risk.  This can be accomplished by retaking your Smart401k questionnaire reflecting your true concerns for market changes, and changing your investments to match the resulting recommendations.

The questionnaire we ask you to take before providing you with our recommendations is designed to assess your tolerance for market risk.  If the current markets have caused you significant nervousness, it can be a sign that your true tolerance for risk is less than what you originally answered in the questionnaire.  By adjusting your answers to reflect even a temporary concern, you will get a more conservative recommendation from us that should have less ups and downs than a more agressive allocation you may have used in the past.

If you feel you need to do something other than stay the course, please give us a call – we’d be happy to talk through your situation with you and help you figure out the best course of action.

At the worst point yesterday, markets were down 10% from this year’s market highs, right in the range of a typical market correction.  Market levels are where they were in mid-April of this year.  While it’s natural for the current market volatility to put fear in all of us, and cause us to want to “stop the bleeding” by getting out of the market, here are a few facts to help you keep things in perspective:

1.       Over the past 75 years, the markets have averaged a market correction of about 10% every year yes, that’s an average of once every year.

2.       Last year, in the early spring, late fall, US Markets experienced a correction about the same magnitude of today’s correction.  By the end of the summer, the market had recovered and we ended the year with very healthy returns.   While we can’t promise that something similar will happen here, we still believe this is a market correction, not the beginning of a bear market.

3.       While things look bad for companies involved in sub-prime loans, and for investments in those companies, the rest of the economy continues to demonstrate strength. Corporate earnings announcements have been strong and are a key factor to watch as we move forward.

In the words of Adam Bold, our Chief Investment Officer, “Underneath it all, the economy is very strong.  This should bode well for stocks throughout the balance of the year.  I think we could still end the year with the markets up 10 to 15%.”

Current Market Commentary

Adam Bold, Chief Investment Officer, Smart401k.com:

S&P Performance August 1-2006 to July 27, 2007 (Red Line indicates the 1450 line, about the market close for August 1st.  The 1450 line was last crossed in mid-April 2007.

I talked about last week’s five-percent negative move in the markets, saying I was obviously concerned but not overly worried. I’ve tried in my recent commentaries to emotionally prepare our clients for the possibility that we would go through a correction sometime soon.

Market downturns are a part of the normal investment process; markets move up and then they come back a bit. No market moves straight up all the time.

The market made its high at 1,552.50 in the S&P 500 on July 13; it closed Friday July 27th at 1,458.95, almost a 100-point decline over two weeks. On Feb. 20 earlier this year, it made a high at 1,459.70; two weeks later (March 5), it made a low at 1,374.10. We had close to an 85-point decline, a greater percentage decline than what occured last place. It took 42 days to get back to the Feb. 20 high. The resistance at 1,460 has become the support; I believe the majority of any decline in this cycle has taken place barring some natural disaster or terrorist attack we can’t foresee.

The economy remains good. Corporate earnings are good and getting better. Corporations continue to make massive stock repurchases, creating less supply for the same demand which drives prices up. Interest rates remain historically low; I believe we’ll continue in a range between 4.5 and 5.5 percent on the 10-year treasury.