Update on 2011 Current Events (Aug 2011)
By Ric Edelman
August 1, 2011
Frustrated. Furious. Astonished.
These are words that best describe how we feel about the embarrassing debacle that's been occurring in Washington for the past several weeks. We suspect you share our sentiments.
I have long said that you never get hit by a bus you see coming. Instead, it's the unknown risks that represent our greatest challenges. And yet, today we see a bus coming and it looks like it really might hit us!
It's 10 p.m. on Sunday night, July 31, as I write this. Less than 30 minutes ago, President Obama announced that he and congressional leaders from both parties have reached an agreement that will enable lawmakers to avoid a government shutdown and default. Passage by both houses of Congress is still required, and the vote is to occur in the morning. Perhaps by the time you're reading this a law has been enacted — or, perhaps, as has been the case up to this point, something will interfere with efforts to resolve the debate. Keep this in mind as you read on.
As I stated on my weekly radio show this weekend, we are confident that a deal will be reached by the deadline (11:59 p.m., on Tuesday, August 2). But what if that doesn’t happen? And if there is a deal, what does that mean?
Because of the extreme jockeying that has been occurring in Washington over the past several weeks, and because the news has been constantly changing, we have refrained from sending you a letter, fearful that anything we might say would become outdated by the time you received it. But with the president announcing that a deal has been reached, we (finally) have sufficient information to be able to provide you with meaningful advice and commentary.
First, we do hope that the president is correct and that the deal he's announced will be approved by Congress. We say that, not because we like the deal (I haven't even had an opportunity to study it yet), but because of the consequences of not approving a deal.
To understand this, let's provide some perspective. The Dow Jones Industrial Average fell 538 points last week, dropping 4.2%. July, which just ended, was the worst month we've had in a year (since August 2010). Last week was the largest weekly point drop in a year (since the week of May 7, 2010) and the biggest weekly percentage drop in a year (since the week of July 2, 2010). The stock market fell for the past six trading days — the longest consecutive down streak of the year.
Amazingly, the decline had little to do with recent economic news. The decline was not about earnings announcements, inflation, unemployment, housing prices, the dollar or Greece. As we all know, the market's declines of the last six days were largely, if not solely, due to what's been happening in Washington. Investors have been saying, "I'm going to sit and wait and watch and see what they do on Capitol Hill." And the closer we get to August 2 without a deal, the more that people feel pessimistic.
It's worth noting that the Dow's 538-point decline didn't happen in a single day. It dribbled out throughout the week, losing 70 points here, 80 points there. A single-day loss of 538 points would have generated big headlines, and perhaps would have gotten lawmakers' attention more strongly. That didn't happen, giving Congress and the White House opportunity to ignore Wall Street and the investing public.
This is why we believe that failure to reach a deal by midnight on Tuesday would result in a sharp decline in the Dow. It would be Wall Street's way of demanding that lawmakers pay attention to the needs of the country, prodding them to take action that they, up to now, have refused to take.
So, it appears that there's a deal. But, as Yogi Berra said, "It ain’t over til it's over" – and that means that unexpected (and undesirable) developments could result in significant market volatility. Brace yourself. If it comes — and at this point it appears it won't — we believe it will be short-lived — lasting only until a bill is passed and sent to the president for his signature. Assuming no last-minute obstacles surface on Monday, we expect that Wall Street will signal its approval by increasing the Dow's level, and a substantial increase would not surprise us in the least.
In other words, we might experience some volatility, but volatility does not necessarily translate to losses — except for those who have panicked and sold during these recent weeks of political theater and who, therefore, no longer own their shares. They won't be able to enjoy the price increase that we believe will follow Congressional approval of the deal.
But let's not get cocky. The deal that has riveted the nation's attention has little to do with the economic recovery. It won't solve our unemployment problem or result in an increase in housing prices. Even after the debt ceiling crisis is resolved — and it will be resolved, if not on Monday, then eventually — there remains a risk that Moody's or S&P will downgrade the credit rating of U.S. Treasury securities1 from AAA to AA. What will that mean?
Actually, it might mean nothing. Nobody knows, and analysts have offered a variety of scenarios. In some, loss of our AAA credit rating has no impact. In others, interest rates rise, and in still more, interest rates actually fall. So, nobody knows. And when the answer isn't clear, it's foolish to take any action. It's better to wait for the picture to become clear.
Why might a ratings cut have no impact? Because investors know that, regardless of any label, the financial stability and solvency of the United States of America remains the strongest in the world and therefore, from a safety and liquidity perspective, investors would rather own U.S. Treasuries than any other security. Very few financial institutions are required to hold only AAA-rated paper; most have no such obligation and therefore will not be affected by a downgrade. Money market funds will continue to be allowed to own Treasuries and they will therefore not be affected; they would not have to dump them or stop buying them. Life insurance companies will still hold U.S. Treasuries. Banks will not have to increase their capital reserves. The Federal Reserve will still accept Treasuries as collateral. And China will continue to purchase U.S. Treasuries. Thus, because demand will remain unchanged, there will be no impact from any ratings cut.
Why might interest rates rise after the rating is cut? Because that's normally what happens. Investors pay a premium for safety; the more risk they must take, the higher the return they demand. This is why AAA bonds pay lower interest rates than AA bonds. AA paper is deemed riskier, and therefore it pays higher interest rates — to compensate investors for the higher risk they are taking. Therefore, this logic goes, falling from AAA to AA means interest rates will rise. Even a slight increase costs a lot of money: An increase of one-half of a percent will increase the cost of a $200,000 30-year mortgage by $65 per month.
Why might interest rates fall after the rating is cut? Because that's what happened in Japan. Australia has a AAA rating, and its 10-year treasuries pay 4.9% in interest. But Japan, which lost its AAA rating in 2009 and is now AA, pays only 1.1% for its 10-year notes. Go figure.
Thus, no one knows what impact, if any, a cut in our rating will mean for investors and consumers.
Wall Street, however, is providing some indication of its attitude, visible in the price of Credit Default Swaps2. CDSs are used by investors to insure themselves against the risk that their investments in U.S. Treasuries might default. (The idea of insuring against such a risk has always struck us as silly, but that's another conversation.)
The recent price of a one-year credit default swap implies that investors believe there's a 1% chance that the U.S. government might default on its obligations within one year. That’s pretty much the same as Australia, and it’s a little more than Canada. Interestingly though, the cost of protecting yourself for one year is higher than the cost of protecting yourself for five years — meaning that Wall Street traders are more confident about the government's solvency five years from now than they are for the next 12 months. They are acknowledging that we are experiencing short-term uncertainty, not long-term risks. (All this is due to complicated mathematical formulae dealing with something called "time decay" — the closer you get to a perceived event, the more expensive it gets. Because August 2 is just a day away, the cost of protecting against it is extraordinarily high. Default five years from now is of little concern, relatively speaking.)
All this leads to a simple question: How should you be investing your money right now? Let's consider some options that the media have been touting. We'll start with that favorite of the talk shows: gold. Its price hit another all-time high on Friday, at $1,627 per ounce according to The Wall Street Journal, reinforcing the sentiment shared by many that gold will continue to outperform the dollar, government bonds, the stock market and real estate.
We disagree. We are convinced that gold is experiencing a bubble, like tech stocks did in the late 1990s. And like tech stocks before it, gold's bubble will eventually burst. Here's why we believe this.
Like every other investment, the price of gold is based on the law of supply and demand. If a lot of people want it, the price goes up, and if nobody wants it, the price goes down. Total gold demand in 2010, according to the World Gold Council, was for 3800 tons. Gold mines worldwide produced 2500 tons. Recirculation (people selling their jewelry) placed another 1400 tons into the supply, for a total supply in 2010 of 3900 tons — roughly equal to the demand.
Ordinarily, equivalent supply and demand leads to stable prices. But this is a problem for gold, a problem that isn't found with, say, apples. If I'm an apple farmer and I produce a lot of apples, what happens to the supply at the end of the year? It’s gone: We either eat the apples or they rot. That means I start next year with zero apples. So when I produce a new batch, I create a completely new supply, and it meets a completely new demand.
But what happens to the gold that I've mined this year? It's still there next year, because gold never goes away. It doesn't melt, evaporate or rot. And you certainly don't eat it. Thus, the gold supply grows every year because miners keep adding to the inventory. That means demand has to grow to keep up with the supply. But according to some experts, industrial uses comprise only 1% of gold's demand. The rest is driven by consumers. How long will that demand be sustained?
We don't know. But we do know that as soon as the demand slackens, the price will crater.
So much for investing in gold at today's lofty prices. How about structured notes with principal protection? Or floating rate funds? Both of these ideas are attracting lots of investors; more than $100 billion have flowed into these products in the past two years, according to industry data.
But regulators are worried. So much so that the Financial Industry Regulatory Authority (FINRA)3 last week issued an Investor Alert, warning consumers to avoid these high-risk investments. The alert is aptly named, "The Grass Isn't Always Greener: Chasing Returns in a Challenging Investment Environment."4
FINRA is worried — and so are we — that consumers are buying investments like these in an effort to get higher yields with "guarantees" — without understanding the complexity and risk of these products.
So selling in a panic isn't the answer. Buying the latest fad isn't the answer. Chasing high returns and blindly believing in guarantees isn't the answer. So what is?
The answer, frankly, is the same as we've always provided you. Have a minimum of one year's worth of spending in cash reserves, remain highly diversified, and remain focused on your long-term goals.5 As the markets spin amidst the turmoil, our strategic re-balancing will help you protect profits by selling some assets while they're high in price and reduce volatility and risk by buying other assets that panicked investors have made more affordable. In the long run, you'll come out ahead.
Many have been arguing over whether or not the government will be forced to shut down on August 2. While there has been conjecture over how long the situation will persist — hours? days? a few weeks? — no one believes that the government would remain closed forever. And when this does get resolved, whether on Monday or at some other time, we'll all discover that we still have children headed to college, and we must still contend with our own retirement.
And it is for these reasons, beyond all else, that we encourage you to sit tight. We might experience some volatility, but we'll get past it.
Although this makes sense economically and intellectually, we realize that some people might be struggling with this notion emotionally. If you are having trouble sleeping, please contact your Edelman planner and talk with us about your concerns. We'll get through this period intact — and together.
And as always, we'll keep you informed.
Chairman & CEO
Chairman & CEO
1Negotiable U.S. Government debt obligations, backed by its full faith and credit. Exempt from state and local taxes. U.S. Treasury Securities are issued by the U.S. government in order to pay for government projects. The money paid out for a Treasury bond is essentially a loan to the government.
2A credit default swap (CDS) is a form of insurance which protects the buyer of the CDS in the case of a loan default. If the loan defaults, the buyer of the CDS can exchange or "swap" the defaulted loan (or in some CDSs the reduced cash value of the defaulted loan) for the face value of the loan.
3The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all securities firms doing business in the United States. FINRA's mission is to protect America's investors by making sure the securities industry operates fairly and honestly. All told, FINRA oversees nearly 4,535 brokerage firms, about 163,620 branch offices and approximately 631,640 registered securities representatives.
5Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a diversified portfolio will outperform a non-diversified portfolio.
Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as tax or legal advice. Although the information has been gathered from sources believed to be reliable, we do not guarantee its accuracy or completeness. Please note that individual situations can vary, therefore, the information should be considered when coordinated with individual professional advice. Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal.
Neither the information in this document nor any option expressed herein constitutes an offer to sell or solicit any person to purchase any security. Investment decisions should not be made based on information in this document, individuals should rely exclusively on the offering material when considering whether to invest.
The opinions expressed herein are those of the writer and may not reflect those of Sanders Morris Harris Inc. or any of its affiliates.
Ric Edelman is Chairman and CEO of Edelman Financial Services, a Registered Investment Adviser, and Co-CEO, President and a Director of The Edelman Financial Group (NASDAQ: EF). He is an Investment Adviser Representative who offers advisory services through EFS and a Registered Principal of (and offering securities through) Sanders Morris Harris Inc., an affiliated broker/dealer, member FINRA/SIPC.