Sunday, April 26, 2009

Rest In Peace Tommy Head

Our mission brother in Peru, Tommy Head, was killed in an accident yesterday. Tommy was probably the coolest person I have ever had the privileged to know. A true man of God bringing clean water and medical care to the indians along the Peruvian Amazon tributaries. He had such a great ministry. God bless you and your family Tommy. I weep for our loss.

www.water.cc article about Peru

Saturday, April 25, 2009

Sound Mind Investing

I want to use this blog space to give some credit to one of the resources that has helped make it possible for my family to be in the field serving. Sound Mind Investing is a Christian organization that, I believe, provides excellent financial wisdom and investing advice. It is lead by Austin Pryor who was the financial adviser to Larry Burkett.

Through years of following the advice they provide through Austin's book, website and newsletter we were able to position ourselves to be available to answer God's call.

Here is an example of the kind of advice they give from last months news letter (written by Mark Biller).

Protecting Yourself Against "The Big One"

By Mark Biller
© Sound Mind Investing | April 2009
Over the past two decades, SMI has consistently tried to help readers avoid the most common mistake individual investors make: selling during bear markets when fear is high. But what if this isn't a "normal" bear market? What if this is "the big one?" This month we focus on this what-if scenario and suggest specific steps for investors who want to make the tradeoffs necessary to defend against significant further losses.

Every bull market is followed by a bear market. This back and forth dynamic is a key element every stock market investor needs to understand in order to be successful.

The answers to many strategic questions (e.g., Why is it a bad idea to borrow in order to invest? Why does stock investing require a 5-10 year time horizon? Why is it important to have a personalized, long-term investment strategy to guide your investing decisions?) are derived, at least in part, from the fact that the stock market goes through bull- and bear-market cycles.

Because bear markets are part of the regular investing landscape, they are worth our attention in an attempt to understand them better. This is true even when we're not stuck in the middle of one, which is why we wrote Beating the Bear Market Blues back in September of 2007. (That article covered different ground than this one, so if you missed that earlier bear-market primer, it's worth going back to read it.)

In any bear market, there are two main risks. Unfortunately, the risks tend to be somewhat mutually exclusive, making it difficult to defend against both at the same time.

RISK #1: SELLING LATE IN A "REGULAR" BEAR MARKET

In most bear markets, stocks fall substantially (approximately 30% on average) over a period of roughly 15 months, but they rarely fall in an uninterrupted fashion. Instead, the market tends to have several drops of 10-20%, with significant rallies mixed in between. These rallies sometimes can last several weeks, which serves to keep hope alive as the months pass.

But eventually pain and hopelessness prevail and, in a final selling climax, investors throw in the towel en masse. This creates the bear-market bottom. Needless to say, this final selling takes place after many months of losses, but before investors have any reason to believe conditions are going to improve.

This is by far the most common bear-market scenario and it brings us to our first main risk: selling near bear-market bottoms. This is classic investor behavior and is largely responsible for the poor returns most individual investors earn in the stock market.

In 2006, a survey performed by Dalbar Inc. showed that the typical investor earned 3.9% annualized between 1986-2005. That's roughly one-third the 11.9% average gain of the S&P 500. This illustrates the unfortunate reality that investors shovel money into the market when they feel confident (i.e., near bull-market tops) and pull their money out of the stock market when they are afraid (i.e., near bear-market bottoms). Studies on mutual fund flows confirm this trend. It's completely natural, completely destructive, and it's how nearly every bear market plays out.

Selling near market lows is the most common self-destructive action individual investors take. Worse yet, many investors know it's the most common mistake they need to guard against, yet it remains an incredibly difficult pattern to avoid. Because of this, at SMI we spend a tremendous amount of effort trying to defend against this mistake. And nine times out of 10 (or more) our efforts to help readers stay the course and stick with their plans turn out to be beneficial.

RISK #2: "THE BIG ONE"

However, while most market downturns and bear markets follow the familiar script laid out above, every great now and then, a bear market comes along that is significantly more destructive than normal. The problem is identifying early enough which bear markets are going to plunge into this category.

This is very difficult, because nearly every bear market — and even many downturns that never quite reach official bear-market territory — appear to hold doomsday potential at the time they are raging. Just in the past dozen years we've witnessed: (1) a threat to the worldwide economy from the "Asian Contagion"; (2) our first glimpse at system-wide financial failure with the collapse of the Long-Term Capital Management hedge fund; (3) the Y2K computer threat that many experts warned could have huge disruptive implications; (4) and the deadly terrorist attacks on 9/11 that further weakened a soft market and rattled an economy already teetering on the brink of a recession. Each scenario presented difficult challenges, but in each case the market and the economy bounced back.

Truly devastating bear markets and economic collapses come along so infrequently that they're extremely difficult to prepare for. Everyone is familiar with the Great Depression in the 1930s. Before that, you'd probably have to go back to 1873 to find anything comparable. Before that, 1837. So these financial panics and worldwide depressions don't come along very often. While there's some comfort in that, it's also evident that we haven't had one of these in many decades and could be due for one now.

We've been reluctant to entertain the relatively low probability that we're facing a "Risk #2" scenario. That's because there's a potentially significant cost to defending against "the big one" if it turns out you're wrong. Given that we're already 17 months into this bear market, with the stock market already off more than 50%, we tend to think most investors will be best served by holding on from these levels.

However, in light of the series of events we've all seen unfold over the past several months, we also know there are many who want to take protective action in case the economy and stock market continue to deteriorate significantly from here. Given that, it's time to at least entertain what it means if we're in the early stages of a depression-like period.

THE CASE FOR THE GREAT DEPRESSSION 2.0

Much has been written about why things are "different this time" and why the current economic downturn will eventually become much worse than the typical recession. We're not economists and feel a little out of our depth in these waters. However, here is a brief summary of the argument being made (by some) supporting the idea that an economic depression might be at hand.

The critical element of the Depression 2.0 argument revolves around deleveraging. For decades, the world economy has become increasingly leveraged, or propped up by debt.

This is clearly seen in the U.S. savings rate, which fell from roughly 12% in 1981 to a negative figure in 2005. In other words, each year for more than two decades we saved less and spent an increasing share of our income, to the point at which, as a nation, we've actually spent more than we've earned the past few years. This has been made possible by the use of more and more credit. As the chart shows, for roughly 60 years Americans have been accumulating ever larger amounts of debt as compared to their incomes.

Chart: Household Debt to Disposable Income

A similar dynamic has been at work around much of the world. Most of the West has been buying more than it should using credit, while the rest of the world economy has boomed by producing ever more products for these leveraged consumers.

Deleveraging simply describes the reversal of this credit trend. As households and businesses pare back their debt loads, voluntarily as well as involuntarily, this death of borrowing and rebirth of saving is having a powerful impact on both the domestic and worldwide economy.

Unfortunately, what's good for the individual — borrowing less, paying off debt, building savings — is bad for the overall economy in the short run. In a very real sense, personal savings comes at the expense of business profits. Not only is new money not being borrowed to fuel more consumer consumption and boost business sales, but neither is the money consumers are using to pay down credit card and other debt balances.

This leads to much lower business revenues, which we see reflected in the terrible economic news reported daily. As companies sell less, they cut expenses, people get laid off, and everyone gets a little more scared. This causes people to cut back their spending even more, and a vicious cycle takes hold.

It's not just the countries that borrowed too much who suffer either. Those countries whose growth was based on producing products for U.S. (and other Western) consumers are also feeling the pain as orders dry up and their factories close. With the world economy never more interconnected than it is today, the economy of virtually every nation is affected.

The scope of this deleveraging process is a big key to the long-term bearish case. If this were a temporary blip, that would be one thing. But the leveraging phase of this cycle was built over many decades, so it seems unlikely that it's going to unwind over a matter of just a year or two. Some see this deleveraging process taking several years to run its course. That may not mean several years of uninterrupted recession, but it could mean the world economy faces a prolonged period with this deleveraging headwind pushing against growth.

THE POTENTIAL IMPACT ON STOCKS

The impact of this deleveraging trend on the stock market has been powerful and threatens to continue exerting downward pressure on the markets for some time yet. Given the scenario we've been discussing, it should be no surprise that business earnings have been collapsing over the past year.

Earnings ultimately drive stock prices, and over the past year estimates of what the S&P 500 companies will earn in 2009 have fallen almost by half, from $113 last April to roughly $64 today. Those are the Standard & Poor's estimates; other investment banks currently forecast 2009 earnings will ultimately come in between $40-$50.

A second factor that drives stock prices is how much investors are willing to pay for each dollar of company earnings. At past bull-market tops, when conditions are good and the future looks bright, investors have been willing to pay an average of roughly 25 times S&P earnings. But at past bear-market bottoms, when the future looks bleak and investors feel pessimistic, that average has shrunk to roughly 14 times earnings and lower, occasionally reaching even single digits.

Combining these two factors leads to some startling possibilities for the stock market. The average 2009 earnings projection for the S&P 500 is currently ~$51 per share. If we use the average historical P/E of 14 from past bear-market bottoms, we would think the S&P 500 is fairly valued at 714 ($51x14=714), or roughly the level it traded at in mid-March.

But what if earnings end up coming in lower than $51 per share? Or what happens if investors get so pessimistic they ultimately attach to those earnings a P/E ratio closer to 10, as they did in 1929, 1974, and 1982? Earnings of $50 per share coupled with a P/E ratio of 10 implies an S&P 500 index priced at roughly 500. That would mean further losses of 33% from today's levels. Gulp.

Before anyone runs away screaming, please understand that there are counterpoints which argue against the market heading to these extreme levels. But in fairness, we didn't expect to be down over 50% at this point either. If we're going to deal with the "what if?" scenario, we have to acknowledge that it's not difficult to construct a scenario with significant further downside, enough downside that taking additional protective measures makes sense.

WHAT TO DO (IF YOU'RE PERSUADED TO TAKE FURTHER ACTION)

First, I need to reiterate that the scenario we've been discussing is not our prediction of what will happen. It's more of a worst-case scenario. Both Austin and I still believe that selling at these low levels (risk #1) is a greater danger than not taking further protective action now (risk #2). As such, neither of us intend to make any further changes to our personal portfolios right now.

This conviction has been strengthened by the comments we've noted recently in the SMI Weblog from conservative money managers like Jeremy Grantham and John Hussman. These valuation-sensitive managers have been nervous about stock market valuations for many years, and have each recently discussed the possibility of the stock market declining further to lows similar to the 500 range just mentioned. But they also believe that from today's valuations, returns over the next several years should average roughly 7%-11% per year.

Hussman recently referenced "the iron law of finance" in one of his reports, referring to the fact that lower valuations imply higher long-term returns. If the S&P 500 were to reach the 500 price level we've been discussing, he suggests that total returns over the following decade would likely average 14%-17% per year. As long-term investors with strong stomachs, this is risk/reward we can live with.

But we also acknowledge that not everyone can live with that type of risk. Even many younger people, for whom a downturn like we've seen the past 18 months is actually a good thing and an event to invest into, are finding it difficult to stay the course in the face of the current market fear. Naturally, many older investors are feeling this even more acutely.

So, here are some ideas for investors at different stages who want to add some additional protection to their portfolio in case this bear market continues significantly lower. Just recognize that each step taken now to reduce portfolio risk will mean lower returns if the market recovers more quickly than this worst-case scenario projects.

Ages 45 and under: As crazy as it may sound, anyone under 45 should probably be thankful for the market decline. Sure, it's hurt your portfolio value, perhaps significantly. But it also provides a great opportunity for you to build your long-term retirement savings at dramatically lower prices. With 20 or more years until retirement, you've got plenty of time for your current portfolio to recover and for the new seeds you're sowing now to grow.

It goes against what we feel, but the iron law mentioned earlier is true — the money you invested two years ago when stocks were double their current levels was only half as productive as the money you're investing today. Fight the urge to get defensive here. As a member of this group, you should probably be increasing your stock exposure, not decreasing it.

Ages 45-55: If this is your situation, you likely feel the losses a lot more acutely. You had thought you were much closer to achieving your savings goals, but now, with your shortened time horizon, it may be hard to see how the math is going to add up the way you thought it would.

Even so, in terms of what to do right now, you still have enough time to reasonably expect the stock market to dig you out of this hole. Guarantees? No. But reasonable expectation? Yes. Selling here with the expectation of getting back in later carries a substantial risk of its own, namely missing much of the upside that has the potential of erasing a significant portion of the recent losses. Missing that surge could be damaging for this age group who may not have many of those surges left.

Some of you in this group aren't going to be content waiting this out, though. So for those, the first protective measure against the idea of a prolonged depression starts with a change of thinking. Specifically, understand that ten years is the new five years.

Here's what we mean. In the past, SMI has always told investors they shouldn't be in the stock market at all if they don't plan to leave their money committed to stocks for at least five years. Given the current uncertainty and risk in the market, a more conservative guideline would be to only invest money in the stock market that you can afford to keep invested for the next 10 years. Over that long a time-span, investors are very likely to earn positive returns from today's relatively low stock market valuations.

True, the market has lost ground over the past decade, so there are no guarantees. But again we come back to the iron law: starting from today's significantly lower valuations, the outlook for the next decade looks bright, as long as you're willing to stay invested through any further downside in the short-term.

Another reasonable step to reduce risk is to adjust your stock/bond allocation. This is what Austin did last month (as noted in My Hopes for 2009 Have Suffered a Setback). As we've written many times, your stock/bond allocation determines your investing outcome to a greater degree than any other single decision you make. So if you want to get more conservative now, reduce your stock allocation by 10%-20%. Just be sure you have a mechanism firmly in mind to boost your allocation back up where it should be when this crisis is over.

SMI's "All Clear Indicator" is a slow, but safe, signal to return things "back to normal." It will give up a lot of the early gains from the next bull market (historically about 21%), but at least it will keep you from going through most of the next bull market stuck in a more conservative allocation than you should be.

An alternative that will cause you to act sooner would be to adjust your allocations when the stock market climbs X% above the level where you sold. (The percent you use will be somewhat arbitrary. A lower percent, say 6%, will be reached more quickly but is more susceptible to being a false signal. Using 12% would reduce that risk, but would surrender more upside potential. As usual when it comes to investing, it's a tradeoff between risk and potential reward.) If you used a 6% target, for example, it would work like this: if you reduced your stock portion when the S&P 500 was at 750, you would shift back when that index closed above 795 (750 x 1.06).

A third reasonably conservative step to reduce risk is to shift some portion of your Upgrading money over to the SMI Managed Volatility Fund (SMIVX). This fund won't eliminate all further losses, and may well frustrate you eventually by lagging significantly once the next bull market finally gets underway. But in the meantime, it should help reduce any further losses this bear market inflicts, while still providing some upside potential (from December-February, SMIVX lost 4% while the S&P 500 lost 17%). The idea here is to retain the opportunity to participate in some of the upside gains if the market doesn't tank over the next year or so, while protecting you significantly if it does.

Ages 55-65: Hopefully, if you're in this group, you already had some defensive measures in place before the market started to slide, by virtue of your asset allocation. Still, you may feel that additional protective measures are in order, as the potential of significant further losses coupled with your shorter time frame make the prospect of full recovery less probable.

Your first step is to read everything suggested above for the 45-55 age group. Your starting steps are largely going to be more drastic versions of those ideas. Consider carefully your investing time frame.

Think about temporarily reducing your stock allocation: a reduction of 30%-40% is obviously going to have a more dramatic impact than the 10%-20% suggested above, as will shifting more (or all) of your Upgrading money over to SMIVX. In either case, you also need to build into your plan a pre-defined trigger to get you back to your normal allocations once this is over, as discussed above. Additionally, consider the ideas for retirees that follow.

Retirees: In addition to the steps listed for those aged 55-65, another approach that could be helpful is to segment your portfolio into two or three pieces. This allows you to take measures with one part to protect against a "doomsday" scenario without compromising the whole portfolio.

For example, retirees might choose to divide their portfolio into the following pieces. The first piece would include enough liquid assets to cover all living expenses for at least the next five years. These liquid assets will allow you to live normally without feeling any pressure to sell other investments while they are still facing dramatic pressure from the current crisis.

The second piece would be a traditional stock/bond portfolio invested using the SMI strategies. This is the piece that acknowledges this bear market could end sooner rather than later, and if it does, this portion of your portfolio will help keep your finances on track for reasonable appreciation.

Assuming the liquid piece takes a significant chunk of your total portfolio (greater than 25%), you should avoid getting too conservative with your stock allocation in this second piece. For example, investors who would normally allocate their portfolio 50-50 between stocks and bonds would likely want to still keep at least half of their remaining portfolio allocated to stocks after setting aside a significant liquid piece to meet expenses in the coming five years.

For most retirees, those two pieces should be sufficient. But it's true that retirees are particularly affected by another factor we haven't discussed yet — inflation. That's where the third portfolio piece comes in. Given the response of our government to the economic crisis, many are concerned the cure may be worse than the disease.

Specifically, what if the government's massive spending, borrowing, and dollar debasing leads to a period of abnormally high inflation? This presents investors with a dilemma because in a depression, cash is king. But in a period of hyper-inflation, cash is trash. Balancing these two risks can be a serious challenge. We'll take up a discussion of "inflation fighting" strategies in next month's cover article.

CONCLUSION

If you choose to incorporate any of these defensive steps into your portfolio, we recommend moving cautiously and in moderation. While the doomsday risk may be dominating your thinking right now, it's important to keep in mind that the risk of selling near the bear-market bottom is actually the more likely scenario. Any significant portfolio adjustments made now should be viewed more as "insurance," and like any insurance purchase, you should weigh carefully what you really need.

Regardless of your age, for a majority of people the most important financial decisions they make this year may not involve their investments at all. Their most important financial moves will involve a return to the basics: paying down debt, building a savings reserve, aligning spending to fit within a conservative budgeting of their income. While this may seem like boring advice, it is the crucial foundation upon which your financial progress will rest — regardless of whether this economy picks up quickly or drags out into a multi-year depression.

Finally, remember that as Christians we are to have a different outlook on difficult events like these than the world around us. For many years now, our country has increasingly made money its god and materialism the chief goal of its people. This shaking of America's economy and financial system — in many respects, you could say its very foundations — is creating tremendous fear, but also a recognition among some that wealth is a fickle master.

This presents the church with opportunities that may not have existed just a year or two ago — opportunities to help financially by our giving, as well as opportunities to speak with friends, neighbors, and co-workers who, now that their world has been shaken, may be open to hearing about an unshakeable Kingdom.

It's an unfortunate reality that society's interest in spiritual matters has often decreased at a rate directly proportional to its increase in material prosperity, and vice versa. Let's make sure we aren't so focused on our own material circumstances that we miss what may be a final great opportunity to spread the gospel of Jesus Christ. End

I have to recommend to you to read Austin's book, "Sound Mind Investing" and to check out the website