FSG Client Communication Briefing - Who Spiked the Punch Bowl?

October 13, 2008

“This time it’s different.” We’ve all heard this quote before to describe new situations and why the “old” rules don’t apply to the present. The typical historian’s response is that things really are not different; we’ve just forgotten the past. I think there is some truth to this response but also some reasons why our present economic situation truly is different.

In the past, investment banks and brokerage houses have created new types of securities which they then sold to investors. We saw this most recently with the tech bubble of the late 1990s and the use of Initial Public Offerings (IPOs). Wall Street has always been very creative in mixing together the right ingredients to create really good tasting punch (at least for awhile).

It appears this time, the punch was spiked and the people ladling out the punch were drinking it themselves. This has led to a serious hangover in the financial markets. In the past five years, sub-prime mortgages were used to fuel the desire for an ever increasing number of homeowners to buy homes they could not afford. Lax lending standards and an increasing level of greed on the part of investors and lenders accelerated the risk. In order to satisfy the thirst of borrowers and investors, the lenders kept adding new ingredients to the punch bowl which turned otherwise stable investments into leveraged toxic sludge.

Due to fears regarding who else drank from the punch bowl, banks have ceased their normal lending practices for fear of giving their money to another bank that may not be able to pay them back. Not only has this affected US banks, but foreign banks also joined the party as the punch ladlers were very efficient at distributing their punch around the world.

In order to detoxify the system, the banking system is coming together on a global scale to restore trust in the system. Over the past weekend, leaders of the major European countries met to coordinate a response to the freezing of the credit markets.

While the credit markets are where the real issues lie, the stock market has indirectly received the brunt of the bad news. In these troubling times it is easy to lose sight of what stock ownership really means.

Each share of stock represents an ownership interest in the underlying company. This ownership, whether owned individually or collectively through a mutual fund, entitles the holder to a share of the future profits of the company. Each company is comprised of the equipment and buildings or physical assets, the combined human capital of its employees and most importantly an interest in the future earnings and innovation of the company.

One way to measure the benefit of stock ownership is to look at the share of earnings that are paid to shareholders in the form of dividends. The 30 companies in the Dow Industrial Average are currently paying the same amount in dividends as you could currently earn in interest on a 10-year US Treasury note.

Even if earnings decline (which undoubtedly they will in the near term), you could buy a part of each company in the Dow stock index and expect to make about the same amount of money from dividends over the next ten years as you could from interest on a government bond. More importantly, you would also gain from any price appreciation and dividend increases that occur over the next ten years as well.

While the immediate future of the stock market is uncertain, we’re strong advocates of the global economy in which people will continue to produce goods and services desired by others. As this occurs, we want to be positioned to benefit from the economic prosperity when it returns.

The hangover in the market needs time to work its way through which may very well result in additional losses and bankruptcies of companies. While government action is needed, too much government action can also prolong the hangover. We will know more in the coming days whether the global response has been adequate to address the fear in the market.

For a really great, albeit technical report on the details of the credit crisis, call or e-mail our office for a recent newsletter published by Michael Kitces. Justus met Michael through his involvement in the NexGen group of the Financial Planning Association. Michael is an industry-recognized author and speaker on some of the most sophisticated and technical issues in the financial planning community. It is the single best report on the crisis I have read.

In the meantime, we are preparing to send quarterly statements from the end of September which does not reflect the last two weeks of mayhem in the markets. Needless to say, these are anxious times for many people so do not hesitate to contact us to talk further.

Appreciatively,

Michael P. Haubrich, CFP

President