Sales Insight - January, 2008

Imagine that you are communicating with one of your best clients right now, and you have just enough time to offer a few words of advice. What should it be?

A. The U.S. stock market has always rewarded patient long-term investors.
B. The U.S. economy has always bounced back from difficult periods.
C. Diversified investment strategies should be maintained for the long-term.
D. These are complex times, and you should feel confident and in control.

The correct answer is the one that: 1) motivates clients to consider changes in the economy and challenges in investment markets; and then 2) take timely actions to adjust for them.

Financial advisors communicate with clients several times per day in ways that are conscious and subliminal. Today, many advisors are sending clients signals that echo answers A, B, and C above, perhaps without understanding their influence or potential impact.

In this article, I will explain why you should consider evaluating and changing the tone of your client communications for these unusual times. The article includes five Power Phrases that you can use to help clients recognize new challenges and respond with actions or decisions. Because creative ideas can help clients recognize timely opportunities, the article also highlights four investment strategies that may help clients protect portfolios while keeping long-range investment programs on track.

I have observed that even the most ethical and objective financial advisors may have biases in favor of “truisms” practiced over time. For example, one truism is that “patient long-term investors in the U.S. stock market have always been rewarded.” Over the past three decades, this conviction has helped many investors increase investment discipline and net worth. However, it can also represent bias.

To illustrate, I often ask advisors how much the S&P 500 Index declined from peak to trough during the bear market of 2000-02. Answers usually vary between 30% and 40%.

The correct answer is a price loss of exactly 50% from the peak (S&P: 1553; 3/00) to the trough (768; 10/02). This gap indicates that some advisors are subconsciously discounting the severity of loss, in part because it conflicts with their mantra that patient long-term stock market investors are always rewarded.

50% is a number that every financial advisor should memorize because it represents the real downside of broadly diversified equity investing (500 large-cap stocks) in the world’s largest stock market over a short period of time (31 months). Following a 50% loss, it takes a 100% gain to fully recover.

For many individual investors, the 2000-02 market downturn was a crushing blow, from which they have just begun to recover. Some investors might never be able to recover from another similar experience, financially or emotionally.

Financial advisors should avoid communicating to clients that 2008 will be a good year, an ordinary year, or a transition year in which any economic or stock market downturn will be brief or painless. On the other side of the coin, advisors also should avoid signals that increase clients’ fears or anxieties. The first Power Phrase models a middle ground.

Power Phrase #1: These are complex times, and we don’t know how long they will last. Times like these require careful review of investment plans and assumptions. Whether or not the environment is favorable, you can feel confident and in control.

It’s not clear that 2008 will produce gains in either the U.S. stock market or U.S. real gross domestic product. But you can confidently predict appreciation in the value of personal trust with your clients.

The modern investment industry has been built on a model of gathering and maintaining stable assets. In countless ways, the industry broadcasts subliminal messages that encourage investors to “stay the course.” Advocates for the industry reinforce these messages with cheerful predictions about the economy and financial markets, even when hard data argues otherwise.

Advisors stand between the industry and their clients, helping the two communicate. In complex times, smart advisors demonstrate that their primary allegiance lies with clients, not the industry. The second Power Phrase will help you remind clients that you are on their side, and you’re not going to sugar-coat the story.

Power Phrase #2: You may hear or read comments stating that these are normal times for the economy and financial markets. I believe otherwise. We have entered a challenging period, and I want to understand the specific issues that are keeping you awake at night, if any.

During difficult markets, financial advisors differentiate themselves from competitors by offering their clients proactive communications and personal service. This is a good time to affirm how much attention and service clients require in complex times. It may help to offer clients three broad choices for building relationships this year:

1. Minimal changes – We will agree that your planning and portfolio are in good shape, and you will let me know if anything changes or your concerns increase.

2. Modest changes – We will evaluate and make specific adjustments in your planning and portfolio, and we will keep monitoring events and results to see if other changes are warranted.

3. Major changes – I understand why these issues are keeping you awake, and we will address them quickly, so that you feel more in-control and confident.

Over the next 30-60 days, you should reach out to all clients and clarify which of these choices works best for each. Power Phrase #3 will help you initiate this process.

Power Phrase #3: You have a choice of making minimal, modest or major changes in investment planning, and I can help you evaluate this choice. This is not a time to procrastinate. I believe it’s a critical time to review where you are financially, and where you want to go, with an open mind.

The past year has produced an unusual investment environment, perhaps unique in your lifetime. During 2007, most major stock market benchmarks, domestic and international, achieved all-time highs. Gold, oil and many other commodities soared to record prices. Interest rates stayed low, which kept bond prices high.

As 2008 began, some investors were having a hard time finding attractive valuations in any asset class. To complicate portfolio diversification strategies, correlations between many asset classes have been increasing, which could indicate that many asset classes have common vulnerability. The table below shows recent correlations of major equity asset classes with the S&P 500 on a 5-year and 10-year look-back basis. (1.00 = perfect correlation)

Asset Class	Index	Correlation with the S&P 500 Index
Asset Class	Index	5-year look-back	10-year look-back
Large-cap growth U.S.	Russell 1000 Growth	0.97	0.94
Large-cap value U.S.	Russell 1000 Value	0.98	0.89
Mid-cap U.S.	Russell Mid Cap	0.92	0.89
Small-cap U.S.	Russell 2000	0.84	0.72
International developed	MSCI EAFE	0.87	0.81
Emerging market	MSCI Emerg. Mkts. Free	0.76	0.71

The high correlations mean that any broad downturn in equities could leave investors with few sanctuaries for protecting assets, and style-based asset allocation strategies could be especially vulnerable. During the 2000-02 downturn, exposure to value and small-cap styles helped to cushion the market’s broad decline. But that cushion may not help as much in the next downturn – in part because of strong multi-year performance in value and small-cap styles.

The concept of diversification has timeless benefits for investors. But the strategies that have helped to diversify portfolios in the past may not work as well in the future. They should be reviewed and updated, especially by clients who fall into the “modest change” or “major change” categories.

Power Phrase #4: In any broad equity market downturn, all styles of stock market investing could be vulnerable. Do you feel prepared for any significant down trend? Or would you like to review your risk exposure and asset allocation now?

If you can offer a few actionable ideas that help investors maintain progress while reducing risk, you will strengthen client relationships in 2008. The best ideas show you are creative and open-minded to concepts that address changing needs and new challenges. This is not a year for “sticking to your guns.” In the investment world, as in the political landscape, 2008 will be a year of change.

Power Phrase #5: What does the term “investment continuity” mean to you? To me, it means helping you stay on track with the best strategies available. In complex times, you may want to consider new ideas that align with changes in the economy, financial markets, and your own needs.

1. Increasing Cash – On Internet investment blogs, debates rage over whether the next phase of the U.S. economy will tilt toward inflation or deflation. It’s a sign of changing times that each side has many champions, with few advocates in the middle. By helping your client increase allocations to cash, you can position portfolios for a trend in either direction:

It is interesting that many financial advisors heartily endorse the concept of “target date funds,” in which holdings of cash (or short-term bond) increase gradually as the client ages. Yet, some of these same advisors have not increased the cash portion of clients’ overall portfolios, despite advancing age and signs of increasing volatility and risk in financial markets.

2. ProShares Short Equity ETFs – ProShares has created a unique family of short ETFs designed to mirror the inverse of leading U.S. and international benchmarks. To ignore these ETFs because they are “bearish” is to miss a valuable planning application – namely, a “do-it-yourself hedge fund.”

Investors can continue to hold their favorite actively managed mutual funds or separate accounts while simultaneously buying a short equity ETF, thus creating the same type of “portable Alpha” strategy that long/short hedge funds offer. Performance is driven by the Alpha that long managers generate in excess of the benchmark, while the overall volatility (Beta) of the combined long/short position can be as low as zero (or even negative).

“Do-it-yourself” hedge funds are far more transparent and economical than professionally managed hedge funds. The short ETFs can be sold quickly and easily whenever investors become confident that the stock market has stabilized and is poised to rebound.

3. Japanese Equities – Of all global equity asset classes, only one has consistently produced low correlations with the S&P 500 Index, and that is Japanese equities. On a five-year look-back basis, the correlation between the S&P and the Nikkei 500 Index is 0.35, according to FactSet. Historically, the Japanese economy has moved in cycles that run counter to those of the U.S., and Japanese stocks currently appear to be at low points in both a long-term secular cycle and shorter-term economic cycle.

The Nikkei 500 Index peaked at 39,000 at the start of 1990 and finished 2007 at 15,300, down 61% in price over 18 years. For 2007, the Nikkei lost 11.1% in price, the worst performance for any developed global market.

Japan has the world’s second largest national economy, and U.S. investors who buy its equities through mutual funds or ETFs can participate in the appreciation of the yen vs. the dollar. Some experts believe the Japanese currency may appreciate during 2008 as the “yen carry” trade unwinds. An unwinding of this trade, which borrows yen at low interest rates to purchase margined investments, could put downward pressure on U.S. stocks.

4. Diversified Commodities ETFs – Any single commodity can be volatile and subject to sharp price declines. But a diversified basket of several commodities can participate in two levels of diversification: 1) commodities baskets historically have had fairly low correlations with U.S. stocks; and 2) individual commodities futures contracts have fairly low correlation with each other. Commodities prices tend to move in long up/down cycles. For example, the last great bull cycle in commodities lasted nine years – from 1972 through 1981. The current bull cycle began in mid-1999 and accelerated dramatically in 2007.

Diversified commodities are perhaps the best pure investment hedge against higher inflation. When a basket combines several volatile commodities with low correlations to each other and rebalances frequently, research has shown that the overall portfolio can achieve about 2-4% more return over time than the raw average of all components (unrebalanced). For details on ETFs that hold baskets of commodities futures contracts, see: www.freeerisa.com/insightnew/200612si.asp.

Financial advisors perform a valuable service by reminding clients to “focus on the long-term.” But during complex times, many investors evaluate personal progress and the value of advisors’ services from year to year. This may be particular true for investors whose wounds from the 2000-02 bear market have not yet healed.

Nobody knows where investment markets are heading in 2008. But it seems likely that U.S. and perhaps global equity benchmarks will be volatile and unpredictable all year. Wherever they finish, you want your clients to look back and believe that they received proactive advice and creative ideas that anticipated challenges.

Use the phrases in the section below to help your clients understand why these are complex times, perhaps unlike any they have previously experienced. Then, offer to help each client evaluate the minimal, modest or major changes that are warranted. The actions that you take over the next 30-60 days can influence how satisfied your clients will feel about your relationship a year from now.

o Real estate – U.S. home prices are experiencing the largest declines since the Great Depression, and many observers believe prices will not bottom until late 2008 or 2009. Commercial real estate has begun to show signs of stress.

o The credit crunch – Banks are worried about rising delinquency rates on many types of credit including car loans, student loans, credit cards and commercial construction loans. Many banks are tightening credit standards.

o Corporate earnings – In late 2007, U.S. corporate earnings decelerated at one of the fastest rates in years, especially in two sectors that often signal changes in economic cycles – financials and consumer discretionary.

o Inflation – Driven by increases in energy and food, the U.S. Consumer Price Index increased in 2007 at a faster pace than in any year since 1990.

o Employment – According to the Bureau of Labor Statistics, U.S. civilian employment increased by just 22,000 jobs per month on average in 2007. From 2003 through 2006, civilian employment increased by an average of 198,000 jobs per month. The U.S. has lost 3.4 million manufacturing jobs since 2000.

o The Federal deficit – The U.S. federal budget has gone from a cumulative surplus of $559 billion from 1997-2000 to a cumulative deficit of $1.8 trillion during the period 2001-2007. Large deficits limit Congress’ options in implementing economic stimulus programs.

o The U.S. dollar – On a trade-weighted basis, the U.S. dollar has declined by 23% since early 2002. A weak dollar makes U.S.-denominated investments less attractive to foreign capital sources.

o Income taxes – Tax rate reductions enacted by Congress in 2001 and 2003 are scheduled to expire at the end of 2010. All leading Democratic candidates for President have promised to increase income taxes on the wealthiest taxpayers.

o The trade deficit – The cumulative U.S. trade deficit from 2004 through 2007 was $2.9 trillion. Even with an increase in exports (due largely to the weak dollar) the trade deficit is expected to exceed $100 billion in 2008. A high trade deficit gradually drains wealth from the U.S and sends it overseas.