A Year Never To Forget

There isn’t much that I need to say to emphasize just how bad this year was in the financial markets. The world went through a capitulation, and in that process all the cracks and flaws within the financial system were exposed. From dismal company 401(k) performance to the complete collapse of hundreds of hedge funds, we learned first-hand that we need to focus on the basics.

For comparative purposes:

I point all this out to make a few points:

1. Our financial system has for years encouraged people to use mutual funds and corporate 401(k) as methods to invest for retirement and diversify our risk. For those who followed this approach, they witnessed a loss of nearly half their investments. This is an astounding depletion of value, at exactly the wrong time as the country heads into a prolonged recession and enormous job losses.

a. I have for years been a staunch opponent of mutual funds for their lack of true diversification combined with elevated fees, both disclosed and hidden. With the stresses and dislocation we’ve seen this year, these flaws came to the forefront. Most funds lost more than the market this year – at a time when risk mitigation was critical to preserving family wealth.
b. The tax benefits of deferred tax accounts are dubious at best. Placing money pre-tax into a 401(k) makes certain assumptions regarding tax burdens in retirement and the benefits of growth of pre-tax assets. With such an enormous national debt generating in the past eight years and the manner in which income is progressively taxed, it is possible that the tax benefits of deferred accounts won’t exist.
c. Firms such as Fidelity are going to have much to answer to the investing public and lawmakers as they try to explain why so much of America’s retirement savings was wiped out in a single year.

2. There was no place to hide in the markets. The traditional notion of diversification did not work, such as international versus domestic investing. Any exposure to any risk results in enormous losses. Even the sole winner, Treasuries, has likely formed a bubble and could fall quickly in 2009. That, combined with the prospect of long-term inflation would make investing in the sole winning asset class of 2008 a risky and speculative investment in 2009.

3. Cash is Always king. I have used this mantra as cornerstone of our investment philosophy, and it is true now more than ever. Whether it is the cash flow off an investment (such as dividends or interest payments), or the cash flow going to the corporation, it is the first determinant in our investment approach.

Economic and Market View for 2009

By every measure, we are in a tough economic environment. Unemployment, the primary measure of a growing economy, is headed towards a 10% level – higher than we have seen in a generation. While the Obama stimulus plan could eventually generate the number of jobs that he is projecting, it will be at a steep cost. This cost will be in terms of an enormous budget deficit and a strong potential for dollar devaluation. The only mitigating factor helping the dollar is that every major economy across the globe is facing similar issues. It is a matter of who will recover first and at what cost.

The markets, however, will advance prior to the recovery in the market. Any sign that the worst is over will generate significant inflows into the general equity markets. The bond markets are already going through a rapid recovery: high-grade corporate bonds (AA and above) have rallied to pre-crash levels, many other investment grade corporate bonds have shown a similar recovery and preferred stock are showing strength as well.

The long-term prognosis for the US is difficult to determine. Unfortunately, it will largely rest on the incoming Administration and their policies, both domestic and foreign. Through years of indulgence and short sighted (aka greedy) policies, we have gutted the core of America. Our auto industry is in need of a shot of arsenic, we have exported a large part of our manufacturing base, and our primary growth industry – financial services – is in risk of permanent impairment. We need to find innovation, productivity and vision.

The good news is that we have an incoming Administration that is addressing these very issues. Alternative energy, energy independence and the related innovation will be a crucial first step in these policies. America’s focus on savings and breaking the addiction with consumption are the other necessary steps. Frankly, as a consumer-oriented society we need to go on a 5-step recovery program and stay in that support group for some time to come. The recovery will bring a good amount of pain, and we’ll be prone to frequent relapses if the entire situation is sugar coated.

While it may sound like doom and gloom, as are still the leading innovators of the world, with our research institutions and entrepreneurialism unlike anything in the history of civilization. Most of our institutions will survive, including the corporations that produce good stuff and have strong intellectual property. The ones who produce poor goods and don’t innovate (i.e. the auto industry) are going to ultimately fail, or at the least be unrecognizable in the future. Those in between will struggle to find their place in the next economy.

Portfolio Positioning

At Vodia we had a number of successes and failures during 2008, the most destructive of which was the government take-over of the GSEs, Fannie Mae in our case (I am still pissed-off at the Treasury for this one). But to our credit, we also took many steps in advance of this crisis: we realized some impressive gains earlier in the year, we were already positioned with low equity exposure, our cash positions were high, we avoided the emerging markets and commodities collapses, and most of our investments were based on strong cash flows.

As a result, we were able to reduce the damage by half, give or take depending on your risk profile and account specifics. This is great news. With a horde of cash to invest at this market bottom and the prospects of an eventual recovery we are well positioned going forward, we can ride up with the markets at an accelerated pace, making back any losses and then some as the recovery takes hold.

For 2009, we are repositioning the portfolio as follows:

As usual, please call or write with questions or comments. A detailed performance report will be emailed or mailed separately. We also have our annually updated Form ADV available in print and electronic version. Feel free to write clemail@vodiacapital.com or call 978/318-0900 for a copy of it. Best wishes for a healthy winter, David B. Matias, CPA

Best wishes for a healthy winter,

David B. Matias, CPA