Market Update — Facing fear — the credit crunch moves to Main Street

William F. (Ted) Truscott, Chief Investment Officer
September 30, 2008

"Nor need we shrink from honestly facing conditions in our country today. This great nation will endure as it has endured, will revive and will prosper. So first of all, let me assert my firm belief that the only thing we have to fear is fear itself — nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance."

Franklin D. Roosevelt
Inaugural Address — March 4, 1933

"The word 'risk' derives from the early Italian risciare, which means 'to dare.' In this sense, risk is a choice rather than fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being."

Against the Gods — The Remarkable Story of Risk
Peter L. Bernstein
John Wiley & Sons, Inc., 1996

No speech seems more appropriate at the moment than FDR's inaugural speech in 1933. While it is hard to imagine right now, things were considerably worse in our nation some 75 years ago and yet somehow in the face of incredible adversity, our nation overcame its ills and prospered. The same will happen this time around, and while we have many issues to work through, I remain faithful in our nation and the world's ability to face the challenges ahead. Yesterday's failure of the Emergency Economic Stabilization Act of 2008 in the House of Representatives was a step backward. Today is a new day and many are working to craft a workable compromise that will be seen less as a bailout of rich people in the financial world and more as a way to help solve the distress in the credit markets that has already arrived on Main Street.

Fear is a remarkable thing. As FDR noted, it paralyzes us. We are uncertain, and no one likes uncertainty. As we think about the massive uncertainty that confronts us, Peter Bernstein might tell us to take a dare. He would point out that in a free world we have a choice at this very moment to take a risk and potentially profit from it.

Unfortunately, the financial world is now all about avoiding any kind of risk. All you need to do is look at 30-day treasury bills, which are yielding somewhere between .01% and .17% (1-17 basis points in financial language), and you know the reward for risk aversion — a pittance, nothing. Never before have I been asked so many questions about where safety lies, which deposits have insurance and which do not, which company is safe and which is not. In just 14 months we have gone from a world of inveterate risk-seekers, safe in the complacency that volatility was at all-time lows, to a world of risk-avoiders with volatility at all-time highs. There must be a better way to think about things.

My mentor was a grizzled veteran by the name of Ed Games. Ed followed a number of industries in the U.S., particularly U.S. banks. His understanding of the Latin American debt crisis that rocked the banking system in the late 1980s led him to manage Latin American equity portfolios as the country emerged from its crisis in the 1990s. The adoption of free market policies spelled opportunity and a lot of money was made investing in Latin American equities and bonds. Then in December of 1994, the Mexican government devalued the peso, which set off a huge confidence crisis in much of Latin America. Money was lost, customers were angry (Ed and I both de-listed our home phone numbers) and a new paradigm that seemed so certain appeared to vanish. As markets continued to decline, Ed looked at me one day in March of 1995 and said, "Ted, the Mexican people are still eating tortillas and I am off to buy some shares of Maseca."

In that simple sentence lay the investment genius of my mentor. Maseca was the largest industrial manufacturer of corn flour, the main ingredient in tortillas. It was a strong and well-managed company and it provided an everyday necessity in the life of all Mexicans. Its share price had fallen so far and so fast that the market appeared to believe this strong company might go out of business. The security was mispriced and had plenty of what the famous investor Benjamin Graham called "margin of safety." Ed took a risk (and many others just like it) in buying Maseca. It took awhile, but he went on to make lots of money for our customers. A life lesson had been learned.

Many advisors and clients now believe that they should go to cash and find the safest place to invest, including insured CDs. While this may be a wise choice for some who have special circumstances, such as needing certainty in the late years of retirement, I have a more fundamental reason for reminding you not to follow the crowd into complete and utter safety. What I know is that many stocks and bonds are horribly mispriced. They are mispriced because there is no liquidity in the markets, a lot of forced sellers and plenty of fear.

The lack of liquidity, particularly in the so-called credit markets, is the chief reason that Congress should pass an economic rescue package. As I told several Congressmen over the weekend and yesterday, the lack of liquidity and fear in the marketplace has already arrived on Main Street. Banks are less willing to lend to credit-worthy borrowers — big companies, small companies and individuals. When this happens, you can throw out all of the economic forecasts because credit is the grease of the economy. Remove the grease and the machine will seize up and stop working. This is not good news for the economy. As we have said for months, the root cause of this problem is the deeply distressed housing market and the securities that are associated with it. If there is a way to remove these securities from bank balance sheets and lower the risk of failure among financial institutions, then liquidity and confidence should return to the marketplace.

In the meantime, lack of liquidity is creating opportunity in both bonds and stocks. We do not make individual recommendations in these updates, but my colleagues and I have long lists of bonds and stocks where repayment is highly certain and yields more than compensate for the risk. These are solid businesses that will prosper again in the future and in the meantime are paying dividends to help compensate for the uncertainty of when that point of prosperity arrives.

So we now need to face our own fears and doubts and think about taking some risk and finding our own versions of Maseca. If you dare to do so, you will be swimming against the tide and have plenty of naysayers giving you well-reasoned arguments about why a stock, a mutual fund or a bond should never be purchased again. Remember, when you have the price, you don't have the proof and when you have the proof, you don't have the price.

Finally, there are some who will say that their circumstances do not allow for taking on much risk. This is understandable. This is why we stress the need for product diversification as part of the arsenal to defend against volatile markets. The opportunities mentioned above are translated for you in products that hold less risk than a traditional stock mutual fund, stocks or bonds. These products include insured money market accounts, certificates, fixed annuities and variable annuities with living benefit riders. While no financial product is risk-free, these products all offer a higher degree of safety.

Ameriprise Financial continues to be a financially strong and sound company, and we stand firmly and confidently behind the products we manufacture. Talk to your financial advisor now about the opportunities, risks and rewards that exist in the current marketplace. They can tailor a suite of products that appropriately balance risk and reward in today's markets — to suit your individual needs.