From the November 2006 issue of Wealth Manager Web • Subscribe!

The Sky Is Falling?

I don't know a financial advisor who hasn't received the occasional, "Is the sky falling?'' call from clients. Even when the markets are reasonably well-behaved, there always is some study, report or forecast to spook investors.

Consider last year when, in a USA Today cover story, the comptroller general of the U.S., the director of the Congressional Budget Office and other knowledgeable number crunchers described how demographically prompted surges in Social Security and Medicare coverage could further increase the federal budget deficit. This, they predicted, would throw the U.S. into a long-lasting recession. Nearly two weeks later, The New York Times explained why a respected economist believed that even a "mild recession" in 2006 could trigger a financial implosion, due to the combined impact of rising interest rates, historically high consumer debt, and a less expansive housing market.

A "financial train wreck," the Times suggested. "A demographic tsunami," quoted USA Today. Different metaphors, but the same overriding message: Investors beware!

Financial advisors cannot fault their clients for expressing concern when dire predictions of that magnitude are voiced in the national media. Indeed, investors have experienced some vertiginous moments in the past two decades. Many of them still remember October 19, 1987, when the Dow Jones Industrial Average lost more than one-fifth of its value within hours. Fourteen years later, almost to the day, it was d?j? vu all over again: on September 17, 2001 the DJIA experienced its greatest single-day percentage-point loss in modern times.

In both of these cases, the equity markets rebounded fairly quickly. Unfortunately, such was not the case with the severe market downturn of 2000-2002. This experience caused more lasting damage to both the portfolios and the pysches of many investors.

Before those difficult three years, virtually every financial advisor heard innumerable warnings that the equity markets were excessively overvalued by virtually any historical measure. A number of market savants declared that "this time was different." But as the Nasdaq and other stock indices raced upward in 1999, many financial advisors trimmed clients' stock allocations and rebalanced away from growth stocks. However, it is likely that very few strategic equity allocations were reduced to minimum exposures, or that even more radical market timing shifts were completed. Indeed, an advisor who heeded some of the warnings during those last go-go years too early would have significantly underperformed, adding to the risk of falling short of longer term goals.

Ultimately, of course, the dire forecasts were proven right. Many investors experienced net losses through 2002, even if the full impact of the equity market's fall was cushioned somewhat by a properly diversified portfolio. Given that experience--and the ever-present potential for bad things to happen to good investors--shouldn't we pay attention if the comptroller general of the U.S. and a respected economist both proclaim that the economy and markets are in jeopardy?

The simple answer is "yes." Advisors have a responsibility to consider all plausible forecasts. Clients who seek guidance regarding a gloomy outlook really are asking what steps, if any, should be taken to protect their portfolio and financial well-being. That is always an appropriate question.

However, this exercise must be approached cautiously. At any given time, there are far more doomsayers voicing calamitous scenarios than there are actual doomsday events.

When evaluating dire predictions, it is helpful to pose the following five questions:

How credible is the prognosticator? It is worth noting that clients with sky-is-falling questions are generally quite adept at distinguishing between credible and questionable sources. Our own experience is that clients are rarely unnerved by the smooth-talking, self-proclaimed "market sage" who urges investors to immediately shift most of their assets into commodities futures or gold in order to withstand the current inflationary cycle. However, it is not as easy for clients to disregard the remarks of highly knowledgeable individuals whose probity appears to be beyond question.

Advisors must help clients understand that even the most prominent economists and investors are often wrong when they make far-reaching predictions. John Maynard Keynes is recognized as one of the foremost economists of the last century, but he lost personal fortunes several times over due to misguided expectations. More recently, one of the leading names in investment research experienced public embarrassment when he shorted oil in 2004, just in time to watch it climb to striking new highs.

This is not to suggest that all market seers are to be ignored. Some of these professionals have extremely interesting insights into how economies and markets work, and they back up their predictions with valuable data. At the very least, they can compel a re-examination of presumptions and outlook, and a consideration of the markets in a different light.

Is the dire prediction plausible? Just 15 years ago, otherwise sensible politicians and corporate savants--as well as some savvy investment professionals--warned that the Japanese economy would soon outstrip ours and would leave the U.S. an economic has-been. Even during Japan's economic heyday, there was little evidence to support this contention, but it was a public concern for years. You also may recall the spate of books and articles that appeared in the late 1990s predicting that the DJIA would rise to 30,000 or higher, perhaps in our lifetime.

It is the far more plausible scenarios that give us pause. Consider one from a highly regarded technical analyst who noted about a year ago that (a) the yield curve is inverted; (b) inverted yield curves almost always signal an impending recession; (c) the stock markets have a history of sliding into a bear market prior to a recession; and (d) that the odds are extremely low that "this time is different."

This is a plausible scenario, backed by considerable historical data. Nevertheless, an advisor might want to ponder this red flag a bit more before rushing to underweight equities and overweight cash in a client's portfolio.

Is there good news that may help to offset the bad news? Well-meaning and knowledgeable forecasters can become so focused on flaws and weak points in the economy or markets that they may neglect to give potentially good news its due. Additionally, they often expect an economic slowdown or market drop to occur in a compressed period of time, rather than spread over a longer period in which investors could have time to respond before portfolios are unduly damaged.

If it appears that the economy and markets are vulnerable to a severe setback, what is the likely outcome for investors? This rarely is a simple call. It is instructive to remember that many professional market observers believed that "Black Monday" in October 1987 portended the end of the equity bull market--and failed to anticipate that the following decade would be one of the best ever for U.S. stocks. Conversely, it would have been advantageous for advisors to dramatically reduce their clients' equity exposure when the market began to crack at the end of the first quarter of 2000. Unfortunately, this bear market was so outside the historical norm in both its severity and duration, that few advisors were prepared to take such a radical step.

Based upon a dire prediction, should client portfolios be re-positioned to address less favorable circumstances? The challenge for an advisor is to avoid portfolio refinements that inadvertently compromise a client's long-term, strategic asset allocation and financial plan. As advisors, we must be certain to always reinforce with clients that any recommendation that reduces total portfolio risk may impact their return upside and the ability to reach their goals.

This process of attempting to divine the future--especially those elements of the future that may have a nasty bite--is an ongoing process for financial advisors. There are major investment challenges on the horizon today, but if memory serves, that is the case almost every year. The advisor's responsibility is to watch, evaluate, and temper any assessment of doomsday with an open mind and a proper dose of skepticism.

Timothy A. Schlindwein is Managing Principal of Schlindwein Associates, LLC, Chicago, www.sallc.com.

Reprints Discuss this story
This is where the comments go.