January 14, 2009

2009 1st Quarter Newsletter

Happy New Year from everyone at Wagner Wealth Management. We hope that 2009 brings you many blessings. Enclosed please find your performance report, a current asset allocation, a list of your holdings, and an invoice.

Unless you are close to 100 years old, today’s economic and investment environment does not fall within your adult frame of reference. Stocks, bonds, commodities, hedge funds, and any other asset class other than cash or treasury bonds are at historic lows.

We can review the history in detail, but with some economy of words, let’s just say that the crisis in the banking system has caused investors to run from any investment with risk. As a result, there is a disconnection between today’s price of many assets and the true value of those assets.

Leveraged investors—mostly hedge funds—have been forced to reduce debt and to meet redemptions, resulting in massive and indiscriminate selling to raise cash. This has been going on for several months. Investment banks, insurance companies, and public pension funds have also been forced to sell to raise cash for a variety of reasons. Mutual funds have also been selling to meet massive redemptions.

This may be an overused phrase, but we don’t think that most veteran investors suddenly “woke up stupid.” The severity of a situation, which was unprecedented in our lifetimes, blindsided even the most sophisticated managers of university endowments and large pension funds.

By any measure, stocks, bonds, REITs, private equity and commodities appear to be cheap. Opportunities to buy are present. Yet, there still appears to be an acute aversion to risk, and short term risk of further declines is also present.

For our clients, how should we trade off short-term risk versus potential for long-term returns?

This is the $64,000 question. We take our responsibility in answering this question very seriously. After spending many hours, we have developed the new asset allocations included in this report.
We recognize that virtually all investors, including our clients, are deeply pained by portfolio losses experienced in recent months. The magnitude of any long-term opportunities becomes meaningless if investors can’t make it to the long term. Recognizing this, we have decided to take a middle ground in this environment.

Equities: We believe all public equity asset classes are now priced to deliver good returns, with some priced to deliver outstanding returns, but over a five-year horizon. We realize that U.S. equities created 0% return in the last 10 years when measured at the end of 2008. Historically, every time this has been the case, U.S. equities have averaged over 10% annual returns for the next ten years, about 175% cumulative return. As long-term investors we believe it is important to maintain equity exposure. However, we are sensitive to the psychological impact to our clients of increasing equity exposure only to see more declines in the short term. In this environment we assume any equity buys we make will be followed by more weakness—that is not a prediction but rather an acceptance that we can’t predict what will happen in the short term. We also believe other asset classes may outperform equities in the short term. Therefore, we have slightly reduced our allocation to public equities for 2009.

Furthermore, as we rebalance the portfolios, we are using the Core Funds from Dimensional Fund Advisors. These funds are inexpensive, tax efficient, cover thousands of stocks in the U.S, foreign, and emerging markets, and have still managed to outperform index funds over a long period of time. We are adding these funds primarily to insure that when a recovery does occur, the portfolios participate. We don’t want to take a chance that your money is concentrated in too few stocks or managers, and that those managers have a bad year during the recovery. We will still keep some of our active managers, but believe more diversification at a lower cost is prudent at this time.

Bonds: Bond prices began a recovery in the 4th quarter and may appreciate in the short term. We have increased our allocation to bonds as a result. We believe our bond funds have an appropriate mix of conservative and aggressive bonds. We are also maintaining a small position in foreign bonds as a hedge against the decline of the dollar against other currencies.

Alternative Investments: Our goal here is to earn 7-10% with bond-like volatility. We avoided any major hedge fund blowup in 2008. Now that the dislocation in the hedge fund world is coming to an end, we believe that the alternative strategies we have selected have opportunities for appreciation in the short term.

Commodities and TIPS: Commodities prices have fallen 62% in the last 6 months and are currently undervalued. Our research tells us that over the long term, portfolios with commodities have a better risk/reward relationship than a portfolio without commodities. Commodities also provide a hedge against inflation. TIPS, or Treasury Inflation Protected Securities, are also very cheap at present and will increase in value if there is inflation. We can obtain both commodities and TIPS in the Pimco Commodities Real Return fund and believe this fund to make a solid “inflation basket” for our clients. Accordingly, we have added a small dedicated position to commodities

Private Equity: A broad investment in private companies has outperformed the public stock market over the long term. Private equity investments come in what we call “vintages.” We make an investment and expect a return in a 3-7 year period. Our research tells us that private equity vintages in the middle of a recession are excellent long term investments. We have added a mutual fund – the Listed Private Equity Fund – and a private placement to cover this asset class.

REITs: Real Estate Investment Trusts have declined in price 40% in the last 3 months. Given the income paid to investors by REITs, we believe the prices are reasonable, but are also subject to possible price declines in the short term. We have maintained a small position in the asset class.

Overall, there is no sugarcoating the very serious challenges to the global economy. That being the case, it is important to remember that markets almost always bottom while the headlines are still grim and fundamentals are still weak. Almost every bull market that started from a period of economic weakness was well underway while corporate earnings continued to decline and unemployment continued to rise. A good way to get whipsawed is to wait until it feels safe to re-enter the equity markets. At that point stocks are likely to be much, much higher and it will be psychologically more difficult to commit to investments at much higher prices. This is a clear and unequivocal lesson of history.

We want to note that these asset allocations are not a mandate, but a proposal. We believe investors are very likely to capture good returns over the next five years with these allocations. But in the meantime we make no claim to know what the next few months may bring. Being a long-term investor would be easier if we could all come back in five years and check our portfolio values without worrying about what happened along the way. Since that is not the way the world works, we reiterate the importance of being in the portfolio strategy that is right for you. We welcome an opportunity to discuss this new allocation with you at your convenience.

Sincerely,

Wagner Wealth Management