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By mwleach
July 24, 2002

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I recently wrote the following e-mail to my compatriots in the Navy's PFM (Personal Financial Management Program) community. With a few minor changes (technical details for the FE's - Financial Educators), I thought some of you here might be interested as well.

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Greetings to all my (former) fellow FEs. An old Chinese curse says, "May you live in interesting times." We certainly do .... I recently returned from Morningstar's annual investment conference in Chicago (where sentiment among most of the professional money managers was quite negative). Since I've had a couple of weeks to digest what I learned there, I thought it might be a good time to try to use some of this information to help put our current situation into perspective. Finally, with the big drop in stock prices this past week, including the mini-panic last Friday, I thought now would be a good time to send out a note to you. Rather than write you each individually, I've decided to compile some general remarks

To start off, I feel I should remind everyone that I claim no special insights that enable me to predict market moves, particularly short term. However, I have held a current Certified Financial Planner designation for over 10 years, was an active FE for 9 years, and have some background in the markets. Perhaps my major "qualification" (such as it is) is my age and background. At 55, and coming from a family whose father, grandfather, and great-grandfather were all stock brokers (I have in the past referred to this as one of my genetic defects ;-), I have hopefully learned at least bit about how our capital markets operate, some of which you only discover over time (and often the hard way.)

As Financial Educators, you [are] all facing a particularly tough job right now, trying to encourage our young military folks to invest for their future, and teach them the importance of sound personal money management, during a period of considerable uncertainty. At the same time, all of us cannot help but be bit nervous about our own futures. So what, exactly, is going on? Where do we stand and, and where are things likely to go in the future? Also important: What can you tell your CFS's and clients about all this? To answer, I will talk a little about bear markets and discuss some ideas. Finally (since I'm not currently in "the business" and can do this now), I will provide a couple of specific options for you to consider.

Let's begin with a few basics. First, we are in a bear market (no special insight there!). To be precise, we are at least in the middle and probably in the later stages of what is called a "cyclical bear market". Bear markets are somewhat arbitrarily defined as occurring whenever the major stock indexes close at a level 20% or more below a previous closing high. As of Friday, July 19th, the Dow Jones Industrial average has fallen 31.6% from its high in January 2000. The broader indexes (the S&P 500 and the NYSE Composite) are off 44.5% and 31.7% respectively. Finally, the tech-heavy NASDAQ Composite Index has plummeted 73.9% from it's all-time high in March of 2000.

Cyclical bear markets are always painful for us as investors. They are always scary. But they are not (should not come as) any surprise, because they are not unusual. This bear market only seems unusual, because it has been so long since we have had one. Depending on who's accounting you read, the US stock market has had 17 or 18 cyclical bear markets in the 20th century - that is an average of about one every six years (plus 3-4 other declines of close to 20%). Nine of these bear markets were serious ones, with stocks off by a third or more. The worst was an 89% decline from 1929 to 1932 - this at the height of the Great Depression. However, except for the stock market crash in 1987, which those of us who went through it know was scary but quickly over, we have not had a bear market in over 17 years. That is a very long time by historical standards.

How bad are cyclical bear markets? They generally last 1-2 years. None have lasted longer than three years. We are currently experiencing the worst cyclical bear market (in terms of duration) and the third worst (in terms of severity) in the modern era. The worst decline since WWII was 45%. So guess what? The worst is probably just about over for this one. If your clients have not panicked by now, it is too late - tell them not to bother. Seriously, if history is any guide, stocks are overdue for a rally in the short term, and should be headed back up for a multi-month or more rally no later than the middle of next year. That's the good news.

However, there is possibly also some bad news. Remember, I said were "at least" in a cyclical bear market. We might also be in the early stages of what is know as a "secular bear market". This is a different animal entirely. A secular bear market is a long period of flat or declining stock prices. We have had two secular bear markets in the modern era. The first lasted from 1929-1942, along with the Great Depression and the Second World War. Although the low point was reached in 1932 (with the Dow at 42, down from a high of 380 in September 1929), stock prices subsequently fluctuated up and down, with a lot of volatility, but really did not go anywhere for the next 10 years. The next secular bull market started in April of 1942, with the Dow at 95. (I found that fact to be very interesting, by the way. A new, major bull market in US stocks started during not long after our entry into World War II, before the most decisive battles had been fought. The market "knew" who was going to win over a year before eventual Allied victory began to be apparent to most observers. Remember also the big rally in stock prices on the first day of the air campaign of the Gulf War in 1991? We won that one easy, despite all the misgivings in the news media. The market seems to have a way of knowing such things.) Still, full recovery took a long time, and the Dow did not exceed its 1929 level until 1955. Anyone who took a lump sum of money and bought a broad basket of stocks representative of the indexes any time in the late 1920's went through a period of nearly a quarter century with zero profit.

Our other and most recent secular bear market started in 1972, with the Dow at 1020. (A good argument could be made it really started six years earlier, as the Vietnam War was gearing up - the Dow first got within a few points of the 1000 level in 1966.) This bear market also hit bottom early, with the Dow falling to 607 at the end of 1974. But, again in this case, stock prices essentially went nowhere for a long time. In August of 1982, when the most recent secular bull market began, the Dow stood at 808; however, due to the very high inflation, this was effectively lower than it had been in 1974. The Dow finally exceeded its old 1972 high in 1983, but it was the late 80's before prices for US stocks, adjusted for both inflation and dividends, exceed levels reached in the mid-1960's. Once again, stocks went through a 20+ year period of zero returns.

The point of all this history is to illustrate that we have had two extended periods in the past century where stocks did not go up. Most of us as FEs have learned, and taught our clients, that stocks are the best investment for the long term. This remains absolutely true. However, long term means just that - long term. I seem to recall the New York Stock Exchange put out an advertisement a few years ago, stating that returns for all stocks in the NYSE Index would have beaten returns for bonds over every 25 year period in the exchange's history. That is probably the case - but just barely. It is also the case that investments in bonds or in savings (cash) would have beaten stocks over any number of periods lasting 20 years or more in the last century.

So, we are in a cyclical bear market. The big question at this point is: Have we currently also entered a secular bear market? No one knows for sure. Unfortunately, in my opinion, the answer is probably "yes". At the very least, I believe we are in for an extended period of what most of us would consider sub-par equity returns. Veteran investors like John Bogle and Warren Buffet are calling for average stock market gains of 4-5% over inflation going forward for the next 10 years or so. Assuming (as they do) a relatively low inflation rate of 1-2%, that means we can expect about 5-7% return in our stock mutual funds and 401(k) accounts - minus any expenses, for at least the next decade. These are some sobering facts for a lot of us.

So what do we do at this point? What do we tell our clients? Here are a few of my thoughts for our CFS and young military families:

1. Those just starting their military careers, and even the mid-careerists, should be cheering every day the market goes down.
Buy low, sell high (later). The bear is their friend. They have a long time to invest. Putting money into one or more of the stock accounts in TSP and/or a good fund in a Roth IRA is still the best thing they can do for their futures. I ordered and received a hypothetical illustration from one fund company (Pioneer), which had one of the few open-end mutual funds in existence back in the 1920's. This illustration showed what would have happened to an investor who started in July of 1929 with a $5,000 lump sum, the worst possible time in history, and then added just $100 per month thereafter. That investor took 8 years to first show a profit (at a time when consumer prices were declining, by the way). By year 11, that investor was way ahead and never looked back. Recovery time in 1970's secular bear market was even shorter. So for those in the accumulation stage - and that probably means anyone still on active duty - this is a great time for investing, and a great time to be buying.

2. Anyone planning for retirement needs to use conservative assumptions - far less than the 12% plus that many on-line oo-it-yourself retirement software programs were using until recently. Even DOD (www.dtic.mil) web site's default settings of 3% inflation and 8% investment returns, assumptions some of us once thought of as too conservative, may be very realistic and, if anything, too aggressive over shorter time horizons (less than 20 years).

3. All that the PFM (the Navy's Personal Financial Management) program teaches about the importance of developing a spending plan, of using credit wisely and sparingly, of saving and investing ("pay yourself first"), and starting a sound investment program as early in a career as possible - all this becomes even more important. Increasing personal savings rate by even an extra 1% or 2% of income will go a long way to making up for the lower equity returns we are anticipating. Becoming rich quick by investing in stocks is generally an unrealistic hope. Doing so patiently over a 25 or 30 year period is still, I feel, very possible.

So young investors still have it pretty good. Next, we have to look a bit at the more senior folks (like me, ugh). A few of us, and our clients, may actually be approaching or in retirement. We don't have the happy luxury of waiting 20+ years for a full recovery before we will need at least some of our retirement savings. What about us? Here is where it gets harder.

1. Generally a diversified portfolio is best for a retiree. That means having some in bonds or bond funds as well as in stocks. Percentages can vary, but even a small amount (say 20%) in a bond or money market fund, rebalancing once per year or so, can greatly mitigate losses. Also, many of us (and most of our clients) will receive a fair portion of retirement income from military retirement checks - a guaranteed income streams from the government, indexed for inflation. That means most career military families will have a large part of their future retirement incomes guaranteed, and thus can afford to be more heavily in stocks than most civilians.

2. Again, all the financial basics are important - even in retirement. Since only a portion of a military retiree's income will come from his or her investments, even substantial losses may require only a minor adjustment in standard of living. Controlling unnecessary expenses and getting the most for your money (being a bit of a tightwad!) is just as important during retirement as it is when still building wealth. (Perhaps the FSC's - FEs in conjunction with the Retired Affairs Offices - should consider offering Art of Money Management courses, slightly modified for and advertised directly to the retiree population). If you are drawing off your investments, try to delay withdrawals during periods when the market is down (like now) to avoid depleting too much of your account too early in retirement.

3. For those whom Social Security will be at least a somewhat important source of income - that's probably all of us - I would recommend most strongly that you plan for not taking Social Security at age 62, but waiting until full retirement age (65-67), or even later. Delay retirement or take part time work if necessary. By doing so you earn more credits, which will further increase your benefit level. I have read several financial analyses on the advantages of taking Social Security 62, calculating so-called break-even ages, etc. This is a good example of a great theory that has nothing at all to do with the real world - the one in which most retirees live. Most fully retired people, particularly surviving spouses, would give their right arms for the higher monthly benefit they would receive had they and their spouses had delayed drawing Social Security. Come to think of it, this same general principal also applies to those trying to decide exactly when to retire from the military. A high paying second career may or may not materialize, but a higher military retirement benefit is good for life. This makes a good case for delaying military retirement for a couple of extra years if a service member has that option.

Finally, in response to requests, I do have a couple of specific ideas- with another disclaimer: The following really are my own very subjective opinions - ones that are at least very arguable and may well be proven wrong. However, several of you have asked for some this, including fund names, so I am giving it my best shot.

1. IF you have decided that you are exposed to more stock market risk than then you desire, I would still be reluctant to sell at the present time (July, 2002). I re-emphasize I have no talent in calling short-term market moves; in fact, I am surprised the current decline has gone as far as it has. But even if we are in a secular bear market, there will be a number of cyclical bull and bear markets to follow. Sentiment is very negative right now; if I wanted to sell at this point, I would wait for at least a few solid days of recovery, and probably for a 10% to 20% up move. Just about the time you no longer feel a strong urge to sell, and that things are starting to get better - that would probably be the time to lighten up in you wish to so. (This doesn't mean we might not still go lower first!)

2. If we really are to go through a period of relatively low stock market returns, it means that index funds that matches the returns of the general market will be less rewarding than in the past; they may be relatively less rewarding as well. I would be looking towards trying pick out the best, actively managed, value oriented fund(s) that I could. This would be particularly true if I were still on active duty, since I would be contributing the maximum amount I could into the TSP index funds and would want my other investments to complement those TSP as much as possible, rather than be identical. I say this with a clear understanding that many very wise individuals whom I respect believe that trying to outperform the market is a "losers game". I remain unconvinced, particularly for the environment we are now entering. So where can one go to look for such funds if you agree with my assessment and want to take the risk that by selecting active funds, you may end up doing less well than you would with index funds?

� If you are dealing with a financial advisor and paying sales charges, one choice is the American Funds group. They have good conservative, value funds. (Disclaimer - most of my wife LaVerna's IRA is two of their funds - Washington Mutual Investors and New Perspective. They have other good ones as well). Another large fund family, Franklin-Templeton / Mutual Series, has some fine value funds such as Mutual Discovery. First Eagle Sogen, a smaller family of funds, has a global fund (Sogen International) with a deep value style of investment that I feel is another superb choice. If you have an advisor that has never mentioned any of these three fund families to you, you might want to ask why.

� For do-it-yourself investors, Vanguard, the low-cost leader, has a number of potentially great funds. I particularly like Vanguard US Value (a new fund, but run by a very experienced money management team). If you are approaching retirement and/or on the conservative side, the Vanguard Wellington Fund has been around for over 70 years, delivering long-term returns about 1% below that of the overall market (the S&P 500) with far less risk. This fund generally has about 75% in stocks and 25% in bonds, and is down less than 2% over the past three years compared with the 44% loss for the market. Finally, perhaps saving the best for last, there is the Master's Select family of funds. This is another small company; they advertise very little, so you are not likely to find them unless you are looking. (Another disclaimer: I have more of my own money in this fund family than any other, including most of my own IRA.) Masters' Select Value would probably be their best fund for someone who was also a TSP participant, but I like Masters' Select and Masters' Select International as well. I have shares in all of them and think they have a great chance of beating their respective index fund counterparts by at least 1-2% per year or more (after their approximately 1% in additional expenses). They are also one of the very few fund companies I have ever dealt with that I get the impression is treating me like an owner rather than a customer. There is a big difference. If you get interested, do be aware, these funds are not particularly "low risk" and if we are in a secular bear market they (I) will lose money like everyone else - just (I hope) not as much.

� Finally: This is for those who are retired, or are about to, and have a portfolio you expect to draw money from over a long period. Presumably you already have a mix of stock and fixed income investments you feel comfortable with (as comfortable as possible with what's going on!). I will put in a brief plug for (gasp) gold funds - mutual funds that invest most or all of their money in gold mining companies. These have been among the absolute worst investments over the long run (I know. I have kept a small position in one for years. Ugh.) However, they definitely tend to go up when stocks drop sharply, and if inflation does actually return, these could do very well indeed, just as they did during the 1970's. I would not rush out and put a lot of money in one right now (most are up over well over 50% in the past year), but you might want to think about gradually putting money in over time to eventually have about 5 to 10% of your total here as a hedge against bad times. There are several acceptable fund choices - I guess my preference would be American Century Global Gold. (Vanguard's Precious Metals Fund is currently closed, by the way.) Over the past year, owning a gold fund has been a benefit to me both financial and psychologically, (with the latter maybe being just as important as the former).

Well, that's enough for now (I can see I ran over my four pages). Hope you find it of some value.

Where the current stock market decline will end is anyone's guess. It is obvious that I think things will be a bit more difficult for investors than in the recent past. That makes your job as an FE all the more important. I remain very optimistic about the long-range future of our nation, the economy and the stock market, and I hope you are as well. I have read some downbeat, negative, and even scary articles in the press recently pertaining to our future. The worse the bear market gets, the more things like this we will read. The overall sentiment will be the worst at the bottom. However, we do need to put everything in perspective. Think about a couple of those bear markets in the past we talked about. The 1930s saw the Great Depression. This included not only a near-economic collapse but even riots in the streets (you history students will remember the Bonus marchers). People were wondering out loud if the capitalist system could survive. Then came the Second World War. We currently face a real threat in the war against a global terrorist network, backed by radical Islamic fundamentalism - no doubt about it. But how does this compare for an enemy with Nazi Germany and Imperial Japan? Hitler and Tojo between them controlled a third of the world; Osama bin Laden may not control one-third of a cave right now! During the 60's and 70's we had serious inflation, shortages, and rioting in many of our major cities - all of which we survived. We worry today about a terrorist possibly setting off a small nuclear bomb and destroying part of an American city. We seem to forget that in the 70's we faced the most powerful empire the world has ever know, with enough nuclear weapons to incinerate every American city - one that had announced that they would "bury" us. (This enemy, in the end we defeated virtually without a shot being fired!)

I am not trying to make light of our current difficulties. As a nation we face some real challenges. But they are no worse than our forefathers faced. If we keep our faith and confidence, I be believe we can, both as individuals and as a nation, overcome these challenges and continue on to a brighter future - for us, for our families, and for our country.

Mike L.


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