Investing

Market déjà vu all over again

Jack Welch, the iconic former chief executive of General Electric Co., tells the story of a business manager…

Jack Welch, the iconic former chief executive of General Electric Co., tells the story of a business manager who made a strategic error that cost the company $500 million. When asked if he planned to fire the manager, he responded, “Why would I fire him? I just invested half a billion dollars in his education.”

Mr. Welch understood that good decisions come from experience, and often, experience comes from bad decisions. With U.S. markets approaching pre-recession highs, it is a good time for financial advisers to remember that experience.

2007 marked the fifth year of a cyclical bull market, and many of the major indexes were hitting all-time highs. With the Dow Jones Industrial Average above 14,000, there was a lot of talk about when it would reach 25,000.

In October that year, I wrote a letter to advisers, saying, “The thought of the Dow hitting 25,000 may seem crazy, but it will happen eventually. Of course, it may go back to 10,000 first … Children go back to school this month. Why don’t they teach them real-world math — like how it takes a 33% gain to make up for a 25% loss?

“Some investors will learn how to calculate break-even math the hard way in the near future.”

As it turned out, my numbers were off a little. The Dow industrials didn’t stop at 10,000 but fell to 6,600, a loss that required a gain of almost 100% to break even. It was a sobering period for many advisers and their clients.

I didn’t have a crystal ball. I just knew that cyclical bull markets don’t last forever, and cyclical bears, especially in the context of a secular bear market such as we had been in since 2000, should be expected.

Many advisers in 2007 didn’t want to hear that message. Their clients were finally, after five years, breaking even from the losses they suffered in the 2000-02 bear market.

There was a palpable excitement as new highs were reached.

The constant refrain from advisers at that time was that risk-adjusted investment strategies didn’t “screen” well over one-, three- and five-year periods. They were myopically focused on short-term returns without giving any consideration to what happens in a full market cycle.

As a result of that thinking, advisers charged full-speed ahead, with unsuspecting clients in tow, into one of the worst bear markets in history.

In an 18-month period, from October 2007 through March 2009, investors gave back all the gains that they had made in the previous 60 months. It has been said: “You can tear down a house quicker than you can build it,” and that is certainly true, not only of investment portfolios but of a client’s retirement hopes and dreams, as well.

SOME HOPE

It is with that thought that I bring us back to the present and remind advisers to be mindful of the market environment. Despite several head winds from around the globe such as the eurozone debt crisis, the pending fiscal cliff here in the United States and the slowdown in China, to name just a few, U.S. markets are once again nearing all-time highs, and several major indexes have produced double-digit returns year-to-date.

And while clients may be pleased with their returns this year, an adviser’s job is to be on the lookout constantly for what is around the corner.

Some cautious facts to consider:

• The average bull market since World War II lasted 41 months. This one has lasted 43, so history isn’t necessarily on our side.

• The Dow industrials are bumping up against 14,000 — again.

• The S&P 500 jumped above 1,440 for the third time in 13 years, and in both previous instances, the market fell sharply shortly thereafter.

It is also interesting to note that we have never had a secular bear market end and a new secular bull market begin with price-earnings ratios as high as they are now, which suggests that the secular bear may not be ready to go into hibernation just yet.

I am not predicting that another cyclical bear market is imminent and advisers should avoid trying to time the markets, but I do think that there are reasons to be cautious, and advisers should remind themselves of 2008.

The two market periods share strong similarities, so now is a good time to sit down with your clients, review their portfolios, assess their goals and risk appetite, and consider building up risk measures and preparing for a potential pullback.

Are advisers today better, wiser and more informed, or are they poised to repeat the mistakes of 2008?

Tim Chapman is chief executive and co-founder of Stadion Money Management LLC.