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The two biggest questions facing investors

Be ready to trim your expectations in a new and changing market, says this advisory, which also asks how long the financial crisis will last.

Things change. They’re changing right now and if investors don’t keep pace with those changes, they’re liable to wind up with the wrong assets at the wrong time. That’s the word from Mr. Bob Carlson, who has two very straightforward questions on the future ahead of us.

What can we expect? And when can we expect it?

Writing in Bob Carlson’s Retirement Watch, he answers the first question with reference to the opinions of two experts — including the world’s greatest investor.

To answer the second, he compares the crisis to a baseball game (were this a Canadian advisory, we might expect some apt analogy with hockey at this time of the year, but we won’t quibble on that score).

Don’t look for double-digit returns

On the Fortune magazine web site, Mr. Carlson found two articles laying out a revised view of the future for investors — a view he shares.

The theme is, don’t look for double-digit stock market returns anytime soon. In one article, Mr. Allan Sloan advises investors not to look for a bull market of the same magnitude as the 1982-2000 run. Mr. Sloan is emphatic, saying “there’s no way” we’ll see another market like that.

Stocks will outperform bonds, but don’t expect high double-digit returns for years.

At the same time, Mr. Warren Buffett issued his annual Berkshire-Hathaway report and said much the same thing. “He chided investors and corporate pension plan managers who anticipate 8% or greater annual returns for the indefinite future.” In the last century, the Dow Jones averaged annual gains of just 5.3 per cent, Mr. Buffett reminds us.

Search for the new and changing

In the same vein, Mr. Carlson observes that he began warning investors a decade ago that the biggest risk was a sustained bear market.

With this in mind, he looks for innovations, like hedge funds (the real thing, not the reckless private funds we’ve heard so much about lately) and a greater emphasis on international markets.

“Opportunities for investors are developing in the markets. An investor has to do what we do — maintain a constant search for what is new and changing. What worked in the past won’t always work in the future.

“Investors who rely on what worked recently often will own assets about which investors have been extremely optimistic and are likely to turn pessimistic.”

But this new and changing market cannot be judged accurately until we emerge from the ongoing financial crisis. When will that be?

Three worrying trends

What if this crisis were a ball game, Mr. Carlson asks? What inning would we be in? Optimists would say we are in the seventh inning, he reckons. If that’s true, we would be rising for the seventh-inning stretch and getting ready for the last few innings. The editor doesn’t agree.

“We likely are earlier in the game,” he says. Instead of two innings to go, we have three obstacles to overcome.

“Three worrying trends must be kept in mind,” insists Mr. Carlson. They are the deleveraging of the economy, the decline in housing prices and the reduction in economic growth. “While there are ties between them,” he adds, “reversing one trend does not mean the others will follow.”

Crisis of confidence

Deleveraging the economy — draining off the excess debt — is going as smoothly as could be expected, the editor reports.

Two months ago, sellers of debt were holding out for unreasonably high prices. Now buyers and sellers are finding common ground. Financial firms are cleaning off their books, and there is some optimism that the largest writedowns are behind us. Still, only the best assets have been sold. The “toxic” debt still sits on a waste pile, unsold.

Many saw the selling of Bear Stearns as a market bottom, because it showed the Fed would not allow a systematic failure of the system and would ensure liquidity in the system. “Yet the economy is weak and liquidity will not ensure growth in this economy,” states Mr. Carlson flatly.

The credit freeze and decline in asset prices were caused by uncertainty. “Investors suddenly realized they did not know much about a lot of debt they owned and lost confidence in the quality of the assets.”

The worst of that crisis of confidence has passed, but we’re not back to normal yet. Lower interest rates have not stimulated consumers or homebuyers. Retailers are struggling. Businesses are borrowing less and spending less. And — surprise! — financial institutions have less to lend.

Financial stocks were the first losers in the crisis, while the rest of the stock market held up fairly well. That is not likely to continue, in Mr. Carlson’s opinion. The only really healthy part of the U.S. economy is exports and that is only due to the weak dollar.

Last but not least, home prices are still looking for the bottom of the market. Until this happens, consumer spending is not going to revive. It’s a vicious circle, to be sure. And there’s one more problem. Inflation.

Inflation, food and energy

For a while, the official word was that inflation was restricted to temporary increases in food and energy prices. Not any more, says Mr. Carlson. It is obvious to anyone who reads the headlines that food and energy prices are rising steadily around the globe. The consequences could be catastrophic in some countries.

Still, it is likely that in the U.S. at least, the Federal Reserve Board will keep on fighting the credit problem and “worry about inflation later.”

What’s more, Mr. Carlson sees a parallel between today and the 2000-2002 meltdown that seemed to affect only tech stocks at first, then spilled into the rest of the economy and triggered a brief recession.

“While we have not hit a bottom,” he concludes, “I think we are in the bottoming process. Prices of some high quality assets took a beating as part of the deleveraging process and flight to safety.”

And he has started buying some of these assets, not for double-digit returns perhaps, but for a realistic chance of profits in a changing market.

The more things change, the more the need for sound investment thinking remains the same.