"There's a shadow on the wall; stay calm, stay calm There's a figure in the hall; stay calm, stay calm..."-Stay Calm by Griffinilla

My son reminded me of a song from an online game, Five Nights at Freddy's that he played. I thought it was an appropriate link to help keep a sense of humor and remind us all to keep our wits. Even though the market is down 28% YTD we need to remember panic doesn't build wealth. So, if your listening to the radio or watching the news, and there is reporting the end is neigh or the World's economy is approaching an abyss, turn it off, read a book, or better yet flip on the comedy channel. Unfortunately, my job is to listen to the steady drum beat of window ledge prone market commentators and try to filter out the real news. Our business is to help build wealth over time, and that means setbacks and opportunities. Initially when the market started selling off it looked like an opportunity to gather shares in investment grade business at relatively cheap prices, and I, like many other cash flush investment professionals started to nibble for their clients. However, as over leveraged hedge fund managers, oil based sovereign wealth funds, and risk arbs realized they might be short of cash for longer than modeled the "SELL" button got hit without mercy. Once something like this starts, seasoned pros step back, stop buying, wait for the margin calls to clear, try to plumb the depth of the decline, and then start buying again. Finding the bottom isn't possible to model for individual companies. There are good billion-dollar business being shut down for a month or more with the possibly of go bankrupt. You can estimate on a macro scale. We buy stocks for the long term, no less than 10 years in fact, so lets look at the ten-year picture using a likely scenario. Normally we would see 40 quarters of returns from a broad spectrum of companies that have over time grown roughly ~1.5% per quarter. Assuming the economy loses two full quarters of growth and averaging over 40 quarters expectations need to be adjusted down to an average of ~1.4% per quarter. Meaning, instead of gathering $0.81 for every buck we invest, we will only gather $0.76. Some companies may go bankrupt, but others will buy them up and benefit. On net it's a nickel of wealth to get healthy now and perhaps put in place processes which will help restore the economy quicker when something like this happens in the future. Unfortunately, the market doesn't average over ten years in a panic, it pulls the expected loss to right now trying to find the absolute bottom immediately. Assuming a historic long-term earnings multiple of ~16x on that nickel of lost wealth indicates a sharp price decline of as much as ~45%. "Ouch!" But, that said, once through it a sure and steady climb to normal levels will fallow. Looking through the noise helps us to realize over time this too shall pass and helps us understand why the market is dropping to the levels we may see. It doesn't mean we need to "SELL!", it means we need to be patient. If you follow our advice and keep at least 9 months of living expenses in savings and/or at least 20% of a broadly diversified portfolio in short-term reserves this should be an unexpected speed bump, and perhaps an opportunity to buy at bargain prices. There are good companies that are being offered at fire sale prices as low as 25 cents on the dollar because certain funds had to sell at any price. If your feeling greedy, be patient, right now cash is king, take your time and average in over several quarters, this adjustment will evolve with sudden ups and downs. As the song goes "...stay calm, stay calm..."

This month I had planned another of my missives on the US Treasury market, and why yields on 30-year Treasuries are hovering at all-time record lows of 2%. However, I didn't expect the market to give me such an instructive opportunity. As I have expounded on in my previous notes, "risk" or price volatility is a quantifiable and price-able entity. While you can only make an educated guess at an individual businesses stock market risks, the broad markets indexes have been tracked and traded and have averaged somewhere near 20% over time in any given year. It seems like a strange exercise, but I want you to imagine you can parse that risk in time. This is exactly what the famed Black-Scholes option pricing model does. Typically, the stock market moves up or down 1-2% on a bad/good day. An "option" is a right to either buy or sell a specified underlying stock or market instrument at a stated price for stated period of time. It can be used as insurance against loss and typically sells at a price, called a premium, which is 1-3% of the price of that stock or market instrument on that day. The genius of the Black-Scholes model is that it shows a market maker not only the right price to sell/buy options at, but also how to hedge (insure) themselves against loss in the case the option is exercised (they have to pay off on the insurance). Very basically the model indicates that the way to price a risk asset is by assuming it has two parts; a market price part that moves up and down day to day, and a value part which appreciates over time. This means, at least in theory, a market maker can construct offsetting trades using a risk-less asset i.e. cash or Treasuries which have value over time and a counter trade like shorting or going long the underlying asset: stock, bond, futures contract, what have you. Broadly speaking, for every increment of risk the market has to offer there can be a market maker buying or selling a treasury as it's offset. As the ability to understand how this model works has grown, market makers have programmed faster and faster computers to automatically execute options and future trades. This has created a tremendous demand for U.S. Treasuries all over the world as the ultimate risk-less counter trade. It is because risk can be parsed out over time that market makers have been a contributing factor in driving down the yield on longer and longer dated treasuries as counter risk is parsed in time further and further into the future. This has prompted calls for the US Treasury to start issuing 50-year bonds, when all that is needed is an increase in the supply of 10's,20's, and 30's. However, if the Treasury does that, they will force medium term yields higher and create a giant unwind of the hedges in place now. If you follow the long-dated treasury market you've seen that cracks are forming. It's a Catch 22 situation. Either the U.S. Treasury bites the bullet and forces some losses on the banking system and market makers by issuing more long dated bonds or there will be continued shortage forcing treasury yields lower.

GIVE ME A CALL.

If you have questions or concerns about your portfolio give me a call at (508) 237- 2316. If you have a friends or know someone who is worried and doesn't know what to do have them give me a call. I am available, free of charge, to offer advice during this tumultuous period.

Douglas A. McClennen