If 2008 began as a year of uncertainty, 2009 starts off as a year of high anxiety. Even savvy investors suffered big losses in recent months, making preservation of personal wealth more critical than looking for new financial growth opportunities.

We called upon some Greater Cincinnati investment and financial planning professionals to share their insights and outlooks for the coming year. Contributing to our roundtable discussion: Mark Busher, PNC Bank; Brian Clark, vice president and manager, Asset Management Group, U.S. Bank; Drew K. Horter, founder and chief investment strategist, Horter Investment Management LLC; John F. Michel, national tax partner in the Cincinnati office of Grant Thornton LLP; Matt McCormick, portfolio manager, Bahl & Gaynor; and Nicholas Sargen, chief investment officer, Fort Washington Investment Advisors Inc.

What kinds of specific concerns and questions are you hearing from your clients? How are you answering those concerns?

Mark Busher: Clients continue to be concerned with the volatility in the equity and fixed income markets today. If the markets of the last few months have taught investors anything, it is that there is no true “safe haven” investment. The risks of being too defensive may surpass the benefits of maintaining a well thought-out asset allocation.

Brian Clark: Our clients are primarily concerned with two items. First, in the current low interest rate environment, maintaining a reliable stream of income is a priority. Second, the volatility in the domestic and international equity marketplace remains a concern. We are addressing both issues by emphasizing the use of high quality corporate and municipal bonds, as both offer very attractive current yields and stability.

Drew Horter: Our clients are concerned about how long the recession will last and how their retirement income has been and will be affected in the future. They are also concerned about the long-term viability of employer pension plans and how long it will take before the stock market can begin to move up with some consistency.

Matt McCormick: Like all investors, our clients are concerned about how to invest their assets in this “post TARP” reality. We are trying to communicate with our clients as much as possible and focus on issues we can control such as asset allocation, specific securities and potentially moderating their risk levels.

John Michel: It appears many investors are becoming even more short-term in their risk tolerance, with a willingness to abandon long-term investment plans in favor of the security that, for some, being in cash seems to provide. Commercial real estate investors are active on the buy side but they do not believe that great deals are yet to be had. Liquidity for real estate investors is still a concern, and we see many in the market raising (or trying to) preferred equity to appease existing lenders.

Nick Sargen: The concerns primarily are about how much longer equities are likely to sell off and whether it is too late to lighten positions. Our assessment is that the stock market is unlikely to sustain a rally until housing stabilizes and credit conditions normalize. We do not expect this to happen anytime soon, so we are reluctant to add to equity allocations now. At the same time, we are maintaining equity allocations rather than trimming positions, because stocks appear cheap and it is difficult to time the market.

There’s much discussion about the mass psychology affecting equities and bond markets, versus the true value and potential growth. What will it take to overcome the psychological fog and assess opportunities on more fundamentally sound measures?

Sargen: The major factors weighing on investors now are the likelihood of a severe global recession and a lack of confidence in policymakers to correct problems in the financial system. Thus far, policymakers have reacted to events belatedly rather than formulating a comprehensive and forward-looking strategy. One immediate need is to create a cohesive regulatory oversight structure for all financial institutions. There are too many different entities covering the same institutions, but without overall accountability.

McCormick: Unfortunately, only time and patience will remove the psychological fog. Investors will focus on fundamentals after our “economic house” is back in order and confidence has been restored. That will occur after the unprecedented fiscal and monetary stimulus packages are digested and the business cycle runs its natural course.

Horter: Confidence in the global equity markets and bond portfolios has indeed suffered. There must be regulations on hedge funds to minimize their effect on the stock market. Investors will begin to see the light of day only when the volatility starts to get back to normal and company fundamentals are clearly being used as the measurement for stock market valuations.

Clark: Investors can be driven by their emotions — the two driving forces being fear and greed. We have been through the greed part of this market cycle and we must now work through the fear. Investors will be willing to get back into the equity markets when they sense stability. With no clear direction, and the government and regulators changing strategies, investors will remain apprehensive and on the sidelines.

Busher: Negative sentiment is clearly obscuring some great opportunities in the market. The continued fiscal and monetary stimuli are difficult for the markets to ignore. At some point, the inflationary pressures from these stimuli will drive asset prices upward.

Which leads to stocks: When, where and how will it be a good time to wade back into the water as a buyer willing to take some risk?

Busher: For investors with a time horizon longer than three to five years, this is perhaps the buying opportunity of a lifetime. We are in for some more volatility in the short term, but the market may turn sharply upward before investors can react. Equity investors who have stayed the course will benefit the most in this scenario. Additionally, keeping enough cash and short-term bonds on hand for up to a year’s living expenses will help an investor tolerate the market’s volatility.

Clark: At current prices, equities in general have declined in price to a point where they have incorporated many of the negatives associated with the current recession. We are adding higher quality equity names with a domestic orientation, gradually and on price pullbacks. We believe that this recession will be longer and a bit worse than average; however, the equity markets are a forward-looking mechanism that is likely to recover well before the economic statistics improve in mid to late 2009.

McCormick: We do not time the markets. We believe the best course of action is to own high-quality companies, ones that typically grow their earnings and pay a growing dividend, regardless of the economic environment.

Michel: Whether you are speaking about investors with new capital or those who took capital off the table in favor of cash, they will likely want to look for signs of renewed consumer confidence: spending. For the truly skilled contrarians, they are probably active in buying into certain market sectors already.

Sargen: The stock market typically leads the economy by one to two quarters, so the best time to add to risk positions is several months before the onset of a recovery. While stocks currently are cheap from a valuation perspective, we do not expect the economy to stabilize until the second half of 2009 at the earliest. If so, the spring may be a good entry point back into risk assets. One caveat, however, is that we anticipate only a very gradual recovery.

The Crash of ’08 has many investors across the wealth range, from modest to rich, losing confidence in ratings agencies and analysts. For information you rely on, how are you changing your methods or sources?

Sargen: We have primarily relied on our own internal research and valuation methodologies to base our investment decisions. Specifically, we have buttressed our efforts related to investments in mortgage-backed securities, where we have expanded the databases we use to monitor delinquencies. We have also devoted more resources to analyze money market instruments issued by financial institutions.

Michel: Realizing that people who supposedly are smart can fall victim to the hysteria that results when consumer confidence collapses, just as easily as those who are believed to be not so savvy. More self-reliance is needed. More skepticism and common sense is required from investors when they read or hear things from supposedly knowledgeable sources.

McCormick: We’ve been successful in 2008 and previous years because we conduct the vast majority of our research internally.

Clark: Through our internal resources and the outside independent research we utilize, we have tried to lessen our reliance on just one rating or one analyst’s opinion.

Busher: We continue to take a healthy skepticism towards ratings agencies and analysts for whom conflicts of interest exist. We continue to do our own research to complement traditional sources of analysis from investment banks, research firms, etc.

Diversify, diversify. That’s the usual mantra. But what do you tell clients who see reason to be pessimistic about nearly every form of investment and just want to sit on their cash?

Busher: Clearly the nearly simultaneous price decline of every major asset class shakes the concept of diversification to the core. However, the unprecedented stress on markets will eventually abate and the merits of diversification will trump the comfort of holding cash and doing nothing. The baseline benchmark for every investor to beat is inflation; cash and fixed-income securities do not stand up well to the ravages of inflation.

Clark: Diversification of an individual’s portfolio on a strategic basis has provided solid returns with less risk over the long term. In the recent downturn, we have introduced other “alternative” products, such as structured notes and absolute return products which help protect the downside in the market. We have also seen an increase in cash holdings and fixed income during this downturn, which are good alternatives while the market works through this volatile period.

Horter: Proper diversification is still the mantra. We believe in using highly skilled equity money managers in five to six different asset classes and sectors for long-term investing. We have not been fond of bonds or bond funds for the past several years. Their total returns have been abysmal. Clients prefer principle guarantees in their IRAs or trust assets with fixed index annuities that guarantee your principle. They compare very favorably as a fixed-income asset as far as rate of return, liquidity and certainly piece of mind.

Michel: Those who want to sit on cash for a while longer, until they see the signs of life, should continue doing so.

Sargen: The main thing we tell clients is that correlations among securities typically rise during periods of financial crises, so diversification may not always work in the short run. The benefits of diversification, however, generally increase over time, especially as conditions normalize. We believe one of the best opportunities now is in high quality corporate bonds, where yields relative to treasuries are the highest in the post-war era.

What’s your take on the federal financial rescue plan and other government actions to address the financial, credit and mortgage crises?

Sargen: We believe that policy actions were not effective in stemming the crisis because officials failed to grasp the magnitude of the problem and tried to deal with it on a case-by-case basis. Fortunately, G-7 policymakers realized the gravity of the situation in mid-October and have pursued a more coordinated approach to deal with the global problem since then. The Federal Reserve is also demonstrating a willingness to pursue unorthodox tactics to deal with the crisis.

Michel: Government should “stick to its knitting” and avoid getting into the business of reviewing business plans in the private sector, as though government should now be in the business of investing in private equity. Prudent and sustainable tax and fiscal policy will do more to restore investor and consumer confidence.

McCormick: Our take is “It is too early to tell.” We hope the fundamentals will get stronger and bailout demands cease. However, inflation will be a very large concern.

Horter: Nobody is happy about adding trillions of dollars to our federal deficit. Other than the TARP program, which has yet to realize its full potential to free up the balance sheets of the banks, a stimulus package is under way to hopefully move mortgage rates to 4.5 percent (on a 30-year fixed mortgage) or lower. It all starts with housing. If people are buying homes, they are buying appliances, lawn mowers, curtains, etc.

Clark: Government intervention has dramatically changed our future financial landscape. This may well be one of the hottest debated topics today. The government has put an enormous amount of capital into the financial services sector and perhaps others, including the auto industry. With this capital investment, the government will demand increased regulation.

Busher: The Federal Reserve and the Treasury should be applauded for their efforts to solve these crises. The results so far have been mixed at best, but I am encouraged that there is a commitment to stop these crises by any means necessary.

What kind of new government regulation or oversight, if any, might benefit economic recovery and long-term stability of investment markets?

Busher: The idea has emerged where one agency will oversee and coordinate every financial market domestically. Every investor would benefit from increased standardization and transparency in the derivative markets as well.

Horter: We have to end this huge amount of trading volatility with the stock market. Appropriate regulations should be established for hedge fund managers (and the amount they can leverage), so the small investor is not hurt. I also believe the “uptick rule” should be reinstated for those who are shorting the market.

McCormick: Increased regulations are usually good for increasing investor’s confidence in the short term. However, regulations rarely stop the guilty from engaging in nefarious activities.

Michel: None. The law of unintended consequences will rear its ugly head. We each need to hold our elected officials accountable for their actions and avoid emotional reactions that lead to further unintended and longer-term consequences that are much harder to dig out from under.

Sargen: There are several important areas where regulation could help: 1) ensure transparency of information; 2) establish appropriate levels of risk for the use of complicated financial instruments; 3) require better disclosure around any off-balance sheet funds that are sold to investors; and 4) establish meaningful guidelines for the use of derivatives and financial leverage. We also believe proposals to require credit derivatives to be exchange-traded will lessen the risk of contagion in that area.

What do you expect from the Obama administration and a Democratic Congress? Do your higher-income clients have reason to be apprehensive?

Sargen: We believe the top priority of the Obama administration will be to lay the groundwork for economic recovery via massive fiscal stimulus. With respect to tax policy, we think the most likely outcome is the administration will hold off on increasing personal income tax hikes for those families earning $250,000 or more until 2010 or 2011, when recovery is likely to be entrenched. We also expect the Obama administration and Congress to allow the Bush tax cuts to expire at the end of 2010.

Michel: If government acts with restraint, we will be fine. If emotion creeps in and, for example, the ‘rich’ are punished with higher taxes, then we will see the law of unintended consequences with deeper and longer-lasting problems for the middle class. We all should be concerned.

McCormick: I think the Obama administration is composed of realists and understands it is economic suicide to raise taxes in a deep recession. It would be far easier, politically and economically, to let the 2003 Bush tax cuts expire in 2010.

Horter: With the Obama team it was clearly stated during the campaign that those families making more than $150,000 to $200,000 per year would pay more in taxes and those with lesser incomes would pay much less. Some are business owners. They say for their net income to remain the same, they will look at their business expenses and possibly reduce staffing or other expenses, which defeats the purpose of trying to stimulate the economy.

Clark: In the short term, we expect only moderate tax increases. Government spending may provide specific opportunities in some industries such as biotech, alternative energy and infrastructure construction.

Busher: It is reasonable to expect income taxes, capital gains and dividend taxes to increase for high-net-worth investors. The Obama administration, however, has moderated some of the campaign rhetoric, as the recession has drastically changed the administration’s appetite to increase taxes until, perhaps, as late as 2010.

Experts Q & A

Ellis D. Hummel, CFP
Vice President and Portfolio Manager
Bahl & Gaynor Investment Counsel Inc.

Barbara Culver, CFP, ChFC, CLU, AEP
President and Principal Owner
Resonate Inc.

Q: Given the depth and duration of the current market downturn, should I change investment strategies?
Q: What options are there for reducing my income taxes?

Adversity breeds clarity. After more than a decade of expanding debt, collapsing structured investments, the broken promise of out-performance, and lower risks engineered by the “efficient frontier,” many investors will be looking to make changes. Replacing promises and projections with a prudent, well diversified, fundamental strategy always makes sense. Consider also planning or restructuring how you use your wealth by adjusting your ratio of discretionary spending to non-discretionary spending. This will allow more flexibility in managing fixed costs against investment returns. Remember, spending only what you make also makes sense when you’re retired.
My recommendation is that you hold a joint meeting with your income tax and investment advisers. At the meeting, you can examine your investments for tax-loss harvesting opportunities, discuss tax-free opportunities such as Roth IRAs or municipal bonds, consider tax-deductible or tax-deferred options, review annual and lifetime giving strategies, and blend in your values through philanthropic strategies by giving away low-basis assets or considering a charitable lead or remainder trust.