The Impact of the current economic decline on the management of the recoveries of Tort victims

by Richard Halpern

10/10/01

What follows is an overview of what has been happening whether or not related to the events of September 11, 2001 and what our “Opinion” would be of how to approach the management of large sums of money in these trying times. Please bear in mind, that all of these remarks are based on the assumption that the investor is a highly “risk adverse” investor.

First let’s look at the plunge in the stock market. It has been radical and it has been broad based. Substantial declines have occurred in the Dow Jones Industrials, the S & P 500 Index and the NASDAQ Index. One would be foolhardy to assume however that this dramatic decline in the equity markets was based exclusively on the terrorist attack. The global equity markets were already in serious decline long before September 11, 2001. In fact, we tend to forget that there was much concern about the possibility of a recession during the last month of the Clinton administration. The terrorist attack merely accelerated that which was already happening. As a quick example, the first trading day of the month was September 4, 2001. From September 4th through September 10th the Dow Jones Industrial Average declined 3.92%, the S & P 500 Index declined 3.57% and the NASADQ declined 4.26%. 

It is probable that had the stock markets not closed from the 11th until the morning of the 17th, that further substantial declines would have occurred even in the absence of the attack. When the markets did reopen on September 17th, there was a huge “sell off” (the largest point loss in the Dow in history) and yet the next day the markets rebounded. Since that time there have been further declines and increases and market behavior has been consistent with the way it was behaving prior to the attack.

Also, prior to the attack, the airline industry was in total disarray and on the verge of failure, as were many other components of the travel and entertainment industries, notably the hotel and cruise line industries. Computer sales had been crashing. On September 17th the Federal Reserve Board lowered interest rates by ½% prior to the opening of the markets in an extremely rare move. Subsequently, the Fed has lowered interest rates by another ½%.

Generally speaking, the lowering of interest rates proves to be a stimulus to the economy by making the cost of borrowing money cheaper creating an enticement for corporate America to borrow for expansion. Sometimes it works, sometimes it doesn’t. It is artificial, it is not a natural result of any economic forces and it can’t be done forever. The Federal Reserve and the Department of Treasury simultaneously expanded the money supply hoping to avert an economic meltdown. Right after the attack, there was significant discussion about paying for a lot of the damage by having the Government Issue a new version of what in the 1940’s we referred to as “war bonds”.

The cost of borrowing money for corporate America is a cost that is added on to the price of every product and service offered. Therefore, what is the result: inflation. 

ABOUT INFLATION:

Inflation and interest rates always follow the same long-term trends (see attached chart). That is because rising inflation can cause rising interest rates and conversely rising interest rates can cause rising inflation. When corporate America has to pay more to borrow money that expense is part of their overhead and is added to the price of their product or service, raising the price of said product or service. Because the price of the product or service is now higher, yet we still have just a fixed number of dollars to spend and each dollar is buying less. The purchasing power of the dollar is diminished. Rising inflation causes rising interest rates because rising inflation means the goods and services we buy are more expensive causing a decrease in the purchasing power of the dollar. Somebody who wants to borrow that dollar has to pay a higher interest rate to borrow it. Since the rate of inflation is the “rate of reduction of the purchasing power of the dollar”, a bond purchaser must receive interest at a rate higher than the rate of inflation in order to make a profit. If they don’t, then when the bond matures their investment would have less value in terms of purchasing power than it did when they bought it. Thus, the trends of interest rates and inflation are “linked at the hip”. You cannot have one without the other. 

The harder concept to understand about inflation is “how the expansion of the money supply causes inflation”. If the government is borrowing money, it is only for the purpose of spending. It is selling bonds and then spending the dollars it receives. Bonds are debt instruments. If the government sells an additional ten billion dollars of bonds it is for the purpose of spending the ten billion dollars. Therefore, the ten billion dollars that was received for the bonds came out of the money supply and was returned to the money supply when the government spent it. The government will pay (in today’s economy) about six hundred thousand dollars of interest per year over the next thirty years (for a total of eighteen billion dollars) and, at maturity will repay the ten billion dollars. Hence, you have a “double dipping” type of affect. The original ten billion dollars was immediately returned to the money supply followed by eighteen billion dollars of interest payments and a final payment of another ten billion dollars expanding the money supply by an additional twenty eight billion dollars.

If we build a model it might be easier to understand this phenomenon. Suppose you had three cups of coffee and those three cups of coffee represented all the goods and services available for sale. Suppose somebody else had three one-dollar bills and those three one-dollar bills represented the entire money supply. (Remember that money has no value except in terms of what it can buy.) If everything that is available to purchase is three cups of coffee and if all the money that is available to spend is three dollars, it is easy to see how the price of a cup of coffee would be one dollar per cup. But if the money supply doubles to six dollars while there are still only three cups of coffee, the cost of a cup of coffee just went from one dollar per cup to two dollars per cup. That is inflation. That is how expansion of the money supply causes inflation.

Conversely, if we could stimulate the economy so that it produces an additional three cups of coffee, but have not expanded the three-dollar money supply, then you have deflation, because the price of a cup of coffee has dropped to $.50 per cup. The ideal way to manage the economy would be to keep expanding or contracting the money supply at exactly the same rate that the economy grows or shrinks resulting in neither inflation nor deflation. This is also why you often hear attention being paid to the growth of the economy.

When inflation rises you should interpret that as loss of purchasing power; in other words, every dollar that you have available to spend will buy less. This is just as devastating a loss as though you lost money in the stock market or if money was stolen from you. Remember, the only way to measure the value of money is in terms of what it will buy, not just in terms of how many dollars you have. It doesn’t make you wealthy to have a $1,000,000, if the cost of a phone call is $2,000,000.

In a volatile economy any type of long-term fixed income obligation is guaranteed to create a loss in purchasing power. This pertains to all fixed income obligations. Rising interest rates equals lower asset values. Declining interest rates on the other hand, would equal higher asset values. Some of the types of investments that fall into the “long-term fixed income” category are Treasury Bonds, Municipal Bonds, Corporate Bonds, Long-term Certificates of Deposit, Income Producing Long-term Bond Mutual Funds and fixed or guaranteed annuities, (the type utilized in structured settlements).
 

ON ANNUITIES...

In all but the case of the annuity the other instruments at least can be sold in times of rising inflation even at a loss, but the investor can sell them to stop further loss. Obviously, this is not true with the annuity. There is no apparent, active trading market for annuities. With bonds you can find out what their value is on any given day from various types of financial services, institutions, the Wall Street Journal or the Internet. This is because there are active trading markets for all long-term fixed income obligations other than annuities. You are led to believe that you can’t lose money in the annuity because there is no publicly reported trading market to determine the current value of the annuity. That does not mean that you aren’t suffering significant losses and purchasing power, (which after all is the only real value of the annuity), the loss is there nonetheless. 

For verification of this reality just look at how little money is offered by the so-called “after-market annuity buyers” or factoring companies to purchase the income stream from a structured settlement annuity. These factoring companies are the only things comparable to an active trading market that exists. No wonder the insurance and structured settlement industries have spent so much money to "lobby" for federal and state legislation to require court approval for a citizen to exercise their right to sell their own property. This is being done under the guise that people need to be protected from themselves; but, in reality it is just an attempt to close the only free-market measurement of the “market” value of the annuity after it has been purchased. In an open trading market for financial instruments the ultimate price of the instrument is influenced by the credit worthiness of the instrument.
 

ON EQUITIES (STOCKS)...

When we look at equity (stock type) investments we’ve already discussed that the markets were in a very severe decline prior to the attack. Stock prices were totally unrealistic when compared to earnings. They were very heavily over priced and prices had started to come down. They’ve come down significantly but they are still over priced. The year 2000 was the first year in history that 401k retirement plans lost money.

When you hear in the news that Merrill Lynch lowered the rating of the XYZ Corporation from a “strong buy” to a “buy”, that is called a market recommendation. All firms that make market recommendations based on the research of their portfolio analysts are referred to as “investment banks”. This does not mean that they are banks in the traditional sense. They can be banks and many are but what is being referenced here is the part of the bank, stock brokerage firm or financial consulting firm that focuses on market analysis and making recommendations. These are the people that “read the tea leaves” and then tell you what you should do. They are so often wrong; that in the last year an investigation has started in the Congress of the United States of America looking into whether or not this is the “racket” that it appears to be. A web site called “INVESTARS.com” has developed a system for tracking who the best investment banks are. They have put together a system called R.O.S.S which stands for Rate of Success System. It takes all recommendations each investment bank has made since January 1, 1997, through the current day and assumes that all the advice given was followed. Then they create a hypothetical portfolio by following all the advice given. They divide the investment banks into categories of how many stocks they track. Category 1 would be those companies tracking more than 499 stocks; Category 2 would be those companies tracking from 100 to 499 stocks etcetera.

We did a study of those results from January 1, 1997 through October 1, 2001 (including the recent decline and terrorist attack) and looked at all investment banking firms that tracked at least 100 stocks (see attached chart). There are 55 such firms in the United States. That time period not only includes a significant crash in the markets, but also the greatest stock run up in history. Yet only 9 out of 55 investment firms (16.36%) made a profit on their portfolio and none of the 9 were major players such as Merrill Lynch, Solomon Smith Barney, Goldman Sachs, Paine Webber, Wells Fargo or Bank of America.

You may be saying “How is this possible?” Well let’s, look at some statistics. 

• The Dow Jones Industrial average hit its all time high on January 14, 2000. On that day it closed at 11,723.00. Subsequent to hitting its all time high, it hit its lowest point on September 21, 2001, when it closed at 8, 235.81. This represented a loss of 3, 487.19 or 29.75% and that loss was in a time period of just 20 months. 
• The S& P 500 Index hit its all time high on March 23, 2000, at 1, 527.46. Its all time low, subsequent to the high was again on September 21, 2001, when it closed at 965.80. This represented a loss of 561.66 or a loss of 36.77% and said loss occurred over a time period of just 18 months. 
• The NASDAQ hit its high on March 10, 2000, when it closed at 5,48.62. It too hit its low subsequent to its high on September 21, 2001, when it closed at 1, 423.19. This represented a loss of 3, 625.43 or 71.81% and again occurred over a time span of 18 months.

By comparison, let’s look at the crash of 1929. 

The S & P 500 Index opened on January 2, 1929, at 24.86. By January 1, 1933, it had dropped to its low to 7.09. This was a loss of 17.77 points or 71.48%. This percentage loss was remarkably similar to the above-mentioned loss in the NASDAQ. The crash of 1929, which was considered the “worst” crash in economic history, took place over 48 months, whereas the crash of the NASADQ took place in just 18 months. The NASADQ’s recent loss of almost 72% took place in approximately 1/3 the time it took the crash of 1929 to lose approximately the same 72%. If you were to take all the recommendations from all of the stock brokerage firms, bank trust departments and investment banking firms combined during the time period of the recent market declines; less than 5% of their recommendations said to sell anything. That means that even though the markets were “burning around them”, 95% of their recommendations were to either buy or to hold stocks, not to sell. Since this is well documented, why in the world should any risk adverse investor listen to these market “gurus” no matter how prestigious the name of their institution? Every prestigious institution failed to give the proper advice to the small investor. (View INVESTARS.com information on Page 7)

As far as the possible long-term effects of the current situation are concerned, should the government continue to expand the money supply, issue new bonds and stimulate the economy, the probable result would be rising interest rates and rising inflation. These rises may not be seen for some time, but they must be the ultimate outcome of the aforementioned government interventions. The economy appears to continue to endure the long overdue correction that could continue for anywhere from another six months to several years.

This leads us to ask the question, “What should you be doing with the recovery and what shouldn’t you be doing with the recovery?” 

We will start with what not to do, since that is so obvious:

1. Do not put any large portion of the recovery in any long-term fixed income investment. It doesn’t matter weather it is an annuity, Treasury bond or a long-term bond fund. Do not put a substantial portion into it if it is a long-term fixed income investment. If you do, 5 to 10 years from now these investments may be providing significantly diminished purchasing power of the income being received.
2. Next, do not put any large portion of the recovery into any equity (stock type) investment.
3. Do not pay any attention to the “experts”, “gurus” or “pundits”. If they saw the market decline coming they never ever told the public. If they didn’t see it coming you certainly don’t want to listen to them. The facts speak for themselves, either way since the analysts, proved to be 95% wrong why would you want to follow their advice?
4. You may want to question the advice of any “salesperson” of financial products; these are people who are compensated via commissions. Whether they call themselves consultants or not a consultant is compensated via fees that are paid for advice and services given and a salesperson is paid via commission for products sold. Usually the party receiving the advice or service pays a fee to the consultant. The company providing the product as opposed to the consumer pays the commission. Therefore, consultants have a loyalty and a duty to the party receiving the advice or service, whereas, salespeople have a loyalty and a duty to the people who are paying them to sell the products or services.
5. Finally, never allow your emotions to dictate your actions. This is a guaranteed path to ruin.
    

That covers the basics of what not to do. Now, what should you do?

1.  It is our opinion that in light of what is happening in the economy you should keep a significant percentage of the plaintiff’s recovery in liquid short term and safe investments. Any professional financial planner can tell you that the three legs of a sound financial plan are: Safety - Liquidity – Growth. If any one of these legs is missing then you might want to rethink your involvement in that financial program.
2. You should start a program of systematic periodic investment of assets into a long-term fixed income investment, but it should be done in relatively small periodic amounts over many years. That way you minimize your exposure to the radical fluctuations, in the interest rate market place or the equity market place that we have experienced.
3. You should also start a program of systematic investment of your assets into diversified equity (stock type) investments, but this too should be done in periodic amounts over many years, in order to minimize exposure to market fluctuations.

At all times your objective be it with long-term fixed income investments or equity investments will be “buy low-sell high”. This of course is easier said than done. A few tips on how to do it would be:

1. Make sure that you are taking some of your profits along the way while you can. You should take profits in proportion to the rise of the value of your investment as that rise occurs.
2. Make sure that you keep buying along the way during market declines. The amount you should buy when the market declines should be in proportion to the amount of the market decline.
3. Remember what all students of “Chaos Theory” understand: “The more complex a system becomes the greater the probability of an unanticipated result”. The global financial markets represent one of the most complex systems known to mankind! Ergo, since “unanticipated results” represent the “probable outcome”, don’t listen to the “speculative predictions” of what the future will bring. Instead, systematically “react” to the established “fact” of what has just occurred.
4. Have a plan. Plan your strategy and then keep your emotions out of it, follow your plan.

THE IMPACT OF THE CURRENT ECONOMIC DECLINE
ON THE MANAGEMENT OF THE RECOVERIES OF TORT VICTIMS
 

The following data is from INVESTARS.COM as of the close of business on 10/1/01. The “Portfolio Return” is a total return for the time period based on their proprietary “R.O.S.S.” report from 1/1/97 through 10/1/01. This information is for investment banks covering one hundred or more stocks.