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Wirehouses and ‘a new death bomb’ for global economy

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I think most of us realize that the current bull market is not going to go on forever. I’m especially worried that when you add a tax stimulus to an overheating economy, insert rising short-term interest rates to the mix and start a global trade war, there is at least the possibility that suddenly, all investors everywhere are going to decide that it’s time to book their gains and retreat in a heated rush to the sidelines.

I also worry that, in the absence of meaningful regulation, the brokerage firms are quietly building a new death bomb for the global economy, involving highly leveraged derivatives where the wirehouses are betting far more than their total net worth on bond rate movements.

My prediction is that the markets are going to drop — possibly sharply — and that will pose a problem for many financial planning firms.

“None of us know when the markets will drop, and therefore we should always be expecting those unhappy days.”

Why? The first and most basic reason is that most planning firms are still, according to my latest fee survey, following an AUM revenue model. In doing so, they have made themselves quite unusual in the marketplace. In most cases, when there’s a downturn, a normal company experiences lower revenues and can cut back on staffing and capacity to ride out the storm.

But a planning firm experiences that drop in revenue when all hands need to be on deck, manning the phones and attending meetings with anxious clients who are understandably concerned that their net worth has dropped 30% over the previous eight days. Should they stock up on cat food? What are you doing about this? When will the markets go back up again?

You could argue that planning firms need MORE capacity during a significant drop in their revenue, which can put a squeeze on margins.

We’ve been through this before, back in fall 2008 through early spring 2009, and I think we might want to relearn some of the lessons from that traumatic period. Back then, I began writing weekly messages to my Inside Information readers, asking them to share what they were doing with client investment portfolios, what messages they were sending to clients in the middle of the financial hurricane, and also what they were doing administratively to stay afloat. It was a way for all of us to pool our collective wisdom and stay sane while the world seemed to have lost its mind. I also wrote columns for Financial Planning, focused on what advisors could do then to prepare for, well, right now.

The most important thing I learned from this exercise 10 years ago is that financial planners are not immune to the herd mentality. A very few of my readers said that they were having fun buying stocks at absurdly low prices. The majority of them said they were gritting their teeth and riding it out without selling their clients’ stock positions. Upon further probing, more than a few admitted that they had stopped rebalancing to their initial allocations, and thus were building up cash positions at a time when stocks were on a fire sale. In doing so, they were allowing their equity exposure to drift lower as the portfolios lost value. The following year, in a follow-up survey, many advisors regretted this approach; in retrospect, they had a tremendous opportunity to build some extra return into their clients’ financial lives by simply following their normal rebalancing processes.

And, of course, a handful of advisors shared their process for strategically “harvesting tax losses” (selling out of equities) as the markets declined, and I never did hear their strategy for strategically buying back in again. In fact, I never heard from them again, at all.

The messages that advisors were sending to their clients were interesting. Some of them went back into history, noting that downturns were a normal part of market behavior. They reminded clients that history suggests that this one would be followed by another long and only fitfully-interrupted bull run. There would be a return to a time when all the things we have held dear — diversify, buy and hold etc. — would once again work marvelously in client portfolios.

Others addressed the valuation issue, saying that stocks were on sale, and you would only think that companies were less valuable now than they were six months ago if you truly believed that, during all that time, all the workers going to work every morning in all those companies, day after day, were somehow producing negative value for their corporations.

Others invited their clients to come into the office and, if they were thinking about abandoning their stock positions, asked them to revisit their goals and market expectations. I was told that these meetings tended to end with clients saying that they really didn’t want to change their long-term expectations, and therefore they were now willing to ride out the storm.

Jamie Dimon and Lloyd Blankfein remain prominent public figures, but many other crisis-era CEOs have kept low profiles over the past decade.
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Some of the best letters shared the advisor’s own trauma with the situation: that the fatigue associated with these unusual market conditions was not unlike passing that 23rd mile marker in a marathon, when you sometimes feel like you can’t force yourself to muster the stamina to go on. Sharing vulnerability — and the pain that clients were experiencing — turned out to be a very effective way to keep clients calm.

I’m sharing this so that when the Big One hits, you’ll have some tips on how to prepare. But what about preparing your practice? A few advisors, back then, opined that they wished they had shifted out of the AUM revenue model — but of course it was too late now. Others wished that more of their staff salaries were variable — i.e. annual bonuses that were tied to the profitability of the firm. More than a few founders of smaller advisory firms stopped taking personal compensation and put the money into a money market fund, to ensure that they would be able to pay staff salaries as the downturn continued interminably. Of course, they also regretted not having set aside more cash reserves before Lehman went down.

Professional investors always live in a zone of uncertainty; none of us know when the markets will drop, and therefore we should always be expecting those unhappy days. My best advice, today, is to think about preparing your clients for the worst. What would they do (you can ask them now) if the markets were to fall 30% or 40% over a relatively short time period? It’s happened before, and it may well happen again in their lifetime, perhaps in the near future. You cannot guarantee that the markets will recover quickly; all you know for sure is the direction of the next 100% movement.

Perhaps, for some who are at that delicate stage just before or right after retirement, some retirement assets could be moved to an inexpensive deferred annuity. Others, if the thought of a downturn makes them skittish, might want to rethink their goals and portfolio allocations.

Advisory firms, meanwhile, should stockpile cash and see how much of your fixed cost structure can be made variable. And you should start composing reassuring messages that say that a market downturn is not the end of the world. The positive will, in the end, outweigh the negative: You’ll be able to buy stocks on the cheap, your communications and shared pain will deepen your relationships with clients, and maybe (fingers crossed) the next round of wirehouse malfeasances might see some executives finally get to know the inside of a prison cell.

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