Time to Objectify the Subjective … Fear!

Colman Knight Advisory Group uses a four quadrant matrix as a tool to objectify the subjective, especially when it comes to wealth management. Our Integral Wealth perspectives, called Quadrants, are adapted from the AQAL model created by Ken Wilber. The recent swoon which started in the final week in February with the S&P 500 and Dow both plummeting more than 3% in one day is a great case study in how to objectify fear when witnessing investments during a downturn in the market. Before we continue, we offer a simple tutorial on the perspective of the quadrants.

First, the upper left Quadrant begins with I:

"I" represents an individual's beliefs concerning any issue. Beliefs are invisible. No one can see, hear, touch, taste or feel them until expressed either by speaking, writing or some other media. In this example with the stock market, the belief could be whether the market is about to drop and if so, is it a small correction or are we entering a bear market?

Second, the lower left Quadrant is the WE:

"WE" represents the shared beliefs, customs, values between and among people and how they relate to each other around any issue. Beliefs vary. In our example, the beliefs can be different, such as whether the stock market or economy will go down or up. As long as the belief is not spoken or written or expressed, it continues as a belief and helps to build or hinder a relation with others.

The left side of the quadrant is all Interior, that which is invisible and stresses consciousness.

Third, the upper right quadrant is the IT:

"IT" represents a tangible, visible something. It can be either seen, touched, heard, felt and/or smelt. Investments as an intangible asset are the perfect representation of an IT. We, in the financial field, often refer to them as products, whether it is a mortgage, annuity, stock, bond, insurance policy, limited partnership or derivative.

In our example related to the stock market, you would locate the financial assets that you own in various places, such as a bank account, retirement account, stocks, bonds, certificate of deposits, mutual funds, savings accounts, mortgages, loans, equity loans and even lines of credit and untapped equity in first and or second home.

Fourth, the lower right quadrant is the ITS.

"ITS" represents all of the markets, regulations, tax laws and systems available locally, regionally, nationally and globally. Everything in "ITS" influences how the IT behaves and affects both the I and the WE view of the world. In our example, ITS represents the electronic stock market, the Federal Reserve System, the local banking system, the national banking system and the global banking system. Also included are the stock market, bond market, commodity markets, consumers (who use those products), energy markets, the legal system (that either enforces or doesn't certain practices), the taxing system and its enforcer (the IRS), as well as, various world treaties.

The right side of the Quadrant is all Exterior, that which is visible. It can be seen, touched, felt and/or smelt.

First, let me state that we cannot say with certainty whether the stock market is entering a prolonged correction (bear market) or will continue, after a few minor corrections, along the path of the recent bull market. We have our thoughts and they points towards a continuation of further gains rather than a bear market; and, regardless of market direction, we invest so that portfolios perform well and according to financial needs aligned with individual our life objectives.

With the above in mind, let's continue with the recent increase of fear that has crept into the stock market as measured by the volatility chart below.

The stock market experience in March 2007 has been building in force for more than six months. Yet, a sell-off in China and revelation that the Sub Prime market suffered due to high interest rates (interest rates have not been raised since June 2006) and a weakening housing market were the trigger causing fear to enter the market. The housing market has been weakening for about a year.

The two charts below visually illustrate the volatility in the Standard & Poors 500 Index (S&P). The first chart shows the twenty year period ending in December 2006 and the second chart shows the volatility just as the news broke that sub prime mortgages were defaulting at a 13% rate and fear that the rest of the mortgage market may suffer a similar fate. This caused the entire stock market to have a long overdue one day correction in excess of one percent. One market analyst wrote: "The stock market decline that began during the final week of February has resulted in a mind-boggling increase in fear/pessimism."

Just to remind you, interest rates have remained relatively static with short term rates exceeding ten year rates for about one year now. The housing market halted its phenomenal run almost a year ago and has been slowly deteriorating ever since. There are enough forces at work in the housing market to explain either continued strength or a collapse. Considering strengths, the main positive is the echo boomers (children of the baby boomers) entering the job and housing markets at the same time baby boomers are retiring and down sizing. Considering weaknesses, we just finished half a decade of phenomenal growth in housing prices fueled by low interest rates. Interest rates increased over a two year period ending last June and catalyzed a policy encouraging easy mortgages for unqualified home buyers (sub prime borrowers). Now, it is difficult to be certain whether the housing market will collapse quickly, as did the sub prime market, or will continue its modest decline as we have witnessed over the past year. We feel certain that housing prices are headed down for at least the short term. We are uncertain as to how fast and low they will drop!

When the stock market swooned, it became newsworthy because there has not been a 3% one day drop in more than a year. The volatility itself became news and the reporting resulted in a great concern amongst many amateur investors. Colman Knight expects the media to explain drops and then to seek a prediction that we are entering a correction; this type of event sells media. The media bombardment did not surprise us and we were very pleased that our clients were sufficiently secure in the investment strategies we adopted with them that they did not call us concerning the recent market drops. The drop on a percentage basis was much greater in China which had an 8.8% drop in one day as compared to the US 3.3% drop.

I was amazed and very pleased that our clients kept calm as the US equity market experienced its first greater than one percent one day decline in a very long time. The normally pessimistic Barron's ran a cover story on March 10^th, 2007 stating that the Bull market was not dead. We interpreted that statement to mean that many of their readers were quite worried about the latest decline.

The markets reflected this fear. The VIX – an index of volatility in the S&P – shot up an average of 60% from its normal level of the last six months. Meanwhile, the put/call ratio – another measure of fear – made an all-time high.

From an integral perspective, investors (lower left quadrant WE) were more scared two weeks ago than they were at anytime during the past six months.

Four weeks ago, the media was lamenting the over long period of a one percent or greater one day correction and two weeks ago the Dow closed about 5% off the all-time high peak,set only three short weeks earlier. The emerging markets, which slumped much further than the US markets, had rocketed so high so fast that even after their decline off the peak they are still only down to the levels they were just before the end of 2006. The Chinese market, which declined 8.8% on February 27^th, has shrugged off all the losses and is once again in record territory as of March 22nd.

In general, when markets are at turning points, you get unanimity of opinion... today unanimity is not happening. At the top, everyone's bullish and it's hard to find a reason for any market slow down or decline. At the bottom, everyone's pessimistic and investing seems like a lost cause… or even a fool's game. We do not seem to be at either of those extremes but somewhere in the middle. To us that is a signal to stay aware while continuing with our current rewarding strategy.

We are also struck by how quickly the market has forgotten its fear of yesterday. Right now, the market is optimistic… until the next something bad happens… then it turns pessimistic in a snap. In the financial industry this sentiment is called "climbing the wall of worry". In general, the reaction is positive. Given the quick turns from optimism to pessimism, we are not finished climbing the "wall of worry" and are not sliding into the abyss at this moment (bear market).

Said another way, when everyone sells their stock on the first whiff of trouble, it makes us believe the Dow, the S&P, and the Nasdaq still have a rally in them. In 1996 Alan Greenspan gave his "Irrational Exuberance" speech. It was almost four more years before the market peaked and the correction began. During that period, the media focused on how the sky was the limit even though fewer and fewer shares were reaching new highs. I remember writing a short article about the stealth correction around the middle of 1999 because more stocks were declining than rising; the media ignored that fact. Today, we continue to have many more stocks rising than declining, another positive sign. However, as we continue to enjoy the gains of the current rally, we continue to increase our client's portfolio exposure to fixed income and high yield for the inevitable when this rally ends, just as the last rally ended in March of 2000.

We continue on this path because we manage investment portfolios (IT): The upper right quadrant. We are mindful of that responsibility. So this presentation illuminates how the WE lower left quadrant affects the upper right by increasing volatility and how by evaluating and observing this human behavior, we better manage investments (upper right).