Zaks Investment Advisory Service

Current Stock Market Events and Alternative Investments

Foreign market investments represent an integral part of almost any investor’s diversification strategy. We began a foreign market analysis in our previous programs. We talked a little about how economies developed in various countries over the past 15 years, and how foreign stock markets performed in that time. I intended to continue that program today, but our own stock markets’ performance in the past week forced me to postpone that subject until next time.

Last week, the markets dropped again: the S&P 500 by 3.7 percent, and NASDAQ by 6.5 percent. The market has given up all its gains since about mid-April. And only a month ago, the Dow Jones was trading at a record level. What happened? It would seem that there are many causes: first of all, losses at banks and other major financial companies associated with sub-prime mortgages. Second, the falling dollar: last week, it dropped to a level of $1.46 to the euro. Potentially, this could promote inflation growth since a cheap dollar makes imported goods more expensive. Third, the growing price of oil: all of last week, it traded at around $96 per barrel. Fourth, the Consumer Confidence Index fell to its lowest level in the past two years. This index tries to gauge a consumer’s confidence in tomorrow. Many analysts believe that when this index falls, consumers (in other words, you and I) spend less money, which could affect the economy since consumer spending represents two-thirds of Gross Domestic Product.

Analysts cite all this data as they try to explain the market’s behavior. But these explanations have two shortcomings. The main one is that, as always, they appear as commentary, after the fact, and not as forecasts. And second of all, they fail to take positive news into account. And there was plenty of that over the past week.

First of all, employment: in October, our economy gained an additional 166,000 jobs – a result that significantly exceeded analysts’ expectations. Second of all, worker productivity: it grew by 4.9 percent in the third quarter (in annual terms). Again, this result was significantly better than economists’ forecasts. Labor productivity is an extremely important indicator and is closely watched by the Federal Reserve. If productivity grows, then inflation does not pose as big a threat to the economy. Even if wages should go up, this has almost no effect on the price of a produced good since more of it is manufactured per a single unit of labor. Another positive report was delivered by the current trade deficit. It unexpectedly dropped in September despite a spike in imported oil prices. The deficit dropped on account of growing exports, which most like rose thanks to a weaker dollar that made US-produced goods relatively inexpensive.

The market ignored all the positive news and focused on the negative. One may only hope that its mood changes soon. But in the meantime, what should we, investors, do? Perhaps the most unreasonable solution would be to sell all your stocks. Stocks should be sold when are they are trading high, not low. Right now, for investors with higher risk tolerance, this is not a bad time for buying stocks. The rest should simply wait: as we know, sooner or later, the markets will continue to grow.

It is interesting to note that when markets fall, activity picks up among brokers who sell various insurance policies and other alternative investment schemes. I recently heard a long program in which a broker talked about insurance contracts (they are called “equity-indexed annuities”) that guarantee you will not lose your money even should the market fall. Moreover, if the market rises, your investments will grow along. It sounds too good to be true, and of course, when we start to analyze these contracts (which, by the way, are extremely convoluted), it turns out that they are not all that great. So what is the trick that lets these contracts guarantee you a minimum return and at the same time continue to work even if the market goes up? There is not one, but three of them: first of all, investment growth is limited in most contracts to 9-10 percent. Second of all, in other contracts, only a part of your investment grows with the market – for example, about 80 percent of it. And third, the contract’s price grows (up to a certain point) together with the index, which does not include dividend payments. But when you buy stocks (directly or through an investment fund), you also receive dividends, and these make up more than 20 percent of the investment’s total gain. In addition to everything else, these contracts usually stretch over 10 years, and should you want to withdraw your money early, you are forced to pay a heavy fine.

A nine-percent cap on growth may not seem terribly serious. Imagine that the market fell by five percent one year (you will be left with your initial investment – the contract guarantees this) and then grew by five percent the next. Your money would also grow by five percent the second year. But if in the third year the market went up by 15 percent, your money, according to the contract, would only gain nine percent. All in all, that is not so terrible. However, we know that markets sometimes grow by 20 percent a year or more: for example, between January 2003 and January 2004, it went up by 32 percent. If we analyze real data over the past 10 years, then despite the market’s drop in 2001-2002, a diversified stock portfolio would have still significantly outperformed such an insurance contract. These contracts are extremely profitable for insurance companies. So it comes as no surprise that they pay insurance brokers up to 10 percent of their price for each new contract.

And with that, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.