Managing Today’s Risks

   We've been optimistic about the economy and stocks in recent months, as have many investors, and the stock indexes have been doing well. But there are many risk factors investors are overlooking. Our belief is that successful long-term investing requires the identification and management of market risks.
   Here are some of the risks that are lurking in the markets.
   § We are getting close to the longest advance without a meaningful correction. Since the recent rally began in March 2003, we are nearing 1000 days without a 10% or greater correction in the major indexes and 150 days without at least a daily 2% decline.
   § Valuations declined from extraordinarily high levels in 2000, but they never approached the historic valuation cycle lows. It could be that we will see low valuations before we see bull market high valuations.
   § Today's valuation for the S&P 500 is near the historic average, but that might be misleading. The S&P 500 is capitalization-weighted, so the largest companies dominate both returns and valuations. Four companies make up 10% of the index, and have an average price-earnings ratio below 16. The next 10% have a P/E ratio below 14. The largest 19 companies have an average P/E ratio of 14. (European stock indexes are similar.) That means the vast majority of companies have valuations exceeding the historic average.
   § The rate of earnings growth continues to decline. We have had an extraordinary period of double-digit earnings growth, but the quarters of double-digit profit growth appear to be at an end.
   § The earnings growth of recent years also might be distorted. Most of the growth was from energy companies (primarily oil companies due to the rising price of oil) and financial companies (due to low interest rates). For most companies, earnings growth has been more tepid, and trends in oil prices and interest rates could work against energy and financial company earnings in coming quarters.
   § Profit margins have been at historic levels the last few years. Unless this is a permanent change in the economy, profit margins are likely to decline nearer the long-term average.
   § Wages are rising, and the labor market clearly is tight. Without continuing increases in productivity, rising wages lead to lower profit margins and higher consumer inflation.
   § The extent of the decline in the housing market and its effect on the economy still are unclear. The housing boom is estimated to have accounted for about one third of recent job growth, and one to three percentage points of GDP growth.
    § Inflation continues to be a wild card. The Federal Reserve has been betting that inflation peaked in 2006, and recent data support that view. But the tight job market and other factors keep inflation on the watch list.
   § There also are some technical concerns about the stock markets. The indexes have not been able to mount a sustained advance since October, and the lowest quality stocks have been leading the market the last few months. Are they getting ready for another run or a decline?
   § Of course, there are domestic and international political risks hovering over the markets. The 2003 tax cuts might be allowed to expire instead of being made permanent. There also is the risk of trade restrictions and other limits on global trade. The potential for terrorism that disables the economy always is present.
   Most investors are ignoring risk and risk management. Instead, they are searching for the highest potential gains or yields. For example, after Venezuela's Hugo Chavez announced plans to nationalize key industries, there was only a mild decline in emerging market stocks and bonds. A few years ago such a move would have triggered a sharp sell off in all emerging market securities.
   Ignoring risk can be profitable in the short-term but dangerous over longer periods. Managing risk is important, because the stock indexes typically give up about half of their peak gains before the next bull market begins. Another reason to manage risks is that we never know what will trigger a market decline or when it will begin.
   We have lagged the market indexes recently in our Managed Portfolios because we are managing risks. Risk management produces superior long-term returns with lower risk. Investors who ignored risk did well in the late 1990s and have paid for it since. The S&P 500 has earned less than money market funds or treasury bills since 1998 and had a maximum loss of 47% the S&P 500 incurred at the market bottom. Our portfolios have superior long-term returns.
   Investors are ignoring risk because most investments are earning below-average returns and will continue to do so for a while. Reaching for higher returns without having a margin of safety in place is the first step on the road to major investment losses.

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Key IRA Decisions for 2007
IRA owners can squeeze significant additional after-tax dollars out of their accounts — if they plan carefully. In addition to the usual planning strategies, there are new IRA opportunities available in the next few years.

Managing Today's Investment Risks
   We've been optimistic about the economy and stocks in recent months, as have many investors, and the stock indexes have been doing well. But there are many risk factors investors are overlooking. Our belief is that successful long-term investing requires the identification and management of market risks.
   Here are some of the risks that are lurking in the markets.

How Annuities Can Extend a Portfolio
   Annuities received a bad name over the last few decades, with some help from this newsletter. But there are different types of annuities, and they are not all bad investments. For example, the greatest fear of most retirees is outliving their portfolios. The right kind of annuity can reduce the probability of running out of money by making a portfolio last longer.
   Retirees should consider shifting part of their portfolios to immediate annuities, if not immediately than at some point in retirement.

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