Worth: What are your clients’ main concerns right now?

Robert Elliott: Clearly, we are in for a period of rising interest rates and climbing inflation; we are seeing evidence of this in the markets as we speak. Individuals who previously relied on fixed income markets for their “sleep-well” investments are asking how they can obtain that same risk reduction and low volatility now, either without the same amount of fixed income or with active management within fixed income, or by using alternative investments.

Jeff Applegate: The main issue is clients’ growing focus on absolute returns. We had a terrific bull market run from ’82 to almost 2000, and a terrific bond market run for more than 20 years. And then we had a period when we couldn’t do anything right. So there is really more of a focus on wealth preservation. People are also asking how they can grow their assets. There is more interest in absolute returns and how you can get them using alternative investments.

Mary Doucette: I agree. If you go back five years, the focus was much more on the kind of return an advisor could achieve for a client, and today it’s much more about preserving wealth and prudently growing it. Clients also ask, “What is a safe asset class?” You can find issues with every asset class. We all are expecting interest rates to go up, so bonds are not a safe asset class any more. There are so many dollars chasing hedge funds and private equity deals, you have to ask whether they are good alternatives. Are the equity markets, now that we have had a run-up, overvalued?

I think there is also a general sense of nervousness and concern. Whether that is because of the war, the events of 9/11 or of having a rather prolonged and challenging bear market in equities is unclear. But I think clients are much more focused on risk, control and management and less concerned about return.

Worth: Are clients making investment decisions now, or are they waiting until the dust settles and there is more certainty over currencies, rates, the war in Iraq or the budget?

"We are telling clients now to be much more opportunistic and much more tactical, much more focused than they used to be. They have to become more Machiavellian." -David Darst

Thomas Melcher: The overriding macro concern that I hear is the political direction of the country and the implications that it has for all of us. Whether they are the deficits and the fiscal components that go along with them, or the idea that we have been perhaps a little too macho in our behavior and have increased the likelihood of a terrorist attack by it, the big macro factors seem to be centered directly on the policy coming out of Washington. Then there are all the things that flow from that—the deficit, the currency, the oil prices, everything that we can recite chapter and verse.

The interesting—and perhaps unanticipated—micro concern is income: where to get it, how to get it. Interest rates are low, the high yield spreads have compressed dramatically. You know the absolute levels out there are low. And with the recent pick up in inflation, you’re not even earning a real return. That’s the real challenge: how to meet income needs in a safe way. We all know how to stretch to get income. But as my mentor always used to say, “More people in the history of investing have been burned reaching for yield, than in all the investment scams ever combined.”

DAVID DARST, chief investment strategist, Morgan Stanley.

David Darst: The major concerns of last year and the year before have become more minor: the elections, oil, terrorism, China, debt and jobs. People were saying: I don’t want to invest now, I want to see how the economy’s doing. I want to see whether these jobs are going to China. What does that mean for companies? What does it mean for the economy? The minor issues that are now major—they were really put in the background by the two presidential candidates because no one wanted to tackle or even discuss them—are the pension and Social Security situation and the health care situation. 

I’m asked all the time if the deficits matter. That’s something that ties into the issue of inflation versus deflation. We’ve stressed that they are going to coexist for a few years. From 1871 to 1896, the price level in the United States fell by 1.5 percent per year as the West was opened up by the railroads and the goods from the fields, forests, fisheries and mines flooded the Eastern markets. It was a benign deflation. Is this what we have here now with the opening up of Asia?

JOANNE JENSEN, managing director, Citigroup Private Bank.

One issue that I think is on the minds of many of our investing clients is real estate. Are we in or near peak levels or bubble levels? What does one do about highly appreciated real estate with the taxes low?

Finally, they are concerned about tactical versus strategic moves. We’re telling everyone now to be much more opportunistic and much more tactical, much more focused than you used to be. You have to become more Machiavellian.

Christopher Poch: I personally think that one of the reasons interest rates have been so low for so long, despite the Fed tightening, is that people have an enormous amount of fear, despite the improving economy over the last year. People have been reluctant to get back into the stock market. I think we’ve all seen the times in the market where you’ve had an improving economy; people don’t do anything until after the market goes up, but then the cash starts following again. As David pointed out, being more opportunistic is something we should be encouraging people to do.

Joanne Jensen: My clients feel like they are suffering from information overload. They are trying to evaluate all these risks and find areas where they can outperform. And they’re turning more frequently to us, often to co-invest and to capitalize on what our research is showing and what we’re doing with our own books. This sort of piggybacking is becoming more and more popular.
I think also, in the process of diversifying, they are really trying to weed through this incredible universe of hedge fund managers and private equity managers. I would say I am more of a financial partner than I’ve ever been before because they really want us to get in there and to look under the hood, especially in industries like hedge funds, where the regulations are so loose. They want someone keeping an eye on the ball constantly. In an era when it’s so difficult to find return, they wonder whether managers are reaching; are they doing things that they shouldn’t and not sticking to their specialty?

Worth: Our readers tell us they understand the need to be more active, but worry about the timing in light of the economic and market issues you highlight. How can they make a decision in this environment?

JEFF APPLEGATE, chief investment officer, Fiduciary Trust Company International.

Jeff Applegate: One of the overused phrases in our business is, “Well, the easy money’s been made.” Well, when was that, exactly? Because it is never easy. We just try to talk to clients about thinking strategically, about thinking long term. For most asset classes, the return occurs in a very limited time frame during the course of any given year. If the client isn’t in that asset strategically, he can easily miss the upside.

Thomas Melcher: Whatever tends to do well for a long period of time all of a sudden becomes the safe investment, which, as we all know, is ridiculous. Investing, in many ways, for most of our clients, is a matter of making them better off in real terms at some point in the future. The real benchmark is inflation. Everything over that balances how much risk you are willing to take for an incremental return. If it’s a little bit of risk for another 150 basis points or 200 basis points, maybe it’s worth it. If it’s a ton of risk for another 100 basis points, forget it. It’s really that simple.

Worth: But how do you know you are not going to buy something today that will crash tomorrow?

Mary Doucette: The reality is that if you look at the returns of the last five years, there were three quarters in U.S. equity markets when you got your return—the fourth quarter in 1999 and two quarters in 2003. And if you were not in the equity markets in those three quarters, you just didn’t get a return. So I think it’s important, on the margin, to be thinking tactically. But it’s absolutely critical, in order to achieve your goals, to be strategic in your investments.

Worth: People are having trouble, first, trusting the markets, and second, deciding when to act.

Christopher Poch: Is the dollar going down? I don’t know. Is there a reasonable chance that it might? Probably. What do you do? Well, you have to get some exposure somehow. In ’89 people could have said, “Well, the market in Japan just fell off 5 or 8 percent; now’s a dumb time to invest.” But it was 15 years before the slide ended. You have to move into some things slowly. But also, you can’t wait to act because you’re afraid that you’re going to have a lower price by settlement date. I think helping clients with those timing decisions is really our responsibility.

Worth: What effect has the war had on decision making? Do you find that client psychology changes depending on the news out of the Middle East?

Robert Elliott: Everyone is looking for some sign that will make him or her feel that the uncertainty has gone by the wayside. We have a great chart, listing events of the last 100 years: two World Wars, depressions, inflation, etc. It shows clients that there has always been uncertainty.

We have had several clients who have said, “I’m going to be out of the market till we pass the conventions and there’s no terrorist attack.” After that, they wanted to wait until after the elections, now, for better news from Iraq or on oil. There is always some event on the horizon that would appear to clear the air. People need to understand that and move forward with their decisions.

Christopher Poch: I think it’s not so much the conflict itself but the financial drain that is weighing on people. It’s the deficit. The deficit is at historic levels relative to GDP over the last 30 years, but it’s probably still not too bad. In absolute terms, in headlines, on television, it’s absolutely in the front of their minds. It’s the fear of rates, the fear of inflation, the fear of taxes. I think those are a big deal. I think that fear weighs on people because they think that we can’t keep going along this way forever.

Mary Doucette: I think that the psychological impact of the war and the threat of terrorism dampens people’s expectations, and the sentiment for investment. Despite the fact that we have economic data that has been positive, people are not feeling good about anything. It’s not so much due to specific events; it’s this pervasive environment of fear.

Jeff Applegate: Because the bear market went on for so long and was so dreadful, a whole bunch of people ratcheted down their long-term return expectations. But in fact, if you look at history, if you look across geography and across time, you realize bear markets do not last forever. And when you have a cyclical turning point, the events that define that cyclical turning point are invariably different. But the way the risk of each asset class operates—say stocks as compared to less risky asset class like bonds—is invariably the same, and once you make the bottom, you get a very robust performance in equities.

CHRISTOPHER POCH, managing director, Private Wealth Management, Smith Barney.

David Darst: I see a couple of additional issues. One is the effect on the American companies operating abroad and their sales, their image and their branding. We see more and more anecdotal and newspaper accounts of resistance to American imagery abroad. There is also the issue of financial flows. You’ve seen both China and India do something the last couple of quarters that shocked a few people. They said, “Why are we sending the money to the States?” India has decided to take $10 billion of its $113 billion reserves and dedicate it to infrastructure investment. China decided to take $45 billion of its $600 billion of reserves and dedicate it to recapitalization of two of the state-owned banks. In both instances, they said, “Why send it to the United States? Why don’t we use it to help ourselves?”

I think the third one is the effect on confidence, which Mary mentioned. It’s not just Iraq. Iraq we know. Iraq we are in. Iraq has 26 million people. Iran has 72 million people, and Iran is the world’s leading sponsor of terrorism. The effect on confidence, I think, comes back to this axis-of-evil concept; it’s not just Iraq. People worry that there may be other shoes to drop. There’s a terrorism premium that is being slowly built into the markets. It is certainly in the oil markets.
 
This affects how investors behave. Look at Warren Buffet—he is sitting with 33 percent cash. I know our recommended cash allocation is nowhere near that. Buffet has 33 percent, of which half is in foreign currency. He has never invested in foreign currency before.

Robert Elliott: (laughs) I’m no longer optimistic, for the record.

Worth: What sort of returns should clients expect from a properly diversified international portfolio over the next 10 years?

David Darst: I think we’re going to be in a back-and-forth kind of market for the next few years. As we work off the grand excesses of the ’90s, which still include high leverage, high indebtedness, high borrowing, a grand overdependence on foreign capital, creative and generous accounting and global overcapacity. The world labor force has quadrupled in the last 10 years, and it’s going to continue.

Jeff Applegate: That’s the positive supply that you talked about occurring in the industrial revolution. That’s the same thing—getting more for less.

David Darst: It’s a benign deflation, which helped the United States from 1871 to 1896.

Jeff Applegate: Now we’re playing that out on a global level. You see a difference between $30-an-hour and $30-a-month labor.

ASTUTE ADVISORS Christopher F. Poch and Joanne Jensen.

David Darst: It makes for, we believe, a backward and forward kind of U.S. equity market, where you’ll get about a 6.1 percent return. That consists of 2.7 percent real profit growth; 2.4 percent inflation over the next five years; 2 percent in dividends. You want to buy stocks when you can get them at 11, 12, 13 times earnings. You’ve got to be optimistic and judicious to buy stocks in this kind of environment. So the last part is a 1 percent contraction as interest rates begin to slowly rise. So we see U.S stocks giving you 2.7, plus 2.4, plus 2, minus 1, is 6.1.

We see bonds giving you a 4 percent coupon, and as rates begin to lift, it will cost you 2 percent per year in capital, so a 4 percent coupon, 2 percent capital loss, means you should expect 2 percent per year on bonds. That’s why we say you have to be a little bit more opportunistic, and you have to look at alternative asset classes.

Worth: What happens if the war is resolved? If bin Laden is caught? Do those sorts of large events require a bit of tinkering, at least around the edges, of your asset allocations?

Robert Elliott: Well, Osama bin Laden, I think, is probably worth 500 points to the market—I don’t know if it stays in the market forever, but it’s certainly worth that. Is that any reason to invest? Probably not, but there are reasons to invest that we’ve already talked about. You’ve got to be there, you have to be in the game. And even if he is captured, that will not resolve the whole issue of terrorism.

Worth: What about the war? What if there is, as everyone hopes, a clean resolution to the political situation in Iraq, and we are able to reallocate our forces?

Jeff Applegate: I’d say there are always going to be other hot spots—North Korea, Iran. We are now in the third year of the war on terrorism, so we have this war that is unpredictable and civilian populations, which are huge soft targets, and obviously that’s created a lot of angst for a lot of people. You are not safe in Madrid, you’re not safe in Moscow and you’re not safe in New York. That’s the world we live in. And when we talk to clients about that we say, ”Look at the cold war, when civilian populations were hugely at risk on a continuous basis.” And that war went on for 50 years. Now, God forbid this goes on for 50 years, but the point is that the business cycle came and went. Bull and bear markets came and went, and the same thing will be true during the war on terror.

Capturing Saddam, succeeding in Iraq, capturing Osama—these are not immaterial, but they are almost immaterial in terms of how you invest, because you have to examine the fundamentals around this geo-political risk, which looks like it is already priced into the market.

Joanne Jensen: You know, as much as we try with clients to keep them on their allocation, and assessing their exposures and risks, one of the things that we’ve been doing more often now is when someone has a risk that they just can’t get over, we look at hedging it.

"Everyone is looking for some sign that will make him or her feel that the  uncertainty has gone by the wayside." -Robert Elliott

Thomas Melcher: You want perspective and wisdom and sage advice for navigating through periods like this? Aldous Huxley said, “Religion, superstition and mythology all flourish when individuals have to make decisions under conditions over which they feel they have no control.” And we have all this religion, superstition and mythology flourishing right now, because we’re in a Bermuda Triangle kind of transition phase.

Photography by Thomas Hart Shelby.