Profits at financial firms, inflated through high levels of leverage, were part of the surge in profitability. The Bank Credit Analyst has broken apart the profits of financial firms and the chart below is revealing. Non-financial profitability peaked above the mean about two years ago while financial profits surged well above the mean for almost the entire decade. That unsustainable level of profitability is now reverting to the mean for financial companies at a very rapid clip. Overall corporate profitability is now reverting to its mean of about 10% over the last 30 years. It is possible that, particularly for financial companies, after-tax profits may be well below the mean for several years to come. The market has recognized this and stock prices have fallen more than necessary to reflect the new reality.

Living within our means — a new lesson for the U.S.

The democratization and expansion of credit in the United States over the last 30 years has generally been a good thing. Consumers received increased access to financing that had either been completely unavailable or restricted to creditworthy corporations. Living standards rose and previously unaffordable products became affordable. One of the most useful examples is automobile leasing. Leasing allowed consumers to drive previously unaffordable vehicles and replace them every three to four years. All that was needed was a small down payment and income sufficient to afford low monthly lease payments.

However, our country has become addicted to debt and we must now learn again to live within our means and use debt sparingly. Tightening lending standards, a weak economy and falling home prices all but ensure that consumer debt levels will fall and the savings rate will rise. The chart below from the Bank Credit Analyst visually tells the story. If we travel back 18 years to 1990, household debt was equal to about 80% of disposable income. This level held fairly constant until this decade when the ratio exploded to an unsustainable 130% of disposable income. The savings rate declined to zero on a couple of occasions during this decade. It is now starting to inch up to a level of around 2%, where it had been as high as 8% in the early 1990s. The truth is that consumers felt richer during the 1990s and 2000s until recently. They felt richer because the technology bubble and the housing bubble raised household net worth as a multiple of disposable income. This chart is now rolling over as falling home prices and falling stock prices decrease household net worth. Consumers not only feel poorer, they are poorer and a bleak employment growth-rate forecast only darkens the picture.

If you are in debt, the best advice we can give is to work on repaying that debt and then building savings through contributions to 401(k) retirement plans and other similar vehicles. Saving outside of retirement is desirable and necessary.

Even if you are not in debt, the nasty lesson of this downturn is that we will all have to adjust budgets and live within our means. Wealth destruction means that we will need to withdraw less from our portfolios to supplement our lifestyle. This is especially true for those in retirement. The standard rule of thumb is that only 4% of a portfolio's value should be withdrawn in any given year in order to lessen the risk of running out of money. Levels above 4% increase the probability of running out of money and should only be considered when markets have enhanced wealth as opposed to destroying it.

Sentiment is poor but price is revealing

In several of our recent market updates, we have acknowledged that we face a tough recession and that the twin specters of falling asset prices and credit contraction ensure that this recession will be deeper and more prolonged than the last two. However, we have also been quick to point out that the steep fall in stock and bond prices have created an opportunity that we have not seen in some time. Don't take our word for it. In an editorial to the New York Times on Oct. 17 entitled Buy American, I Am., noted investor Warren Buffett said the following:

"I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds … A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful … Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

Do not be fooled by Warren Buffet's image as a Cherry-Coke sipping, Dairy Queen-eating resident of his front porch in Omaha. Buffett became one of the richest men in America through the purchase of good companies on the cheap. He also has never tried to time the market. His discipline is simple. Buy cheap, sell dear and do your buying when nobody else wants to.

We have talked about fear and greed on these very pages as well. We actually prefer the phrase "When you have the price, you don't have the proof and when you have the proof, you don't have the price." There is precious little evidence that the U.S. economy will rebound and that stock and bond prices will rise again. Pessimism and gloom are the order of the day. However, we have the price in a wide range of stocks and bonds. Dividend yields are now above government bond yields as discussed in the market update presented by our colleagues at Threadneedle a few days ago. We discussed the very same opportunity in our "Paid to Wait List" published a couple of weeks ago.

In our next market update we will again present specific ideas that we believe will be rewarding in the future.

The big risk

Even at today's prices where investors are more than adequately being compensated for the risks, there is one big risk that we should all be aware of. A run on the U.S. dollar would be a very difficult issue for the U.S. and the world economy. The United States consumes more than it produces and we owe the rest of the world a lot of money. If our creditors ever became excessively nervous about our financial picture and started selling dollar-denominated stocks and bonds, this country would be forced to raise interest rates in order to attract creditors back to our debt. We assign no greater than a 10% probability to this scenario as other countries are well aware that a weak United States economy has large consequences for the rest of the world.

The retirement conundrum

An advisor asked me the other day what people should do if they are in retirement, their portfolio value has fallen and there is no new cash coming into the portfolio. I have three answers:

1. Think like a portfolio manager — we teach young portfolio managers that every day they hold on to a portfolio and make no changes, it is as if they bought the whole portfolio that day. This is a tough lesson as young portfolio managers do not like to make changes if it involves recognizing a loss (also called a bad decision). We teach them to stick with the investments that continue to make sense and sell those where the investment premise is no longer valid. You should do the same. For non-qualified accounts, tax losses are valuable and can be carried into the future. Beyond this, re-shaping a portfolio into investments that will perform better given the new reality is a quicker way to make up the losses incurred.
2. Make adjustments — no one likes to hear this but you may have to take less out of your accounts and spend less. It's not just retirees that need to recognize this. We all do.
3. Consult your financial advisor — individual facts and circumstances vary. Talk with your advisor and make the decisions that are right for you, even if they involve personal sacrifice.