| |
 November 2008 Not So Different
Regardless of what was predicted, it all happened. The question now isn’t, “What caused it?” or “Was this the right course, of action?” The pressing issue now is, “What happens next?" As we enter the fourth quarter, investors are still trying to get a grip on the new financial landscape. They’re trying to understand the implications not only for struggling institutions but for the economy as a whole. Typically during an election year, the presidential campaign would have dominated headlines, but this year's contests were just bit players during the upheaval in the financial markets. Tumbling stock prices and tight credit had a much greater impact than political promises and rhetoric. It couldn't be business as usual because business was no longer usual. The world of investing is, by its very nature, forward looking – you can’t buy last year’s or even last quarter’s profits. That’s why it’s important for investors to look ahead and not fixate on the past. Stability and growth will only return when confidence returns to the market.
A Little Perspective
This year’s shocks have been deep and far-reaching, and the fact that they’re focused on financials – the oil that greases the entire economy – certainly makes them more sweeping than the tech implosion. The government’s intervention is another difference, too. But again, from a broader perspective, none of this is truly unique. Financial institutions bore the brunt of the Great Depression. Runs on banks and excessive leverage led to the demise of many firms and portfolios. To a lesser extent, the savings and loan crisis of the late 1980s was another example. In both cases, the government stepped in with stricter laws, additional regulations, and even new government agencies. As is happening today, each of these instances brought broad changes to the economic landscape. In each case, the economy has come back even stronger, taking the financial markets to new heights. For patient investors, that will likely be the result this time, too. Even now, market conditions aren’t that far from normal. Despite the recent selling, the S&P 500’s trailing P/E is hovering right around its historical average. This suggests stocks are fairly valued, but not cheap. If analysts’ expectations for current quarter earnings prove too optimistic (and they are), stocks may still be overvalued. After being ridiculously overbought earlier this year, commodity prices are now returning to more typical levels. The slowing global economy is taking its toll on production, reducing demand and allowing commodities to approach more reasonable levels. Even OPEC's November production cuts will have a hard time stemming the decline.
This, in turn, has the additional benefit of giving central banks more leeway to lower interest rates without fear of sparking inflation. At 1.0%, the federal funds rate is actually at the low end of its traditional range, so the Fed is already being very accommodative. Perhaps more importantly, there is little left that can be done with interest rates. The Fed, however, has some other tricks up their collective sleeve, extending credit to corporations and paying interest on bank reserves. While these may not be “traditional” moves, they’re intelligent attempts to get the credit markets moving again.
Bottom ≠ Buy In the meantime, credit markets remain frozen and selling has accelerated in the equity markets. Yet in the broad scheme of things, even this isn’t so unusual. When bear markets finally come to an end, they don’t do so with a graceful landing but rather with a fear-driven selloff. This is precisely what occurred as the fourth quarter got underway. In previous months, selling focused primarily in the financials and consumer discretionary sectors, but in October it became almost indiscriminate. This is how bear markets bottom. They don’t end until everyone who wants to sell finally has, and this typically is the result of a few days of panic selling. When it’s over, there’s no one left to sell and share prices can begin to stabilize as buyers slowly return to the market. But just as the government’s intervention can’t put an immediate end to the financial crisis, a bear market bottom won’t immediately put an end to the bear market. Typically the final stage is marked by a period of investor apathy. Rather than racing back as soon as the selloff is over, investors remain on the sidelines, content to hold cash until there are clear signs that it's once again safe to buy. This can take months. In the meantime, the only thing that’s certain is that selling near the market bottom will convert unrealized losses into realized ones. The time to sell was a year ago when equity markets were making new highs. The time to hold – and consider buying – is now, when all the gains are washed away and stocks are on sale at their cheapest prices in years. In the words of legendary investor Warren Buffett, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is.”
After weathering this year’s declines, there’s little reason for anyone still invested to get out now. Those with diversified portfolios have not only fared a little better but are also well positioned to benefit regardless of which areas of the market show the first signs of life. Whether they know it or not, those who are investing on a regular basis, such as 401(k) participants, are also taking advantage the current market conditions by buying more shares when prices are lower thus positioning their portfolios for greater gains in the next upturn. This is not the time to stop investing and hide in cash, but rather an opportunity to start investing and truly buy low. It’s not a time to change your investment strategy, but rather a good time to stick with it. Savvy investors realize that time is on their side. Despite all the ups and downs of the past century, since 1926 there have only been 10 five-year periods and 5 ten-year periods when the S&P 500 did not have positive returns. This covers the Great Depression, the 1987 crash, the malaise of the 1970s, the dot-com crash, and the aftermath of 9/11. These were all major events and blows to the economy, yet each time, the markets clearly demonstrated their resilience. There’s little reason to believe it will be different this time. At times like these, the biggest mistake for investors is to make long term decisions based on short term concerns. While cash may seem preferable in a falling market, the decision to sell is actually one of market timing. Conservative investors usually shun market timing as being too risky, and indeed it is, even in a declining market. Once out, investors are often too frightened to return to the market, compounding one bad timing decision with another. Investors should strive to avoid that mistake. Things really aren’t different this time, and time is on investors' side.
What is Different This Time In an of itself, that's not an issue for alarm. What's more concerning is how governments will react. Congress and the Fed have already been much more proactive than in the recent past. They're not through yet, either. One of the most frightening things on the horizon is the promise of more government regulation. Throughout the development of the credit crisis, politicians have been quick to blame the deregulation in the financial markets that began in the Reagan era. Now, with public money being used to shore up private institutions, Congress is demanding a greater hand in regulating them. Sadly, Congress already played a role by abdicating their responsibilities with Fannie Mae and Freddie Mac. Despite calls from the republican side of the aisle as well as the Fed, the democrats controlling Congress not only maintained lax oversight, they encouraged the GSEs to take on more questionable debt to fulfill the mandate of making home ownership available to more low-income Americans. Ironically, it was these same politicians who were so surprised when the government had to step in to keep Fannie and Freddie afloat and they're the same ones now conducting hearings into the situation.
Even more ironically, the same voices are now calling for more government regulation. This is what is truly different with this recession. Not since the Great Depression and the New Deal has government been so quick to intervene and regulate the "free" market. To be fair, this isn't a simple periodic recession, it's a recession coupled with a frozen credit market. The government is essentially fighting economic problems on two different fronts. Yet sometimes no action is better than ill conceived action. The affects of additional market regulation can be more harmful than helpful. Arguably, it was knee-jerk regulations following the Enron scandal that helped precipitate the present crisis. Requiring that institutions value their holdings on a "mark to market" basis had the unwanted (and unintended) consequence of suddenly turning billions of dollars worth of assets into worthless paper. Naively, this rule makes sense. Marking to market simple means assets should be priced based on what they could sell for today if they were to be liquidated. Generally this price is defined as what a willing buyer would pay and what a willing seller would accept. Prior to the enactment of this requirement, some institutions would use sophisticated but often unreliable models to come up with prices for thinly traded securities. The whole idea was to get rid of such fantasies and tie valuations to real market prices and conditions. Had Enron or WorldCom been held to this standard, problems would have surfaced sooner and the results may not have been so devastating. But those favoring a mark to market requirement never considered what would happen if trading suddenly came to a halt. That's precisely what happened in the credit market earlier this year following the collapse of Lehman Brothers. Lehman was such an established and well entrenched institution, it had tentacles in just about every aspect of the credit market. When Lehman went under, the entire credit market froze. Everyone was afraid to trade not only because they weren't sure how this would impact them, but their trading partners as well. More importantly, when trading froze up there were no willing buyers so assets were marked to market as worthless. We'd submit that the government's mistake wasn't lax regulation, but rather the seemingly arbitrary decision to let Lehman Brothers collapse. While there was certainly no mandate requiring the government to step in and support a private institution, the precedent had already been set when the Fed brokered the sale of Bear Stearns. This sent the message that the government wouldn't let established institutions fail, and gave market participants the confidence to continue trading. But that was negated by Lehman's demise and touched off the global credit freeze. Neither the subsequent $700 billion pork-laden bailout nor another "fiscal stimulus" giveaway will restore confidence to the pre-Lehman collapse levels. It's difficult, if not impossible, to see how additional government regulation can do that, either. It's much more likely that heavy handed regulation will do more damage than good. The mark to market requirement seemed to make sense, but accounting is fraught with fantasies (e.g. "goodwill" or just about any variable in pension accounting) that are necessary constructs. Misguided regulation is much more likely to prolong the problems plaguing the financial markets rather than solve them. Ultimately the solution lies in the restoration of investor confidence. The government can neither legislate nor regulate it. It has to return on its own, and no degree of government meddling will speed it along. This, assuredly, is not different this time. Search this site! Just enter you key word or words:
Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
|
||||||||||||||||||||||||||||
HE THIRD QUARTER OF 2008 will long be remembered for its sweeping changes in the financial markets. Entering the period, few would have predicted the government would have to step in to shore up Fannie Mae and Freddie Mac. No one would have guessed that Merrill Lynch would be subsumed by Bank of America or that venerable Lehman Brothers would be wiped out by bankruptcy. Although many realized the threat to balance sheets stemming from excessive subprime lending, few predicted the demise of Washington Mutual or the ongoing threat to other real estate-based lenders. Most importantly, back at the beginning of summer, absolutely no one would have guessed the government would be offering a $700 billion-plus bailout in an effort to get the financial markets back on their feet.
