Financial Markets Q&A

By June 30, 2011Main

by Rob Schulz, CFP® 09/22/08

Q. The financial world is in a panic. Exactly what is going on?

A. In addition to a recession and bear market, we are now experiencing a massive deleveraging as financial institutions that have lost access to capital and credit are forced to merge, fail, or be taken over by the government. In a short period, Fannie Mae, Freddie Mac and AIG were taken over by the government, Lehman Brothers went bankrupt, and Merrill Lynch decided to merge with Bank of America to protect itself from becoming the next casualty. Now Goldman Sachs and Morgan Stanley are becoming commercial banks on the theory that the investment bank model is broken. The Reserve Fund, America’s oldest money market fund lost 3% of its value due to holdings in Lehman and had to halt redemptions, almost causing a run on money markets. At one point last week the Dow was down 1000 points. It wasn’t until the Fed and Treasury announced a comprehensive plan modeled after the Resolution Trust Corp that the markets recovered, eventually regaining almost everything lost.

Q. Why did this happen? How did we get to this point?

A. A combination of low interest rates, plus increasingly lax lending standards in recent years led to a housing bubble, which when popped, left homeowners and investors with loans they could not afford to pay back, collateralized by assets that were declining in value. These loans had been packaged into securities which highly leveraged and inadequately regulated Wall Street firms purchased using borrowed funds. This created solvency issues for these firms when the securities lost value. These firms lost access to the capital markets as the value of their portfolios and stocks plummeted. Since all of these firms trade with each other, and owe each other money, failure of one could lead to a contagion of failures in the financial system. Fear of such a contagion took hold and a panic was set in motion. Obviously, this is a simplified and shortened version of what occurred, but it tells the basic story.

Q. Is this really the biggest financial crisis since the Great Depression?

A. It is fair to say that it is. While the bear market is normal by historical standards, and so far the recession is fairly mild, the housing situation and deleveraging we are now experiencing are serious problems. That said, risks are lower today, since the financial system is much stronger than it was back in 1929.

Q. How is the system stronger today?

A. Commercial banks are heavily regulated and deposits are FDIC insured. Brokerage firm accounts are protected by the SIPC. The SEC, while not omniscient, provides investor protections that simply didn’t exist 80 years ago. We have Social Security and Unemployment Insurance. Most importantly, the Federal Reserve, Treasury and monetary authorities around the world have learned from the mistakes of the past and are unlikely to allow the present situation to morph into a fullfledged meltdown. The recent creation of a program to insure money market funds is an example of the ability and commitment to appropriately respond to risks as they unfold. Finance, like medicine, has made tremendous advances since the 1930’s. Those advances make a huge difference.

Q. Are you saying that the Government can control the economy?

A. No. We are still in a recession and that has to run its course. But proper monetary and fiscal policy can greatly reduce the risk of a 1930’s type scenario developing. The Great Depression probably wasn’t inevitable. In 1929 the Fed actually raised interest rates in order to preserve the value of the dollar; causing credit to contract further and restricting the availability of money for people and businesses. They also allowed banks to fail, which caused everyone to pull their money out, further restricting credit. Instead of easing credit and boosting the money supply, in 1929, the Fed let it shrink by almost 1/3. Obviously, these policies made the problem worse not better, sending the economy into a tailspin. Fortunately, Ben Bernanke and Henry Paulson have observed history and aren’t likely to make these types of errors.

Q. Aren’t there economists who say the Fed should raise rates now to defend the dollar and allow financial institutions and housing to collapse, so that the economy can reach equilibrium without interference?

A. Yes. Thankfully, none of these nuts are running the show at the Fed or the Treasury.

Q. Can you summarize what the Fed and Treasury are doing to shore up the financial system?

A. In addition to their open market operations and the takeover of the GSEs, AIG, and providing a mechanism for money market fund insurance, the Treasury is creating a program to buy mortgages, mortgage related securities, and other debt securities from the institutions that currently hold them. The goal is to get these assets, which put these institutions and therefore the financial system at risk, off the balance sheets of the banks and onto the Government’s balance sheet, so banks can start lending again and stop worrying about their mortgage portfolios. The SEC has also instituted restrictions on short selling in financial stocks on a temporary basis.

Q. I know you discourage market timing, but at a time like this isn’t it smart just to get out of the market, until the storm passes?

A. Only if you believe that the system is so broken that the principles of successful longterm investing no longer work. There are people who have this view. I do not. But if you truly believe that we are about to repeat the 1930s, it would make sense to sell all of your current investments and buy Treasury Bills and gold. Everyone else should probably stick to their investment program.

Q. But can’t we just sell and buy back in later?

A. Sure. If you want to cut your risk because recent market action has made it clear to you that you misjudged how much risk you can handle, and you want to make a longterm change to your investment strategy, then I’m all for it. But, if you are going to ramp up stock exposure as soon the market starts back up again, then I’d advise against making changes, since over time, such a strategy will probably lead to buying high, selling low and poor returns. According to JP Morgan, over the 20 years ended 12/31/2007, the S&P 500 Index averaged 11.90% annually. Yet the average equity investor only made 4.50% per year. This massive underperformance was largely caused by getting in and out of the market at the wrong times, which is definitely not what we want to be doing.

Q. Are there any reasons to be optimistic?

A. Yes. The Fed and the Treasury seem to be making all the right moves, plus commodity prices and oil have fallen quite a bit from their highs. Also, although not likely to end anytime soon, the recession so far has been pretty mild, despite the horrible housing market. At current prices, stocks are fundamentally cheaper than at any time since the early 1990s, with price to book, price to sales and other measures of value lower than any time in almost two decades. This is very different from back in 2000 when stocks were expensive relative to their fundamental value.

Q. Are there any other reasons to be positive?

A. Yes. Even though stocks broke their July lows last week, almost 60% of stocks now are in uptrends as defined by their 50 day average price, which is rising. At the July 15th lows only 26% of stocks were in uptrends. This means that the recent decline was concentrated in fewer names, and that is good. Also, as crazy as it sounds, the action in homebuilding and financial stocks suggest the worst may be behind us. Homebuilding stocks made their lows on July 15th and are up 30% from those levels. Financial stocks, except for the obvious losers, on the whole look much healthier than they did in mid July, despite the market having broken its July lows last week. Right now 76% of financial stocks have rising 50 day prices vs. only 4% back in July, which may be telling us something.

Q. Anything else?

A. Yes. Over the longterm, stocks have earned an average of 9%10% per year. However, when Leading Economic Indicators, the Federal Funds Rate, and stock market prices are all declining yearoveryear, the median return for stocks over the following oneyear has been more than 20%. While past performance is not a guarantee of future returns, all of those factors being in place could make for higher stock prices.

Please contact me with any questions.

 

Investing involves risk of loss and nothing in this Q & A should be viewed as an inducement to take risks that you aren’t comfortable with. Past performance is not a guarantee of future returns which may or may not be profitable. The S&P 500 and Dow Jones Industrial Average are indices and cannot be directly invested in. Information is obtained from sources believed to be reliable, however accuracy and completeness are not guaranteed.

By Rob Schulz