Catch a Falling Star


This has been a very ugly week so far in global financial markets, and clearly the markets and many investors are quite rattled. What follows are a few of my thoughts about the situation.

  1. There are serious issues with the balance sheets of many of the world’s largest financial companies. The fundamental issue is that many are holding huge investment loan portfolios that may not be worth what the companies still owe on them. Simply put, they borrowed money to make investments and the investments turned out to be bad ones. Because of the uncertainty about the quality of their balance sheets and their ability to make good on future loan payments, other institutions are hesitant to lend money to them. Since the free flow of capital is critical to the functioning of all economies, this is as much a crisis of confidence as anything.
  2. There’s a reason why stocks, over the long term, have produced higher returns: It’s that they are more volatile in the short-term than more conservative asset classes, and when and how their returns occur is unpredictable. This risk is inseparable from the longer-term superior returns that stocks have offered; you cannot have one side of a coin without having the other. We are seeing this fact in most manifest form right now.
  3. The early summer run up of oil to $147 per barrel looked to me to be driven by emotion and a speculative mania. Oil prices have plummeted since then, which would seem to support that conclusion. Similarly, the wave of selling we’ve seen in the world markets this week looks to largely be panic-driven selling. Such panic-driven selling is often a sign we’re nearing a bottom, although that’s not a prediction, and I’ll be the first to say this could get uglier before it gets better. That said, selling into a panic is almost never a good idea.
  4. For clients who are very well diversified, their returns are not tied to financial stocks alone, but to the much broader world markets. Although that broader market is suffering right now at the hands of the financial stocks, the world economy is not going away. Ultimately, the profits of the global economy — and not fear and over-reaction — are what will drive stock market returns in the long-term.
  5. Stock valuations, meaning what you get in anticipated future earnings for what you pay in stock price today, are getting more attractive by the day. While painful for those present owners, this “value rally” bodes well for future stock market returns.
  6. The next few months are uncertain, as they always are, and there may be yet more emotional selling to come. Over the longer-term, however, and as this mess is sorted out, I believe equities will be fine, and quite likely superior to most other “more conservative” asset classes. That’s what history has demonstrated.
  7. Many of the past panic-driven market downturns have been followed by very strong rebounds that appeared quite unpredictably. This, along with my previous point about this looking like panic-based selling, make me think it’s not a good time to be getting out of the market if you’re already in.
  8. For long-term, well diversified equity investors, their behavior — especially during manias and panics — is the key to actually achieving the long term return equities offer. Equity markets work, although it sometimes takes time for them to get it right. Over time, they have historically delivered positive returns in excess of most other asset classes, but it takes patience I don’t think the ultimate outcome this time will be any different.
  9. This next point is courtesy of Weston Wellington, director of research at Dimensional Fund Advisors: History offers abundant evidence that market economies are resilient. The world will find way to manage its financial affairs without the advice of Lehman Brothers, and the residential mortgage loan will survive even if Fannie Mae does not. The key issue for investors is to make sure their financial future does not get derailed by events at a handful of firms, and so these recent events have provided an unusually harsh lesson of the importance of diversification. In a matter of days, shareholders of four financial giants -Fannie Mae, Freddie Mac, Lehman Brothers Holdings, and AIG-have seen their shares plunge into the penny-stock category. For well-diversified investors, the financial carnage associated with these four firms has been painful, but comparatively minor (although I know the last week doesn’t feel very minor.)
  10. And finally – Warren Buffet’s definition of a bear market: the period when stocks are returned to their rightful owners (that is, to those who have the patience and fortitude to actually own them in good times and bad). I think there’s a lot of that going on right now.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.