Where Do We Go From Here


The last year, and especially the last two months, have been difficult for all investors. Last week was perhaps the most challenging week any investor has had to endure in recent memory. Up until last Monday, the markets had been relatively patient in waiting for a unified rescue package to unfreeze the credit markets, but confidence had clearly diminished last week as evidenced by the precipitous fall of global stock shares.

I think there are two big questions on the market’s mind: 1) Will the steps the Federal Reserve and the other world central banks are taking unfreeze the credit market and restore confidence in lending or has confidence diminished so much that it may be hard to jump start the frozen credit markets at this point? and 2) Will the lack of confidence and optimism resulting from this crisis and the 40% to 50% drop in equity values cause a self-fulfilling recessionary cycle?

The honest answer to both questions is “No one knows for certain.” My gut feel on the first question is this: throw enough liquidity into any situation and you will probably get the money moving again. The Federal Reserve and the other world central banks appear poised to do just that, and that has been, and is still, one of the reasons I am cautiously optimistic. Markets were clearly cheered today by the movements of the European central banks. Now we wait for the Fed.

On the second question about pessimism and the potential for a self-reinforcing recessionary loop, toss a coin and your guess is probably as good as anyone’s. I was more optimistic a week or so ago that this would be avoided, but the precipitous plunge in world markets and my sense of the global “mood” in the last week have made me less certain on this point. Pessimism was reigning last week, followed by a bit of hope today, but time will tell.

What follows are a few key points that can be argued for either an improving or a deteriorating market and which I would be more than happy to discuss with you in detail, if that would be helpful.

I’ll start with my two thoughts on the potential for further downside – and by “downside” I mean the potential for more downside from where we are.

  1. There are two times in the last century of which I’m aware in which major developed stock markets decreased from peak-to-trough by much more than what we’ve already seen. The first, of course, was the 1929 to 1932. The second was the Japanese market’s spectacular decline over the course of the 1990s after an equally spectacular run-up during the ’80s. In the US major markets (the Dow and S&P) there have been no post-WWII declines that were significantly larger than what we’ve already seen in the last year, but there has been in Japan.
  2. Even after today’s rally, sentiment is fairly pessimistic right now (it always is at low points), and the entire world is no doubt feeling a little poorer and a little less secure than it did a week ago or a year ago. If the credit doesn’t start flowing, and soon – and even if it does, the concern is that this has the potential to turn into a self-reinforcing cycle of: People feel poorer –> They spend less –> Corporate Earnings are Lower –> More people are laid off & they feel poorer –> They spend less, etc, etc. That’s a recession. There have been 10 recessions in the US since WWII, and none caused a decline much larger than what we’ve already seen in the US markets. Hopefully, this won’t be the first.

Here are the arguments as I see them against a substantially worse outcome:

  1. There were many other issues at hand in the 1929-1932 market downturn:
    1. The Federal Reserve did not get materially involved in resolving the credit crisis until 1932, three years after the problems started. They let a deteriorating liquidity / credit situation unfold for far too long and it became not unlike trying to revive a patient who had a coronary arrest three hours ago. In this case, I think the Fed – despite some fumbling around – and other foreign central banks have responded much more timely and that may make all the difference. This is a huge difference.
    2. The stock markets in the US in 1929 and in Japan in 1990 were much more over-valued than the market is now and more over-valued than where we started from in this cycle. Both markets had gone up by a factor of almost five times in the years leading up to those respective downturns, whereas we had not seen nearly the run-up from the last trough in ’02 to the last peak in October ’07. Our market had only doubled during that time. At the high point, the Japanese stock market was trading a 80 times earnings, which is almost as expensive as tech stocks were trading here in early 2000. We were not looking at nearly the level of overvaluation in the developed stock markets even at the last peak in October 2007.
    3. The US stock market in 1929 was largely built on leverage used to buy investments, which is always a house of cards, and we have nowhere near that much leverage in the actual stock market today. Today, the system at-large, because of the credit-fueled housing bubble, has entirely too much leverage, and that delevering is what is causing much of the pain right we’re presently experiencing. That delevering will almost certainly go on for a while longer but the large market participants (institutional investors, etc) certainly know that.
    4. We are not facing the agricultural drought of the early 30s, which exacerbated the unemployment situation (which reached 25%), and are not presently looking at deflation either, which is anathema to business capital spending and business outlays and can make a bad situation very bad.
    5. Finally, the economic numbers that developed throughout the early 30s were staggeringly bad – 25% unemployment, 40% foreclosure rate, and a 60% reduction in Gross Domestic Product (30% in real terms after accounting for deflation). These numbers are staggering by comparison to anything we are looking at the moment and anything we’ve seen in the post-WWII era. Right now, the reality is a 3.5% foreclosure rate, 6.1% unemployment (with 11% – 12% in 1981 being the post-WWII high), and so far no recorded reduction in GDP. Not that these numbers can’t / won’t get worse, but we are a long way, empirically, from anything we saw in the early ’30s.
  2. Markets tend to over-anticipate good news and over-price it in. (Think tech stocks in the late ’90s, trading at 100x earnings.) They also tend to over-anticipate and often over-price in bad news and thus under-shoot where they really ought to be. Given the amount of panic and anxiety that we’ve seen in the market and how far we’ve fallen already, that is a very real possibility: the market could be assuming an economic recession and a reality far worse than anything we actually end up seeing. If that’s the case, it’s entirely possible stocks are already lower than they should be and rebound once the panic subsides, or they could yet “over-shoot” on the underside yet more.
  3. And finally, Warren Buffet, who has made his fortune purchasing companies he likes at very low prices, has put $10 Billion of the $44 Billion in cash he has into market investments. I take that as an encouraging sign, but keep in mind that Warren Buffet tends to think in decades and knows the markets can be radically mis-priced from year-to-year.

So, here we sit today after a difficult year, and a very difficult week. Could this get yet uglier for the stock market? Sure. Will it? Your guess is probably as good as anyone’s because picking market tops and market bottoms is exceedingly difficult, and in many well-regarded opinions, about as accurate as astrology. That said, I am encouraged by the currently low market valuations – as of Friday’s close, they are at some of the most attractive levels we’ve seen in the last 30 years. Things that are “too high” often disappoint in the long-run and things that are “too low” often surprise in the long-run.

I would keep in mind a couple of points as you look forward. First and foremost, do not think about where you were a year ago vs. where you are today. That is a moot point and those are sunk costs. (If you really want to look backward, by the way, think back to where you were, say, six years ago at the last market trough and compare that to where you are today. You might be pleasantly surprised.) Instead, think about where you are today and the potential upside vs. the potential downside moving forward. The most important point from where we sit today is what makes the most sense to do from where we are today – not from where we were a year ago. Owning stocks requires an essentially optimistic outlook and often taxes the gut, as it’s done recently. Secondly, and very importantly, all decisions have an emotional as well as a financial aspect. It’s important that you be able to sleep at night, too, regardless of your expectations for outcomes. If you’re not sleeping or are overly worried, you should talk to your financial advisor.

In closing, I know how difficult a stretch this has been. More than financial savvy or a high IQ, good long term investing requires a high EQ (emotional quotient) and, as they say, these are the times that try men’s souls. Try not to get too caught up in the fear that seems to be being peddled at louder and louder volumes on all of the major cable channels. If ever there was a made-for-cable spectacle, this is it (although last month’s round-the-clock Hurricane Ike coverage would certainly qualify too). That said, I as much as anyone, know how important money is, but I would hasten to add this: try to keep all of what’s going on in perspective within the context of your overall life. I hope for everyone I’m who is reading this, you have good health, the love of family, and peace of mind regardless of what the market is doing. Those, ultimately, are the things that matter. The sun should not rise and set on the month-to-month (or even year-to-year) performance of the global equity markets or on your portfolio, although it’s very easy to forget that in times like this.

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.