“Change is the law of life and those who look only to the past or present are certain to miss the future.” —John F. Kennedy
Change dominates life today and it is painful to work through the excesses of a generation of conspicuous consumption. We have not seen such financial turmoil and economic uncertainty in our lifetimes and probably won’t again. If we look to history to guide us through this we risk repeating mistakes or ignoring opportunities that will grow out of this mess. One thing is certain; recessions end, balance sheets are restored and in time prosperity and security are the norm.
The recessions we remember, those over the past 25 or so years, have been shallow and mild compared to today’s downturn. To assume this recession will end in the same length of time or follow the same pattern as past downturns is dangerous. It will take time and many adjustments to find the path toward solid economic growth. Unemployment will probably go higher than today’s 7% and reports of home foreclosures will continue well into 2010.
Looking back it is easy to see what happened. Years of low interest rates made borrowing easy and lucrative. Homeowners lost sight of the balance due on mortgages and the need to pay the debt. If things got tight we refinanced our homes, took out more equity and moved on. Did anyone believe the music would stop and the value of their home would be less than the mortgage? We borrowed at low rates and spent or invested the funds for higher returns. It worked. Our standard of living surpassed our grandparents’ wildest fantasies. We didn’t save to buy that special thing – we borrowed now and worried about paying for it later.
Later is now. We are forced to take a look at our finances and rationalize the debt we’ve accumulated. The banks, which made these loans, are in trouble and Uncle Sam is bailing them out. Billions of dollars in mortgages, auto loans and credit cards will go unpaid. Consumer loans and corporate debt have shifted to our government’s balance sheet. Keep in mind – these loans have not disappeared; they are the property of the US taxpayer!
The financial crisis that began 2007 is intensifying. Governments around the world have responded with bailout packages that barely make a dent in their banks’ troubled balance sheets. Barak Obama takes office and immediately faces a troubled economy, a collapsing banking system and global uncertainty – not to mention political unrest – that will test his leadership skills off the blocks. He is hope and change – but can he live up to our expectations?
Economic Outlook
The recession began a year ago and won’t end until late 2009 or early 2010, higher unemployment will dominate the first half of this year and uncertainty will prevail. The central banks of the developed countries, and those like China and India that are emerging economies, will go to any length to avoid economic calamity. The cost to restore bank and corporate balance sheets will be enormous. The risk exists that when we bail someone out we are getting someone else in trouble. The US balance sheet is expanding to an enormous size. Trillions of dollars are moving from individual and corporate balance sheets to the US Treasury. In the end, this could be inflationary – a worry that is a few years away, but very real nevertheless.
Recovery from decades of fiscal irresponsibility will not happen overnight. We are about to witness a change in spending and savings patterns – a return to more conservative, responsible behavior. We can expect the culprits of this financial disaster, the banks and other lenders, to face government involvement and oversight for years to come. Their shabby practices are a thing of the past. As a result, these financial institutions will pay much closer attention to the financial strength of their borrowers. This new (or restored) awareness of risk will prevail and result in a healthier, more sustainable level of economic growth.
We are witnessing the end of the longest expansion in consumer spending since World War II. Consumers are now spending less than they are able to and saving is more of a priority. This belt tightening has had a devastating effect on the retail sector. We saw a decline in year over year spending during the Holiday season of almost 3%. Retailers are reeling from deep discounting and many won’t survive. Earnings for many of these companies will be much worse than expected. Consumer spending did not decline in the last recession. This is a painful change and one that makes this recession feel worse. Complete economic health will not be restored until a reasonable and responsible level of spending is resumed.
The news media is full of statistics and information that does little more than increase fear. We are not headed toward another Great Depression. Why? Bank deposits are backed by the FDIC and guaranteed to $250,000 per person, unemployed workers collect benefits, many households have more than one income and the government took action immediately to deal with failing financial institutions. Bread lines, years of shortages and widespread poverty are unlikely.
That doesn’t mean this isn’t a difficult and delicate situation. Foreclosures will continue well into 2010 and jobs in the financial services sector may never come back. The auto industry will have to address their problems and produce product people want. If they can’t compete effectively the bailout funds they receive will only delay the inevitable!
The key to kick starting this economy is employment. Spending, investing and a resumption of normal economic growth will depend on the confidence that jobs will be retained or another job will be easy to get. The higher the unemployment figure goes, the greater the fear and the less companies and individuals spend. This downward spiral only worsens the situation. President Obama has indicated that employment is his highest priority. It is the key to recovery. The unemployment rate in the Great Depression was 25%. In the 1980’s we saw 10% unemployment and at the end of 2008 the rate was 6.5% It could easily go higher before this is over and employment fears will dominate the first half of 2009.
In summary, the worst of the economic crisis is most likely behind us or will unfold soon. Any good news will help to restore confidence. It is only a matter of time before we leave the past behind us, have dealt with the challenges of today and look forward to a more conservative, less consumption oriented economy in the future. We will be more aware of risk, and the shabby practices of the past few decades will remain a thing of the past.
Investing For the Future
On January 8th, Obama said that the “devastating loss of trust” in our financial markets and government will take time to rebuild. The Bernard Madoff scandal is broadening in scope. This is a clear example of greed run amok and a reminder that when returns are too good to be true, they probably are!
What happened? Risk management was abandoned in favor of high returns and investors focused on very short term results. Regulation of the financial markets has been virtually non-existent for years and prosecutions for financial fraud declined 48% from 2001 to 2007. At one point there were almost as many hedge funds as there were registered stocks. As these funds close they sell stocks and mutual fund redemptions have been at historic levels. This short term selling pressure, rather than long-term fundamentals, has exacerbated an already falling stock market driven by fear of economic collapse.
Today, investors are hoarding money and responding to the drumbeat of negative news. Cash is the virtual “mattress” and the asset class of choice. There is an estimated $8 trillion on the sidelines! The flight to quality has driven money market yields to less than 1% and Treasury bills are yielding less than 2%. Return doesn’t matter – preservation of capital does! Investment research has been virtually abandoned and the outlook for the economy is what is driving the stock and bond returns. This “macro” view of the investment environment overshadows the long-term prospects for individual companies. This is extreme today but typical in recessions. The lower stocks go the more we hate them!
Secretary Paulsen said “Government owning equity stakes in corporate America is objectionable to many Americans, me included”. Yet, this is the direction we are moving. Is this new government role temporary? Will they really dictate whether or not banks pay dividends or set executive pay? This could have a profound and potentially negative impact on investor enthusiasm and corporate profitability. The ten most frightening words in the English language are “Hi, I’m here from the Government and I’m going to help you.”
Investing in troubled companies is not recommended and “cheap” stocks could stay that way for some time. Broad based government intervention may solve a short term problem but would dampen the entrepreneurial spirit and reduce competitiveness. Weak companies that exist because of government support will be disruptive to competitors and weaken corporate America in the long run.
Ben Bernanke said the “crisis will end when investors come back to the market”. No kidding! The key is identifying when and why investor confidence will be restored. A bell will not ring when the market hits bottom and begins to recover. The November 20, 2008 stock market low may be retested in the very near future as companies report earnings and provide conservative guidance for 2009. However, investors with time horizons of more than a year or so will be rewarded and those that remain on the sidelines will miss an excellent opportunity to build wealth.
On the positive side, stocks are discounting a severe recession that is already playing out. It is possible expectations are overly pessimistic and the bad economic and earnings news is reflected in stock prices. It feels as though we are very close to a market bottom. As a colleague said two years from now we will wish we bought just about any stock and more of it. Today’s stock market is not driven by fundamentals. It is dictated by what happens in the economy. Stock prices anticipate future announcements and will begin to recover many months before we are confident or even know for sure the economy is on the mend.
Asset allocation is a process, not a point in time decision. Investors might sell stocks at the top but often don’t get back in the market. The best strategy is to trim positions at high levels in the market and add to them when fear prevails and stocks are trading at low levels. Rebalancing to a target asset mix works. We trimmed stocks for our clients in November, 2007 and we are gradually investing the funds now as strong, high quality stocks are sold down with the rest of the market. Earnings expectations have come down to levels that are achievable for most companies. This means that if reports are what people expect, or even slightly better, the stocks will hold up or move higher.
We have a tendency to assume things will always be as they are today. When stocks are high we are reluctant to trim them and give anything up. When fear prevails we are afraid to buy. This emotional reaction to the markets will reduce returns significantly over time and result in the opposite behavior of what is rational and productive. Recessions happen and markets decline. This is an excellent time to look at your risk attitudes and assess whether you have the temperament to make good investment decisions.
Investors are rational. At some point the very low returns from cash will not go unnoticed. Stocks are yielding, on dividends alone, almost 2.5% more than cash. If the level of the stock market remains where it is, which is unlikely, then the return is attractive relative to cash. If stocks recover from the 30% plus decline, which we expect, then the returns will be very attractive indeed.
This is also not a good time to live off the principal of your investments. Investors who sell stocks today to make ends meet will lock in the devastating effects of this market decline. It’s a better idea to take a close look at spending and expenses and adjust to a new reality. The high returns of recent decades are a thing of the past. The stock market will recover but it will be a long time before risk is ignored and we can live off of substantial profits from our investments or our homes. Returns will be in keeping with fundamentals.
The bond market declined with stocks this time around. There were few hiding places as returns were impacted by deteriorating economic circumstances and the resulting effect on corporate cash flows and balance sheets. Many high quality corporate bonds are trading at very attractive yields relative to Treasuries and government agencies. The bond market has begun to recover but it still offers better returns than cash. Municipal bonds, those that are in quality states and communities, are very attractive. In all cases, quality is the key. If you don’t have the expertise or interest in reviewing corporate balance sheets or fundamentals use mutual funds.
It is very hard to find words to console investors who feel their life savings or their homes are down and won’t recover. Do you work longer or spend less? It is true in most cases that when fear prevails and a feeling of hopelessness is widespread that the capital markets have reached a low point. It is dangerous to get too caught up in the past or worry that what happens today will be true going forward. There are opportunities in the future – the economy and stock market will recover at some point when confidence is restored and those investors who take advantage of today’s discounted asset prices and invest long-term will be rewarded.