*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains a message initially sent to clients just after the “bailout” (TARP) in 2008 as part of that communication effort***

What in the world happened in the markets last week?

Make no mistake about it, the US stock market crashed last week. It happened over five days instead of just one as it has happened in the past, but the broad US stock market (as measured by the S&P 500) fell more than 23% from its closing value one week ago to the morning lows on Friday. Foreign markets in Europe and Asia actually fared worse, and emerging markets even worse than that. Panic and fear dominated as credit has become virtually frozen and companies, funds, and some individuals have been forced to liquidate portfolio holdings to free up cash that is badly needed. Forced selling leads to lower prices which leads to more forced selling and even more credit restrictions. It is a vicious cycle and the result is a loss on the order of $4 trillion dollars of aggregate wealth in the U.S. stock market. Additional circumstances likely contributed to the cause, like the unwinding of some complex derivatives (think of them as huge bets b/c that’s really what they are) that had to do with the Lehman bankruptcy and worsening economic data that has increased the probability of a technical recession in the U.S. and abroad. But for the most part, market action last week was based on emotion and fear rather than facts and events.

How did we get into this mess?

Our banking system is built on leverage. For every dollar of assets that a bank has, they’re allowed to loan out $10 (that number isn’t exactly right and isn’t fixed, but it is determined by the Fed, and it’s the fact that they can loan more than they have that matters). As long as their loans continue to be repaid close to on schedule, the system continues to work. Banks have plenty of money to pay back deposits, provide new loans to individuals and other banks, and continue to do business. Some of the biggest loans that these banks own are mortgages. Many mortgages, for reasons I won’t get into, were given to people who never should have had them and who had no ability to pay them back over the long term. The thought was that as long as housing prices continued to rise, repayment risk really wouldn’t matter because if the borrower couldn’t pay their mortgage, they’d just sell their house for more than they paid for it, repay the loan, and move somewhere more affordable. When many of these risky loans are lent in the same time period, especially on an adjustable interest rate basis (which is what happened in 2001-2004), and those rates start to adjust upward as they are now, it puts pressure on a lot of people at the same time. They all start to try to sell their houses because they can’t pay their mortgages. That pushes house prices down because it floods the market with houses for sale. Pushing prices down scares more people who bought speculative investment properties and they start to sell as well, pushing prices down more. More scared people, who might have bought a house, now stay out of the market. Lack of demand means even lower prices. Now the people that can’t pay their mortgage can’t sell their house for more than they paid anymore. The only way out of the mortgage is foreclosure. This pushes prices down more and the cycle continues.

Meanwhile, the banks that rely on these mortgages (and related products that are too complicated to describe here) start to lose a LOT of money very fast b/c they’re not getting their interest payments anymore and they’re losing huge chunks of principal through foreclosure. That ratio of assets to loans deteriorates and the Fed requires them to raise more capital to maintain a safe ratio. To do that they sell pieces of the company and some of their bad assets for less than they are worth (“fire sale prices”) to try to raise cash. By doing so, accounting standards require that similar businesses with similar assets have to mark down their assets to those prices immediately which puts pressure on their required assets to loans ratio forcing them to liquidate holdings as well. When all is said and done, there isn’t anyone left to put money into these companies b/c they’re all looking for money and in the same situation. If they can’t find the money, they’re forced into failure / bankruptcy which forces more asset sales through liquidation and puts pressure on the other banks again. This domino effect, if not stopped, could literally bring down all the institutions that the economy depends on for business loans, mortgages, car loans, credit cards, and investment products. While doing so, it would lay off millions of workers and force the rapid shutdown of the businesses that rely on credit to build and grow. That would cause layoffs of other workers and cut aggregate spending in the economy, hurt retail, cut more jobs and so on. The single source of strength in all of this is the government (as scary as that is). Both US and foreign governments have the capacity to end the cycle by providing liquidity to the markets so that loans/credit can continue to be obtained, and invest in the banks that caused the problem in order to keep them afloat and keep the banking system running. That’s what governments around the world are doing, but they have to do it in a careful way that takes a bit of time. While time passes, the problem gets worse. What you witnessed last week in the financial markets is the result.

Didn’t the government just pass a $700 billion package to prevent this from escalating?

Yes, we authorized it, but we haven’t started using it yet. In order to make sure the $700 billion is used optimally, several vehicles have to be set up to allow the government to purchase distressed assets at appropriate prices from the banks and other institutions that may be looking to sell them. While this is being set up, the Federal Reserve and the Treasury continue to inject capital and provide liquidity to the markets through a variety of tools including complex short-term loans. Eventually, these injections of liquidity will unlock the credit markets because enough money will be available to meet the demands of borrowers.

When will end?

In some ways, we may have already started to see the end of this crisis. The market rallied more than 5% from its lows on Friday morning before closing for the weekend. Gold, which is usually a safe haven in times of trouble, plunged when the market rallied back. These are good signs but the short answer here is that we really don’t know when it will end. Over the short-term, especially when panic sets in, the stock market is incredibly unpredictable. No one knows when it will bottom or if it already has. It’s very possible that we see an extreme rebound in the stock market over the short-term. By no means does that mean the economic turmoil or credit crisis is all behind us. However, the actions that our government has taken and the coordinated actions of governments around the world (like those coming out of the G7 meeting this weekend) will start to set a floor under panic-driven selling. The open question is, once the panic driven selling stops, how much damage will have been done to the economy and how long will it take to recover.

So how bad is it going to get?

From an economic perspective, it could get pretty bad. Some industry experts are predicting the worst holiday season for retail sales since the popping of the tech bubble and subsequent economic turmoil after Sept 11th. The financial services sector has already seen, and will continue to see big layoffs from bank failures and merger activity. Unemployment is likely rise throughout the entire economy. Housing prices will likely continue to fall for some time as the inventory of available homes is simply too great when compared to the demand for purchases. Recession is almost a certainty. On the bright side, the cost of living appears to be decreasing for the first time in a long time. Energy prices have tumbled. On Friday, gasoline futures bottomed at $1.80 per gallon. When that flows through the system, it should translate into retail gasoline prices well under $3 / gallon, and potentially as low as $2.50 in some places. Food prices (corn, grains, meats, etc.) are also falling. As housing prices come down, the cost of buying a new home comes down with it. Investing in companies has become dramatically cheaper, and in a sense, 40% less risky since it costs about 40% less to purchase the same stock than it did a year ago. All of these things lay the groundwork for a strong economy in the future. Once the excesses of a rapidly growing economy that was fueled by greed and leverage are pulled out the system, there comes potential for a period of fantastic growth. This has happened again and again in our history, and will likely happen again. It’s just a matter of how long it will take, and how involved governments will be in facilitating (or blocking) a natural rebound through regulation.

OK, so what should I do now?

From an investment perspective, you probably shouldn’t do anything different than what you were doing before this happened. If the money you need for long-term goals is in the stock market (as it probably should be), then this is just part of the volatility you have to accept in order to target long-term growth. In time, unless you believe the world will end or the U.S. economy will completely grind to a permanent halt, the markets will recover. For shorter term goals, your money should be more diversified with more and more of it in safer investments like bonds as the need for the money comes closer and closer to the present time. This means the stock market volatility won’t have as large of an effect on that money. During your upcoming reviews, we will re-evaluate your goals, the current funding for those goals, and your asset allocation to determine if any changes should be made in your allocation strategy. In the meantime, I’m taking care of keeping your portfolio in sync with the strategy we determined during the creation of your financial plan, and making sure we’re using the best funds possible to achieve your allocation.

Is there anything else I can do to get through this period and come out in a better position when it’s all over?

Yes. Here’s a short list of recommended actions that would likely benefit everyone during this period:

1) If you’re not retired and are depending on income from an employer, make yourself indispensable at work. Layoffs are coming in most industries. Make sure your boss would go out of his/her way to keep you off the layoff list by performing to the best of your ability. During times of layoffs, it’s often your performance during the past few months that counts most in deciding your fate.

2) Make sure your emergency fund is well-funded. Cut back on discretionary spending if needed to make sure this is the case. The likelihood of needing it in the next year has increased as the economy has faltered. Now is the time to make certain your emergency fund will be there if you need it.

3) Have a contingency plan. Think for a few minutes about your worst case scenario (job loss, retirement asset loss, etc.). What’s your first move if this happens tomorrow (is your resume up to date, do you have enough money to cover your basic needs, etc.)?

4) Continue to make regular deposits to your goal-funding vehicles (401k, brokerage account, etc.). Prices are 40% cheaper on average than they used to be. Take advantage of this and continue to build toward your goals.

5) Be exceptionally careful with employer stock holdings. We continue to see companies go out of business seemingly without warning. You do not want to lose your job and significant assets at the same time if your company experiences troubles. So, even if your stock is down from its highs, it probably makes sense to diversify it and spread the risk to other areas of the market.

As I finish writing this update, US stock futures are up 3%+ from their close on Friday. While this is certainly no guarantee of a successful day tomorrow or an end to the turbulence, I believe it is a good sign. Wherever this week’s rollercoaster market takes us, I hope the knowledge of what’s going on helps you worry less about it. As always, please feel free to contact me if you have any questions or comments.