Market Update (03-24-2009)

*** 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 what turned out to be the market bottom in March of 2009 as part of that communication effort***

With so much focus on the seemingly endless economic collapse that is happening around us I’ve been looking forward to begin able to send a more optimistic update for quite a while. Toward the end of 2008, I provided a few regular updates to all of you as events unfolded that led us into this decline. Over the last week, much has changed and while I’m sure it won’t get as much TV airtime as the bad news did, it’s just as important. Many of you know by now that the stock market rallied more than 7% today. This followed previous rallies over the past two weeks such that the market is now up more than 20% from its recent lows. Many regard the stock market as a view into what is around the next corner for the broader economy. This was certainly true last October when the credit markets froze, the stock market fell 25% in a week, and the real impact hit most people a few months later when layoffs rapidly accelerated. Similarly, I suspect the events of the last week, including today, will not be felt by Main St. until mid to late summer when those layoffs will slow down or cease. So, I wanted to provide a similar update to you now on what has changed, and why the market is reacting the way it did today.

To some of you in our conversations, I’ve already described the announcement by the Federal Reserve last week as a “game-changer”. In case you don’t know what I’m talking about, let me summarize what the Fed said they’re going to do. First some background. We all know that the government is spending a ton of money right now and that we don’t have enough tax revenue to pay for it all. This is commonly known as “The Deficit”. Years of deficits have added up to a very large national debt of just over $11 trillion, or some $36,000 per U.S. citizen. The debt is financed by issuing government bonds called “treasuries”, which are purchased by individuals, corporations, and foreign nations. Because the U.S. has a very stable political system and has never defaulted on its debts in the past, it is considered credit worthy and lenders don’t demand a very high rate in return for their money. But, the deeper the hole we dig, the greater the interest that we have to pay on our debt. As that interest becomes a bigger and bigger slice of the tax revenue, it creates some risk that we might not pay our debts off. This risk would push interest rates up, just at a time that the government wants to keep them low for investment, refinancing, etc. So, we seem to have to choose between deficit spending (needed to turn the economy around) or low interest rates (also needed to turn the economy around). Quite the dilemma. Meanwhile, the recession continues to take its toll on asset prices (stocks, real estate, commodities, etc.). To put it simply, there is just less money out there than there used to be which means people can’t afford to pay what they previously could for similar assets. This creates a deflationary spiral where asset prices are falling because of the recession, and the recession is deepening because of falling asset prices. To combat this, the Fed announced last week that they will now be buying treasuries directly from the Treasury to finance the deficit, and mortgages directly from mortgage lenders to free up capital for new lending and keep mortgage rates low. Where will they get the money? Good question. Believe it or not, they’re just printing it.

Printing money is highly inflationary. If we just double the amount of dollars in the economy, then we double the demand for everything which raises prices until it takes two dollars to buy what we used to be able to buy with one dollar. No one is wealthier, but because prices are rising so quickly, people start to hoard assets pushing up prices further, which can start an inflationary spiral. But, if we’re in a deflationary spiral now, putting some seemingly inflationary actions into play could break the spiral. If done carefully, we’ll end up perfectly replacing the lost wealth that is pressuring the economy which will put a floor under asset prices and return confidence to the normal buyers of those assets. In short, the recession will end and growth will be restored… a game-changer. Things won’t get better overnight, but for the first time in several months, I believe recovery is in sight and that the economy will begin to slowly stabilize over the next 3-6 months. Note that by stabilize I don’t mean the Dow returns to 2007 levels, that unemployment returns to 5%, that housing prices start increasing 10% per year, and that things feel “normal” (per 2004-2006 expectations) again. I mean that stocks will stop falling, unemployment will stop rising, and we’ll have time to get used to the new normal (stable, sustainable, moderate growth). It’s likely that the stock market today and over the past couple of weeks senses this as well, and is pointing toward signs of recovery.

In some additional good news, the Treasury today announced their long-awaited plan for handling illiquid mortgage-backed securities commonly known in the press as “toxic assets”. The plan includes a public-private partnership that will team up private capital, government programs such as TARP (the name for the $700 billion “bailout” that Congress passed in December), and the FDIC to purchase and create a market for these previously illiquid assets. Without a market to sell them, banks were forced to keep ownership despite their rapidly declining value and uncertain future. This in turn rattled investor confidence and prevented banks from raising new capital from private markets; hence the need for government bailouts. The details of the program make a lot of sense, with the private investors determining what price they’re willing to pay for the assets via an auction process, the government backing their investment in a way that will reward them for taking risk while also rewarding taxpayers alongside the private investors, and no penalties for banks that participate in a sale of their assets. As stated currently, this program should be another big positive for both the markets and the economy.

Before we sound the “All Clear” signal, we have to realize that along with all the positives come some greater risks as well. Buying treasuries and mortgages is bold action by the Fed and while it is likely to end the recession in the medium term, if it’s not done carefully, it will lead to potentially bigger problems down the road. We could face runaway inflation, lost confidence in the dollar as a currency, and political tensions with other nations who suffer because our actions devalue the dollar that they own a ton of in the form of our debt (the financial engineering equivalent to highway robbery). The Treasury, the Fed, and the Federal government will all have to work together to cut spending, remove excess dollars, and reign back the flood of liquidity as soon as confidence is restored and the recession is over. If they don’t, $140 oil will seem like a bargain compared to the prices we’ll be paying in a few years!

In addition to the risk of inflation going forward, there is another risk that is worth mentioning. The government is beginning to meddle in the private markets in ways that could hurt the willingness of corporations to do business with them in the future. Last week, the House passed a bill that would tax AIG bonuses at a 90% rate as a way of punishing the firm for paying bonuses after taking government money via the TARP program. While I think we can all agree that rewarding failure at the expense of the taxpayer is not what was intended by TARP, we have to be very careful in retroactively changing the rules on government programs. When TARP was passed there were no stipulations on how the money could be used. While the focus is on AIG who took the money to keep their business afloat, many firms took TARP money so that they could provide additional loans to homebuyers and businesses that needed credit. Now, the government is imposing additional rules on executive compensation for all companies that took TARP funds. If you change the rules in the middle of the game, it’s possible that no one will play with you anymore. In this case, many companies are now seeking to return TARP money which would cut off the added credit to the economy and reduce the effectiveness of the program. This government behavior could also cause skepticism of the new public-private partnership announced today. If there’s danger that participating banks may face new rules 3 months into the program, they may not want to participate at all. Congress needs to make sure that it writes all the rules ahead of the release of programs like TARP, and whatever those rules are, that it consistently enforces them without modifying them midstream. If we have a fair and consistent set of rules, which encourage participation in government sponsored programs to stimulate the economy, then those programs stand a chance of working. If not, we’re just wasting our time creating the programs that no one will use and the downward spiral will continue.

In conclusion, let me be clear… I’m not claiming that the worst is over for the economy. There will be more layoffs, there will be more housing price declines, and there will be more foreclosures as the current damage flows through the system. But, over the next few months, these new programs and the lack of new damage will stabilize the economy and it will eventually begin to grow again. I’m also not claiming the stock market has necessarily bottomed. The short-term stock market is too unpredictable to say with certainty what will happen over a matter of days. But, IF the risks stated above are controlled, and that is a BIG IF, then I believe these plans are likely to stabilize the market. That is why we saw the gains we saw today and why we probably have seen the last of the 20% monthly market drops for a while.

As always, if you have any questions about this update or anything else, feel free to contact me.

Market Update (10-12-2008)

*** 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.