Uncertain times are upon us. The U.S. debt crisis, the effects of Standard & Poor's recent unprecedented downgrade of the U.S. government’s credit rating, and events in Europe are weighing heavily on investors, increasing both concern and market volatility. This week alone has brought wide fluctuations: the S&P 500 lost 6.65% on Monday. Tuesday, it gained 4.74%, Wednesday it dropped 4.42%, and today it gained 4.63%. The road is likely to remain bumpy for some time.
I was recently asked to provide some perspective on these events and their influence on the market.
Were you surprised by the results of the debt ceiling compromise?
Not at all. The debt ceiling has been raised 70 times in the last 50 years. I believed from the start that the debt ceiling crisis was manufactured in Washington D.C. and would only be resolved in the ninth inning. Congress really did very little to solve any of the long-term problems of Social Security and health care. They could have discussed selling off trillions of dollars worth of government property, including drilling rights, land, buildings, airwaves, etc. They could have been proactive on restructuring taxes and eliminating many personal and corporate tax subsidies. In the end, they made their usual decision: print and pay (which is what I figured they would do). In the long run, the debt “compromise” is bad for the economy and for the dollar.
For many years, the U.S. government has adhered to Keynesian philosophy of trying to stimulate the economy through government spending. However, due to our huge debt, this is no longer possible, if it ever was. Essentially, the federal government and the Federal Reserve have now run out of tools to stimulate the economy. We are likely to see slow GDP growth for the next several years as consumers continue to repay debt and business investment remains cautious due to regulatory and tax uncertainty. Therefore I expect U.S. companies to continue to expand outside the U.S.
Are you concerned about S&P’s downgrade?
No. I believe it’s a good thing. It’s a wake up call to an incompetent Congress and administration. I believe that nothing short of this step would have grabbed the attention of the administration and Congress. Furthermore, S&P’s downgrade of the quality of U.S. Treasury debt from the highest AAA rating to the second-highest AA+ rating has not damaged demand for Treasuries, nor does it indicate that the U.S. cannot pay its debt obligations. Since the debt announcement, Treasury yields have decreased (because demand and prices have increased) because investors believe that U.S. debt continues to be a safe haven in the face of headline risk. If there were a viable chance of the U.S. Government defaulting on its debt obligations, global investors would not be buying U.S. Treasuries at the rate they have been. 10-Year Treasury yields have decreased from 2.9 to 2.3 in the past two days.
The causes of the sharp sell-off in the equity markets can be broken into two segments: margin selling by overleveraged speculators and selling by investors concerned about a double-dip global recession. I believe that the S&P downgrade was a trigger but not the fundamental catalyst of the selling. Even if the double dip occurs, its impact may already have been priced into the market, at least partially. Over the last few quarters, U.S. GDP has barely grown and growth figures for 2008 and 2009 were recently corrected to show that the economy actually shrank more than previously reported at the time. U.S. consumer spending, which accounts for over 70% of GDP, continues to be sluggish as unemployment remains high, although stable. Corporations continue to hoard large amounts of cash, afraid to hire or invest in an uncertain economy. Private sector hiring has been slow while the government sector continues to lay off workers. Overseas, Europe is in for a long struggle to keep Greece on solid ground while investors fear that the much larger economies of Italy and Spain could be the next debt casualties.
Is there any good news in all of this uncertainty?
Despite all the negative press, there are some good things about the current economy. There is pent-up demand for both housing and new cars as consumers have postponed purchases that require acquisition of more debt in exchange for paying down their current obligations. Rents have been strong, which, in some areas, should put upward demand on housing sales and thus values. Gas prices have been decreasing which should give consumers more to spend elsewhere. A weaker dollar should help the growth of exports through the rest of the year. The brightest spot for the economy and the stock market, however, has been corporate profits. Earnings per share and net profits of S&P 500 companies have both returned to their pre-2007 highs. The slowing U.S. economy appears to have had less of an impact on corporate profits than in years past. As multinational companies continue to expand overseas, and especially into emerging markets, U.S. companies are less reliant on the U.S. The stock market is driven by the expectation of profits. In these uncertain times, bonds and gold have done well. These last few days have again demonstrated the benefits of a diversified portfolio. However, it’s important to remember that in a crisis, asset classes become more highly correlated over the short term.
Another positive point is that we are probably not as bad off as we were back in 2007 and 2008. I say “probably” because as Warren Buffet once said “Only when the tide goes out do you discover who has been swimming naked.” By this I mean that more problems than we know about currently may emerge. In 2007/2008, both corporate and individual balance sheets were in much worse shape as both held too much debt and were overleveraged. Housing prices were near all-time highs and people were taking all of the equity out of their homes so they could consume more. Individual consumption fueled by home equity artificially inflated the consumer spending portion of GDP. So when the housing bubble burst, GDP dropped as well. The realization that the government would actually allow Lehman Brothers to fail caused a big shock to the system. After Lehman failed, consumers delayed purchases and hoarded cash, fearing an outright depression. Corporations adjusted quickly to lower revenues by laying off workers by the thousands.
Since March of 2010, the private sector has been consistently hiring. Housing sales have reached historic lows but appear to have stabilized. With home equity loans off the table, consumers have focused instead on shedding existing debt and increasing savings. Corporations have done the same, accumulating extremely large amounts of cash which should help absorb some of the shock if consumers decide to stop spending again.
Although there is still the chance that another systemic shock like the bursting of the housing bubble could cause the U.S. to fall back into recession, the economic outlook appears to be more favorable than it was in 2008.
You have been through many difficult market environments through the years. What can you share about what you’ve learned?
One thing I’ve learned is that when fear is rampant, opportunities arise. Another thing I’ve learned is that the market is cyclical and selling in the midst of a market decline like the current one merely locks in losses and eliminates positions that could be poised to benefit from the turnaround to come. Finally, I’ve learned that no one can consistently predict the future direction of any of the financial markets.
Labels: Opinion