August 12, 2011 by Speakers' Spotlight
It’s Not Just Stocks that Are at Risk
Guest blog from Richard Worzel
The stock markets have fallen out of bed since President Obama signed the ludicrous debt ceiling deal. I don’t wonder about that; what I wonder is why they took so long. I was expecting stocks to fall two weeks earlier than they did. But now the question becomes: What happens next? This is actually a much deeper question than it seems, because it goes far beyond just the behavior of stock prices and markets. But let’s start with stocks.
When I started work on this blog, the S&P 500 index was at 1,119 which put it almost exactly half way between the October 4th, 2008 high of 1,565 and the March 6th, 2009 low of 667. Specifically, it was 452 points below the high, and 446 above the low, so almost exactly half way. (And if you want to look at that in percentage change terms, it’s 40.4% down from the high and 39.9% up from the low.) That would seem to imply that while there may be more risks yet in holding stocks, we may be getting through the worst, and should start compiling lists of stocks we want to buy. Indeed, since I went to virtually all cash in my personal and corporate investment accounts more than two weeks ago, I am waiting for buying opportunities, and creating just such lists.
But there’s an old stock market cliché for times like this: Never try to catch a falling knife. Don’t buy when markets are in free fall, because you’ll only wish you waited longer. Barton Biggs, a well-respected market analyst and money manager, was interviewed on Bloomberg TV, and said he had a list of great stocks that were now bargains, but that he wished he’d waited longer to buy them – and that was 150 points higher. So, that being said, what are the risks, and how will we know when the worst is over?
Well, first of all, you need to consult a properly licensed investment advisor for specific information, someone who knows your financial position, tax status, age, risk tolerance, cash flow, and all the other pieces of information that go into making a proper assessment of your investment needs. I am not that person, and this is not intended as investment advice. Here endeth the small print.
Let’s take a step back and see if we can find some benchmarks. To do so, I want to go back to a concept that I’ve written about repeatedly in this blog, and use regularly with my consulting clients: the ratio of risk managment. What are the possible risks? And what are the potential returns? Once you’re assessed those, you’re in a better position to make decisions, rather than just guessing whether the markets will go up or down.
By my definition, risk is the cost of being wrong. So, if we invest in stocks now, or don’t invest in stocks now, what are the risks either way? Let’s start with the potential positive risks, because, unfortunately, this is a much shorter list.
Could the markets surprise us on the upside? There are three factors that drive stock prices: interest rates, corporate earnings, and investor psychology. I don’t foresee any upward pressure on interest rates unless there’s a true financial panic. Even if there were a panic, there are so many trillions of dollars invested in U.S. Treasury securities that there is nowhere else for them to go. Accordingly, absent an end-of-the-world type scenario, I believe interest rates are a neutral influence at worst, and probably slightly positive.
Next are corporate earnings, which have been surprisingly good of late. Yet, I believe the outlook for the U.S. economy – and all others that are at least partly reliant on it, which is everyone – is worse now than it was before the manufactured debt ceiling crisis. That political stunt by Tea Party fanatics shook people’s faith in the American political system, and raised doubts about the American economy that weren’t there before. As a result, more people are talking about a double-dip recession now than before, and such talk tends to become self-fulfilling. Moreover, falling stock markets tend to make people feel poorer, which makes them spend less, which slows demand, which slows the economy. All told, then, I would have to assess corporate earnings as being neutral at best from here, and possibly negative.
Finally we come to investor sentiment, which is always the hardest to get a handle on. Moreover, if the markets have a couple of high-flying up days, then psychology can change from being deeply fearful to being deeply greedy overnight. But one solid indicator of market sentiment which has been consistently good is market volatility. High volatility times, even when markets are rising, are times when there’s lots of uncertainty, which is why values seem to change overnight. The best environment for bulls is one where markets make a slow, steady advance, not ones where markets zip up, then down, then up again. And a handy index for this is the Chicago Board Options Exchange SPX Volatility Index, or VIX index (VIX:IND). This index recently reached levels unseen since April of 2009. All told, then, I would suggest that market sentiment is unsettled and nervous, which is definitely bad.
So could markets surprise us on by running away from us on the upside? There’s always that possibility, but I think the odds are pretty small that we will lose a lot by staying on the sidelines. If the market recovered to where it was in May, the S&P 500 could go back to 1360, which would mean we might miss a gain of about 22%. And that’s if the market took off so fast we couldn’t respond. So the risk of being left behind by the market is, in my view, relatively limited.
Another positive development is that falling stock prices have also brought down commodity prices, notably oil. Since high oil prices act like a tax on the economy, lower oil prices clearly benefit economic growth.
And banks are generally in much better financial condition now than they were in 2007 – except those that have loaned too much to weak European sovereign credits.
Beyond these points, what might is likely to happen to the economy? Well before the phony debt crisis, the outlook for the U.S. economy was disappointing at best, with feeble growth, weak employment, and nothing on the horizon promising to change that. Now the outlook is worse, as I said, so at best we could see the economy return to that slightly depressing, feeble outlook. So, again, the potential to be surprised on the upside, or the return half of the equation, seems limited. Now let’s turn to the potential risks. Alas, here the list is much longer and more compelling.
I’m going to list the risks, and merely touch on most of them rather than go into exhaustive detail. The prospects are dreary enough without dwelling on them. I’m going to save the worst ones for last. Here are the major risks that I see now:
• Stocks go down because they go down. Markets develop a mind and momentum of their own, and while I don’t believe you should ever rely on momentum investing, it’s also clear that when investors become fearful, and especially when they panic, it’s dangerous to get in their way. In particular, investors, particularly boomers hoping to retire, were deeply shaken by what happened to their investment portfolios in 2008, and are likely to be faster to bail out on markets rather than try to ride them out. This increases volatility, which, as I’ve said, is a bad thing.
• A possible double-dip recession. There is no real reason why the U.S. economy should go back into recession. I had been expecting it to dribble along in a slow growth, jobless recovery that was disappointing. Now, though, the talk about a double-dip is, as I said, likely to become self-fulfilling. There’s no fundamental reason for it, but the phony debt ceiling crisis shook confidence, and ultimately the economy. And the markets run on confidence.
• America’s downgrade from AAA. This doesn’t help, but it is currently a split rating, with only Standard & Poor’s lowering America’s credit rating, and only on long-term debt. If the two other major agencies, being Moody’s and Fitch’s, were to follow suit, that would be an enormous negative, but that doesn’t seem to be in immediate prospect. Neither, though, is America likely to get its AAA rating back anytime soon. Canada was downgraded from AAA in 1992, and then got it back ten years later. But that was during a period of strong economic and productivity growth, and the Government of Canada, under Prime Minister Jean Chrétien and Finance Minister Paul Martin ran 10 years of budget surpluses, paying off big chunks of government indebtedness. The odds of America doing that are vanishingly small. The only reason American debt has performed as well as it has so far is because, in the words of one commentator, “It’s the best looking horse in the glue factory.”
• Weak economic growth compounding American government indebtedness. The Tea Partiers have overlooked the primary fundamental of government finance: that government revenues and expenditures are inexorably tied to economic performance. A weak economy will sap government revenues and force up expenditures, compounding deficits, and piling up debts. Slashing spending in such an environment cuts jobs, lowers economic growth, and increases deficits. This is precisely what happened in the 1930s under President Herbert Hoover. He and his counterparts in Congress kept slashing spending to try to bring the deficit under control, only to find that economic growth fell further, increasing the deficit. In response, they slashed spending even more. It became a vicious cycle, and this is still the textbook example on how a government can turn a recession into a depression. Unfortunately, right-wing politicians in America seems to be embarking on precisely the same policies now.
• Another negative that has ramifications that go far beyond stock prices is the high rates of unemployment for men and young people. We can see the results in the riots in Greece and Portugal, but now in London as well. In America, the official unemployment rate is 9.1%, but the percentage of working age (16 to 64) American men who are employed has fallen from about 85 percent in the early 1950s to under 65 percent now. Some put the actual unemployment rate of men in America at 25%, and that for young people at 45%. These numbers are hard to confirm, because unemployment surveys don’t include people who are so discouraged that they’ve given up even looking for work. Whatever the true numbers are, this is bad news economically, bad news socially, and bad for America’s future.
• The political deadlock in the American Congress. America has become steadily more polarized over the past 20 years. There have been many analyses of why this is, but I think there are two primary reasons. First, the media have discovered that it is more profitable to be biased and outraged than it is to be balanced and thoughtful. Fox News in America, and News of the World in England are or were the exemplars of this trend. And with the splintering of media caused by the Internet, people can now choose to consume only those viewpoints with which they agree. This creates the echo chamber effect, where like-minded people reinforce their own prejudices. The result is rather like being surrounded by yes-men: you become convinced that your point of view is the only valid one. This pushes people with different viewpoints farther apart, and causes them to summarily dismiss any views that don’t coincide with theirs as being obviously, even maliciously wrong.
The other reason is jerrymandering. As I’ve discussed this at length in another blog (found here), I won’t go through the arguments again. But the result is that the extremes in American politics are being over-represented, and the center is being ignored. According to The Economist newsmagazine (14 April 2011), the results are pretty stark: “On average, House Republicans have voted with their party’s majority 91% of the time and Democrats 90% of the time. The picture is very similar in the Senate.” This is making American ungovernable, as was clearly on display during the unnecessary debt crisis, and an America that cannot govern itself becomes a danger to itself and others, geopolitically as well as economically.
• Finally, the greatest immediate risks out there right now relate to the financial crisis in Europe. Greece is functionally bankrupt, and all that is left is to decide how to cope with the financial mess. The other weak members of the EU are being shunned by the credit markets with more or less justification, but the net result is a potential run on European sovereign credits. The results of this could be very much like the run on Bear Sterns or Lehman Brothers in 2008, with the same kind of knock-on consequences. Worse, this financial crisis could lead to the possible collapse of the Euro as a currency, which would endanger the survival of the EU. And that would be a very big economic (and financial) shock indeed, especially as the world’s central banks don’t have as many resources left to battle a global financial crisis.
The Costs of Being Wrong
So the cost of being too pessimistic is the potential to lose a market gain of perhaps 20-25%. The market cost of being too optimistic would be a repeat of the kind of bear market we saw following the 2008 market panic, which could be a further 40% drop. But the greatest risk is that the problems in Europe and America are compounded by policy mistakes, such as those followed by Herbert Hoover in the 1930s, or a market collapse brought about by forces that overwhelm the world’s central banks, such as the collapse of the European Union with the subsequent economic catastrophe. Either of these could produce a market drop similar to that of the 1929 to 1932 period, which was a fall of 89% would take the S&P 500 down to the vicinity of 170 points – an 85% drop from where it was when I started writing this blog. That, and the very dangerous economic fallout that would come with it, are the real risks.
So if you’re only mildly pessimistic, weigh the potential for a 25% gain against a 40% drop. If you’re really scared, weight that 25% upside against an 85% downside. Add in your assessment of the probabilities of each, and place your bets accordingly. As for me, at the moment, I’m staying on the sidelines and watching the carnage, biting my fingernails all the while.