Our Current Outlook:
On the back of the difficult decision, politically, to raise the US Debt Ceiling, the US stock market had been falling consistently over the past two weeks. As a byproduct of the debate, the vulnerabilities of the global economy have been thrust onto center stage and the ability of Washington DC to adequately respond is now in question. Making matters worse, the European stock market started trading sharply lower on Thursday, August 4th; this was the spark that set off a 513 point plunge in the Dow Jones Industrial Average.
The past several days have been marked by triple digit swings in the Dow Jones Industrial Average. Oddly, these swings can be extremely positive and extremely negative within the same trading day. Volatility has shot up to the highest levels in more than a year.
The well documented problems in the European financial system do threaten the rate of growth for the global economy. Specifically, European banks and insurers are anticipating a substantial hit to their balance sheets on national debt from at risk countries (e.g. – Greece) gets written down. By contrast, there are fewer specific fundamental reasons for the sharp downturn in US companies. Rather, there are overarching fears of continued economic stagnation – low growth or even a double-dip recession. Investors increasingly question the presumption of growth and now approach investments with diminished expectations.
In simplified terms, it is simple to get caught in a negative feedback loop. Lower confidence is, quite naturally, the result of bad economic data. However, low confidence can also be the cause of poor economic trends. For instance, low confidence and high uncertainty may encourage corporations to hoard cash, restrict capital investments, and limit hiring. Similarly, low confidence motivates investors to stop investing, sell their positions and restrict access to capital.
The Safety Net:
In the 2008 and 2009 financial crisis, the government reacted with programs designed to break these cycles – the negative feedback loop – and reinstall a sense of confidence in the markets. For example, the opened access to capital to large institutions (e.g. – the Troubled Asset Relief Program [TARP], the GM Bailout) and the Treasury temporarily placed guarantees on money market funds to prevent a panic.
After a few years of modest progress, the structural overhangs in the economy (persistently high unemployment, credit deleveraging, weak housing and construction, weak investor demand for equities) have not been resolved and the trajectory of economic improvement appears to be leveling out towards zero. One of the few items compensating against these structural drags has been increased government activity, but the government is only 20% of GDP and recent debt deal in Washington suggests that the government will continue to remove artificial supports for the economy.
As of August 2011, the consensus is that the administration lacks the political capital necessary to provide another shield against an economic slowdown or even an outright panic. For example, further quantitative easing programs (i.e. – QE3) and stimulus programs are politically unpopular. Naturally, many investors are nervous about the absence of a safety net.
A Point of Perspective:
After painful shocks to the markets and the worldwide financial system, Warren Buffett – legendary investor and one of the world’s wealthiest people – set down the following words in an Opinion – Editorial piece in the New York Times:
“The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.
So... I’ve been buying American stocks.... Why?
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”
What was the date on this Op-Ed Piece? October 16, 2008. At the time, the Dow Jones Industrial Average had started near 11,500 in September and crashed to the 8500 range by early October. The low for the 2008-2009 financial crisis finally pushed the Dow Jones to 6500 in March 2009, but investors have since been rewarded with a marked advance of stocks throughout 2009 and 2010.
The biggest fear may be fear itself:
At the time, Buffet’s words sought to remind investors that earnings – although beaten down – should return and that stock valuations should recover as well. Buffett was correct about the first part. 3Q 2008 Earnings of the S&P 500 dropped, as a result of the tremendous write offs in the financial sector, from a high of $24.06 to essentially zero. Earnings estimates for 1Q2011 earnings have recovered to nearly record levels and 2Q 2011 earnings estimates are projected to reach all time highs.
Recall that the situation in 2008 was dire; recent accounting by the National Bureau of Economic Research places the damage caused by 2008-09 recession at -5.1% of US Gross Domestic Product. That is easily the most painful, and longest, recession since the Great Depression. There was a very great concern about a collective, worldwide crash.
By comparison, let us consider where we are with the current crisis. It is entirely possible that European financial problems will continue to spill-over to the rest of the global economy. It is quite possible that we are headed for another recession. However, we find it unlikely that the potential downturn will be as severe as the 2008-2009 recession. The reluctance of corporations to invest and hire has, sadly, kept unemployment quite high, but there are positive aspects to their fiscal caution. As veterans of the 2001 technology crash, most US corporations have not overextended themselves and have solidified their balance sheets; their experience should help them weather continued weakness. Similarly, long term investors may gain the advantage of a positive feedback loop. For instance, if the structural drags on the economy (housing, employment, credit, improved demand for equities) stabilize or even improve, the positive impacts can start a chain reaction in a positive direction. The upside potential is still good for a long term investor. In the meantime, those long term investors will have to tolerate the volatility in the daily market. We hope that investors keep their long term strategies in mind and use large market dislocations as opportunities to re-balance their portfolio.