A Perfect Storm – July 2008

July 26, 2008

Dow Jones Average: 11,349
S & P 500 Index: 1,252


A Perfect Storm

The serious problems afflicting the U.S. economy are well known to almost every adult in the country. From either personal experience or endless media coverage, people are aware that prices for almost everything they need are rising, while values for everything they own are dropping. The financial stress being felt by most Americans is shared by the banks and investment firms that supply credit to consumers and homeowners. The crisis at the banks is worse than it would be otherwise, because of the complex, risky debt packages created by so many financial institutions in recent years. With losses in the hundreds of billions, many of the largest financial companies in the U.S. have needed massive capital infusions from overseas to stay alive. Legendary investor, George Soros, said in a recent interview that the financial crisis is the worst in his lifetime, which spans the past 78 years.

It is difficult to envision a quick recovery from the current economic malaise. Inflation in energy, food, and medical costs continue to hit businesses and consumers. Profits are down, unemployment is up. In recent years people simply borrowed more on credit cards, home equity lines, or through mortgage refinancing to cover any personal budget gap. The banks are in no position to extend more credit at this time, and individuals have less collateral to post against a loan as real estate values have declined. Most people who need increasing amounts of credit to sustain their lifestyles have already mortgaged their homes to the hilt. The entire credit system is paralyzed by a lack of good collateral on the part of individuals and diminished capital at banks. Individuals who need credit can’t get enough, and those who could borrow do not want to go into debt in uncertain times. Jump starting a stalled economy takes some aggressive spending, which is hard to engineer when consumers become cautious.

The government is taking action to stimulate the economy. In hard economic times, as individuals go into a self preservation mode, the government usually becomes the spender and lender of last resort. The U.S. government sent out economic stimulation checks to over one hundred million people in hopes of reviving the economy. Of course, the government is simply borrowing this money itself on behalf of citizens who no longer want to take on more debt. By sending out checks the government is saying that it knows better what to do in such times and is forcing more debt on the public. Many people used the funds to pay down their own debt which nullifies the government’s objective of promoting spending. While some did spend the money, there is little indication that the 160 billion dollars pumped into the economy has had a lasting effect. Congress is already talking about a second round of checks probably in time for the Christmas season. Additional, direct government spending may be needed to offset a retrenchment by individuals. Some astute economists say that it is essential for the government to quickly borrow and spend an additional 500 billion dollars on infrastructure initiatives.

The stock market was surprisingly resilient through May of this year given the magnitude of the financial crisis. Bear markets in the past have been triggered by inflation, a decline in real estate prices, or tightness in the credit markets. It usually takes only one of these powerful forces to cause economic dislocation and lower stock prices. Currently the market is beset by all three of these negative influences simultaneously. Many have called current conditions a perfect storm hitting the financial markets. While stock prices have experienced an accelerated decline since May, the drop is still less than one would expect given the intractable nature of the economic problems confronting the United States economy.

Current Strategy

The stock market has experienced a series of panic declines and swift rallies in recent months. The decline in stock prices has been arrested at times by the large oversupply of capital in the world looking for investment opportunities. Investors have been willing to pour several hundred billion dollars into new common and preferred shares issued by financial institutions. Without these infusions of capital many more banks would have collapsed, creating further upheaval in the financial markets and the broad economy. Investors have also rushed in to broadly buy stocks after the steep declines in January, March, and June. The supply of ready investment capital has not prevented a decline in the market averages which are down noticeably on the year, but it has slowed the rate of descent.

We have been enticed by lower prices on some stocks, particularly after the brutal sell-off in January. We bought a group of seven stocks for clients precisely on the day the market bottomed in January. All seven positions rose significantly immediately after purchase. When investors are rewarded after buying into steep market declines they tend to do it again. We believe that the heightened market volatility has created some investable opportunities, although a few recent purchases we made after the market meltdown in June have not been rewarding so far. While capital preservation is always our top priority, we do intend to increase equity exposure in our clients’ accounts as stock prices fall.

The type of Treasury securities that we typically buy are unappealing at this time as interest rates on Treasuries are low. Corporate bonds, particularly those issued by banks and auto companies, offer much higher rates of return, but the risk of a default on the bonds is too high in our opinion. The rates on tax-free municipal bonds that come due in 10-15 years are acceptable, if one believes that inflation will fall back to its historical average. When buying bonds one has to make a prediction for longer term inflation. We are maintaining a shorter term bond position as we think that government policies portend sustained, higher inflation over the next few years.

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