Uncertainty! | Fee-Only Financial Planners Long Island

Uncertainty!

There’s an old saying on Wall Street that markets can live with good news and they can live with bad news, but they can’t live with uncertainty. There’s an awful lot of uncertainty on Wall Street these days and that’s why there’s so much volatility in the markets.

That uncertainty is derived from a number of overlapping economic and financial factors.

The Subprime Mortgage Problem

Let’s begin with the subprime mortgage crisis, which has effectively capsized the domestic housing market. At the current rate of sales, it would take more than 10 months to move the inventory of unsold homes, which is twice the normal time. In some areas of the country, that time is estimated to be over a year. Economists say inventories are, in fact, even higher because many wishing to sell have simply pulled their properties off the market because of falling prices. It will require a pricing correction on the order of 15% to 20% over the next few years to clear this very deep backlog.

Overall, the housing picture is grim. In 2007 the median price of an American single-family home declined for the first time in more than 40 years and sales of those homes fell 13%, the sharpest annual decline in a quarter-century. Further, permits for new construction – a leading economic indicator – dropped 34% last year.

The recent and future easing of short-term interest rates by the Federal Reserve will eventually take some pressure off the housing market. However, the Fed can’t reduce the federal funds rate much below 1% because of the risk of inflation. So this political move (in an election year) will undermine the economy over the longer term by keeping the U.S. dollar weak and increasing inflation. The housing market probably won’t get back on track in 2008 or 2009. It will take some time – perhaps three to five years – to wring out the excesses that stemmed from a combination of low interest rates and lax credit standards.

The Credit Crisis

Then there’s the credit crisis, which was brought on by the repackaging of risky subprime mortgages into securities that were then incorporated into convoluted investment vehicles called derivatives. And then slicing and dicing those derivatives into more derivatives, which are highly variable and subject to manipulation.

Subprime and credit derivatives are just the latest sleight of hand from Wall Street’s ever-resourceful marketing machine. They created a lucrative (and mostly unregulated) house of cards. Little surprise then that, after it became apparent it was just about impossible to accurately price derivative securities, this flawed enterprise suddenly came apart at the seams, causing write-offs of tens of billions of dollars at such supposedly smart financial institutions as Citibank, Bear Sterns, Bank of America, UBS, etc. It’s hard to avoid the conclusion that the managements of these companies are either stupid or greedy. If they didn’t know what they were doing, then they were stupid. If they understood what was going on, then they are greedy. Either way, they violated their fiduciary duty to their clients and, ultimately, to all investors while jeopardizing the entire U.S. economy.

The real problem here is that the bond market is so much larger and more complicated than the stock market and is much more critical to the U.S. Economy.

Remember when you learned about the planets.  There was a photo of the Sun and a small dot on the Sun, which represented the Earth. It gave us a perspective of just how big the Sun is compared to the Earth.  Well you can use that visual to give you an idea just how big the bond market is compared to the stock and commodities markets in terms of valuation.  The U. S. Stock Market alone is valued at almost $22 trillion (excludes global equity market).  The N. Y. Times reported last week that the Credit Default Insurance Market alone is $44.5 trillion, Mortgage Securities are $7.1 trillion and U. S. Treasuries are $4.4 trillion in size.  Then you need to add U. S. Corporate bonds at $5.8 trillion and the rest of the world’s bond market values to give you some perspective.

So when you hear people try and rationalize by saying that the Sub-Prime Mortgages are only a certain percent of the mortgage market and the mortgage market is only a certain percent of the entire bond market, you should realize that those numbers are meaningless, unless you know the size of the entire global bond market and its derivatives compared to the stock and commodities markets around the world.  The magnitude of the problem is much bigger than most folks realize.

An Election Year

Compounding these two uncertainties is the fact that we are in an election year.  Who will be the next president and vice-president?  What will Congress look like?  Who will lower taxes? Who will raise taxes? Who can defend the country best?

This is certainly a very unusual election. It’s the first time since 1952 that either an incumbent president or vice-president is not on the ticket. It’s the first time a woman and an African-American are running for the nation’s top office. Both are currently U.S. senators.  And the presumptive Republican nominee is also a current U.S. senator. In recent times, sitting and former senators have not been particularly successful in presidential bids (John F. Kennedy was the last). Conversely, governors of states have had a much better record (Jimmy Carter, Ronald Reagan, Bill Clinton and George W. Bush).

The only nice thing about changes in government is that we can take some comfort in the fact that in our country’s 200-plus-year history we have somehow managed to survive even the worst of presidents and governments.

So the bottom line is that, while elections are usually not very important to the economy and the markets longer term, they do tend to divert us from focusing on the real issues shorter term.

Global Conflict, Gamesmanship and the Economy

The costs associated with our occupation of Iraq and operations in Afghanistan have greatly exacerbated the U.S. deficit. It’s also part of the reason the U.S. dollar has been so week. Travel to the United Kingdom today and it will cost you $2 to get 1 (one pound sterling). The dollar is also at record lows against the euro and many other major currencies. That diminished stature is a reflection of the perceived economic weakness of the U.S., which is mired in debt and beset by a slowing economy and troubled financial markets.

Part of the reason the U.S. dollar is no longer in demand is that crude oil trades in U.S. dollars. With a weak dollar the oil producing countries will continue to want more dollars for their most valuable and finite asset, crude oil.  This dynamic was borne out with vengeance earlier this week, as oil hit a record (inflation-adjusted) high and the greenback was simultaneously slumping to a 35-year low against the DXY dollar index, a basket of six major currencies that serves as barometer of the dollar’s overall strength.

With the lack of a practical, long-term energy policy to put this country on the path to independent domestic energy production, there is very little hope in sight.
Oddly enough, the lack of having a meaningful independent energy policy is the root cause of many of our nation’s problems, including the anemic dollar. Yet I’ve not heard one person running for the nation’s highest office discuss this shortcoming in any substantive manner.

There is also the U. S. deficit. We continue to run up huge debt by doing silly things like trying to buy votes in an election year by sending folks a $600 check under the guise of stimulating the economy.  We are borrowing this money from foreign countries to encourage the same bad behavior (spending and not saving) that got us in a fix in the first place.

The U. S. Consumer and the Economy

In the recent past the consumer has come to the rescue of the economy, preventing recessions or shortening the length of them, because they borrowed against the rising values of their homes. Folks used this borrowed money to shop until they dropped while not saving for the future. Well, Mr. & Mrs. Consumer, the future has just arrived and you’re feeling the pressure in the form of higher food, energy and other costs. Your home has recently lost 10% to 20% of its value and nervous financial institutions have tightened their lending standards, making it much harder to get a loan. You have no savings for emergencies and are drifting back to a paycheck-to-paycheck kind of lifestyle with no safety net and nowhere to turn. Should the economy continue to slow down or slip into a recession, you might even lose your job. But don’t worry! The government will bail you out with that $600 check, money it had to borrow because it has no savings either.

Alright, that’s enough of bad news. I could go on with more, but I think you get the point by now. Both the government and the people are living way above their means and now it’s time to change course.

The Good News

Looking at the bright side, we are in a global economy.  While a slowdown in the U.S. economy will obviously have some impact on the global economy, it will not push rapidly growing countries like China and India and many emerging markets into a recession. They will continue to grow, just a little slower, which will actually be beneficial to those economies longer term by easing inflationary pressures.  The most recent indication of this trend is the World Bank, which lowered its estimate of China’s economic growth for 2008 (from 10.8% to a still blistering 9.6%) due to cooling global export demand, particularly from the U.S.

The Prescription

So, what’s the prescription? A serious independent energy policy with an emphasis on efficiency and cleaner (and renewable) energy sources is needed to ease dependence on increasingly expensive oil. You may even begin to hear the “N” word again (that is, nuclear) as the higher cost of energy and food becomes too painful for the consumer to cope with.

Increasing inflation, higher interest rates and tighter credit will eventually help this economy emerge from the recession by imposing some badly needed fiscal discipline, but it will extract a price in doing so. Lower housing values, less consumer spending and higher food and energy costs will be the norm for several years to come.  The government may even attempt to stimulate the economy by using the savings to be gained from winding down operations in Iraq on badly needed infrastructure maintenance and expansion instead of paying down the deficit.

The Strategy

I think a good assumption, at this juncture, would be that the dollar will remain weak and perhaps fall even further. U.S. stocks will remain weak in a slowing economy and bond spreads will continue to widen (short rates go down while long rates increase) generating a more conventional yield curve as we emerge from the recession.

This means adopting a more defensive asset allocation strategy by:

1. Creating the proper risk controlled asset allocation (stocks, bonds and cash) that meets your tolerance for risk (volatility).

2. Placing a premium on high quality domestic stocks and bonds.
a. Large-cap multi-national stocks (dividend paying) are at good valuations at these levels.
b. Municipal bonds are extremely attractive right now for tax-conscious investors as are high-quality foreign bonds. (Increase taxes on the wealthy and the demand for municipal bonds will go up, creating a profit opportunity).

3. Increasing holdings of foreign equities (less exposure to the dollar).
a. An allocation of 20% to 50% can be in foreign equities.
b. Both high quality and emerging market equities.

4. Employ limited portfolio hedging tactics to reduce some of the downside risk for the near-term, until we see some evidence that the economy is beginning to recover.

5. Focus the portfolio’s securities by overweighting promising areas that will have pricing flexibility in an inflationary environment and will maintain the purchasing power of your portfolio.
a. Areas such as agriculture, energy, natural resources, precious metals and health care.
b. Infrastructure companies, should we get a government that will try to stimulate the economy through public works projects (deficit gets bigger and dollar stays very weak or declines further).

In due course, excesses and malfeasance will be wrung out of the system, regulatory adjustments will be made and the economy will regain its balance–it always does. And – not least – Wall Street will sober up from its latest bout of greed and rediscover its sense of fiduciary responsibility to investors large and small alike.

In the meantime, as we navigate this correction, we can draw from the lessons of past market dislocations. Since 1980, the U.S. has experienced four recessions that have each lasted an average of 9 months.  We will use this time to devise strategies and implement tactics that will help to preserve your portfolio’s purchasing power in these uncertain times and be ready for the economy to emerge from the recession.

Like Us on Facebook