My Take on This Very Risky Market

I have been working hard to keep the 120 or so RIA firms with which my firm works informed of what has been happening in the markets and why it is happening, so that they can communicate effectively with their clients. On Friday, I gave the third in a series of talks I have given over the last two weeks or so as the crisis has played out. Below are some notes from Friday's discussion.

We certainly live in interesting times. While I have witnessed events like this before, never have I seen so many at one time and with such a big impact---again, the lesson to remember is to never treat the unlikely as impossible and don't take more risk than you need to (at least without being fully prepared for the possible consequences). With that said, here is a short summary of what I believe is happening.

There are two main things going on now. The first is recognition that the economic crisis in the US is having a much greater impact around the globe on economies than almost anyone expected. So economies are likely to see slower growth (China) and/or steeper recessions (developed countries) than previously expected. In fact, the US housing and auto sectors were already in a Depression, not recession, type condition, with falls of production of more than 20%, and it is clearly going to get worse. So this is the bad beta showing up--economic cycle risks. The likely next step (my guess is that it will happen fairly quickly) is that you will see quick policy responses from Central Banks and governments. I would be surprised if we do not see coordinated rate cuts and fiscal stimulus programs from the developed countries very soon.

However, the emerging countries are another story, and this is compounding the problem. We are seeing here a likely repeat of the summer of '98, with currency crises spreading. It seems likely that the flight to quality will hit emerging markets hard--their currencies are getting hit hard, their debt, which had been rising in value, is getting crushed right now with EM bond prices collapsing. Risk capital is either fleeing on its own or being forced to flee by margin or collateral calls. For example, the Payden EM bond fund, which was up early in the year and down 7% at end of September, is now down 25%.

There are other "legs of the stool" being chopped off. Here is an example:
The commodity producing countries that rely on revenue from those sources to support the government/economy are getting hit hard, including countries like Venezuela, Argentina, Russia, Indonesia, etc. Argentina, on Thursday, basically confiscated (nationalized) the pension system to gain access to the dollars in the plans. There is going to be now risks of country defaults, like the summer of '98. And, of course, that can lead to geopolitical risks increasing.

Of course, the flip side is that the importing countries will benefit by lower costs, but they also will no longer be able to export as much to the commodity producing countries. And while the IMF will almost certainly try and help, there is simply not enough money around to bail all out the countries. As an example, we have seen Iceland basically go bankrupt as a country. Hungary, in the face of a global recession, had to raise interest rates 3% to help stem flight capital. I would not be surprised to see some countries' markets close, like Malaysia's market did in the summer of 1998. 

So that is one of the things now hitting the market very hard: the continued flight to quality is accelerating.

But there is another major factor compounding the problem, leading to the kind of dramatic moves we are seeing. It is the forced selling caused by margin and collateral calls. The hedge fund world, which we have avoided, is basically being destroyed to a great degree. I would not be surprised if a third to a half of all hedge funds disappears within a year or two. You are seeing forced selling by margin calls on those that are leveraged and also forced selling even by those that are not leveraged as they have to prepare for return of capital calls which they know are coming at year end. They are selling at any price---price does not matter, they have to sell; and thus, with few buyers, prices will now simply collapse.

And another place that forced selling is coming from is corporate executives who used margin loans to exercise stock options and or simply buy stock they thought was undervalued. They are now being forced by margin calls to sell. Many examples of individual cases of forced sales in the hundreds of millions of dollars, with Sumner Redstone being just one such case in the news.  

There is also a seeming amazing "anomaly" happening--but the anomaly is easily explained: The two countries with the lowest interest rates are rising at the fastest pace in history. Never have we seen moves like this. EVER. The dollar has gone from 160 to 126 in a few months and seems now certain to go higher as I will explain. And the yen, with even lower interest rates is rising much faster. (and that has another consequence which I will explain). Why is this happening? Two reasons:

First, the dollar is benefiting from the flight to liquidity and quality

Second, the dollar and the yen are benefiting from the forced unwinding of the "carry trade." Those that borrowed "cheap" dollars and yen to invest in other higher yielding currencies have been caught on the wrong side of that trade now. And hedge funds typically heavily leverage this trade, so they are getting the double whammy of the currency bet going wrong, the banks demanding margin, leading to forced selling and their clients asking for money back as allowed and that leads to more selling and the yen and dollar rise in a vicious cycle of forced unwinding of the positions.

But there are other problems. The Japanese economy, one of the largest in the world and still trying to recover from the recession that started in 1990, is getting hit hard now by the rising yen. They are heavily dependent on exports for economic growth (high savings rate in the country keeps domestic spending down) and the global recession combined with the rising yen is hurting bad. That is why the Nikkei is getting hit so hard.

Unfortunately, we are now likely faced with the worst recession for the globe that we have seen in the post war era. We are likely to see steep falls in economic activity. You can see this for example in Friday's fall in oil prices of another $4 to about $64, despite OPEC announcing cutting production by 1.5 million barrels (by the way--I don't see how they can actually sustain a cut since the governments of producers like Venezuela are desperate for cash now that prices are down--that is why cartels never last). Note that we are already seeing major announcements of layoffs by even companies like Merck (MRK), let alone the financial services industry and the industrial sector.

The problem now is that while the markets now recognize this economic weakness (and that helps explain the sharp fall) and prices already reflect that, you still are getting forced selling, so this could get lot worse. It is possible. Keep in mind that we are now faced with both betas, the good and the bad, hitting markets. Risk premiums (the good beta) are rising and the earnings (the bad beta) are falling. Hence, collapsing prices. How bad can it get? Well, if you see P/Es fall to levels we saw in previous bear markets they can fall to 6 and of course earnings can fall sharply. We are now at P/E of about 13. And with earnings falling and risk premiums rising you can see that a further sharp fall, as unthinkable as it was, is possible, it can happen. That, of course, is not a prediction.  But it is important to understand that it doesn't take much of a change in earnings or risk premiums to impact prices.

Trying to keep some perspective: We are also seeing the largest policy responses ever, both on the fiscal and monetary side. But they do take time. The capital injections and the buying of assets from banks has not happened yet. And there will certainly be more policy actions to come if the worst economic scenario does happen to play out. And the liquidity lock up does seem to be easing with LIBOR to Treasury spreads narrowing significantly from almost 500 to about half of that. And just in the last four days muni yields have come way down.  Ten year munis of the type we buy were at 4.90 and are now at under 4.4. And the twenty year munis, which were 5.7, are now 5.1.

And while the housing market is down, it is starting to clear. Housing sales actually were up 5% in September, likely result of foreclosure sales. But lower prices bring buyers. And supply is now though still at about 11 months of current demand is at well below the long term estimate of demographic demand of 1.6-1.7mm units. So this too well eventually come to an end.

But there is no way to know when this crisis will end or if it will end successfully. If you have a faith in the democratic capitalist system, then you must believe that it almost certainly will. And the sharper the fall, the faster the end will come. But remember, the Nikkei was at 40,000 in 1990 and is now about 7600. A dropped of over 80%. And it is now 19 years later!!! Forget inflation adjusted prices (though also doesn’t count dividends). 

What is very important for us to do is help clients recognize the reality. That means likely that they will need to exercise some of the options they should have already considered when they decided on an investment plan that included some possibility of "failure"---by that I mean for example that the MC simulation showed a 92% odds of success. Which, of course, meant that there was an 8% chance of failure. And now that 8% has showed up. So they need to recognize that and adapt. They may need to cut spending, plan on working longer, selling some assets (e.g. a second home), etc. If they fail to take those steps the plan will likely fail, especially if they are already in the withdrawal phase.

Last Thoughts

This may yet turn out to be "the buying opportunity" of a lifetime. We have come through 6 other major crisis since just 1970 and all turned out fine. But investing in stocks is always risky. There is no guarantee. We just don't know. If we did there would be no risk and nor risk premium. This time it could also get a lot worse. What we do know is that trying to time the market is a loser's game. And most of the time investors simply get it wrong, selling AFTER market drops and only buying well after it recovers. That results in the dollar weighted returns they earn being well below the market's time weighted returns. So the important thing to do review the plan, make sure that it still makes sense, and make changes in either the plan or their lifestyle as needed to provide the best chance of achieving their goals and not outliving their assets.

I want to add another thought that came up in a client meeting last week. It is an example of how by keeping our heads we can help our clients in ways they might not think of. This client had a life insurance policy that was no longer needed. In effect it was now an investment with Phoenix Insurance. Not exactly the highest rated company. I would urge anyone with that situation to sell the policy. They are taking long term credit risk and almost certainly not getting compensated for it. It is highly likely that you are lending these companies money at much lower rates then they now have to pay in the bond market. That is another opportunity to help clients who are likely not thinking about such issues with all the noise going on. Or not thinking of them properly.

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

Comments

[Ex15:26:]

Larry,
I'm not sure if you shared anything new here. I would caution you though that your assumption that all life policies should be scrapped is poorly reasoned. I would agree with anyone that there are a tremendous amount of bad insurance companies that sell permanent insurance, however if the policy is a whole life policy it is the one investment that is build to survive your 8% failure scenario (assuming your insurance company has excellent financial strength).
I personally own 2 whole life policies, one with Northwestern Mutual and one with Guardian. Both continue to perform and neither possess anything but less thatn 1/2% of their surplus in either MBS or asset-backed securities. Of all the companies out ther these policies are the last assets that I would sell. In fact my agents and I constructed our plan with these types of scenarios in mind.
Would I suggest have more than 10% or 15% of my networth in permanent insurance? No way! Do you and my financial advisor wish that you would have had a significant amount of your cash in a policy like Northwestern that has actually returned a 5.8% return (net of all expenses - this is not the dividend rate, but the actual Cash RoR over the last 20 years with AAA credit risk)? The answer is "YES! you wish you owned it!"
If you plan on making blanket comments, at least make a concession in your generalization that two companies have outperformed and continue to do so.
While I've latched on to something very specific at the end of your document I take these comments very personally, because quite frankly the permanent insurance policies I own have outperformed most of the indicies for the 1, 3, & 5 years periods easily! By the way, did I mentioned that they are paid up policies now and therefore I own the death benefit and my cash value continues to grow without any premium payments. In other-words, my cash value continues to increase year after year and I pay nothing. My "investment will get better and better with little uncertainty. Perhaps you should mention these two great companies to your advisors so they might actually help their clients rather than guide them to destroy the one asset they may have in their portfolio that might be working. Again, I concede that most companies don't produce - that is why I am blessed that I listened to my Northwestern and Guardian agents!

Cheers.
Ex15:26

2008 Oct 26 10:25 PM

[Moon Kil Woong:]

Anyone who says overpay me for something and I'll give you something for life is usually a crook. Similar to the early days of the Internet when people said pay be $1,000 and I'll give you Internet for life. The execs paid themselves huge salaries and declared bankruptcy in two years. So you paid $1,000 for two years rather than Internet that costs $200 a year. Plus you lost interest on the $1,000.

Why does CDS work. Insurance companies sold CDS that they thought they didn't have to make good on for 20-30 years. In the meantime they could spend all that money because 0% collateral wasn't required because it wasn't insurance. Also since it wasn't a financial instrument covered by the SEC, FDIC, Fed, Treasury, or anyone else they could arbitrarily say that risk was dropping and claim that they made profit every year. Who cared about the facts... They would be chillin in anywhere but America by the time the game was up.

And there you have it. A great crooked game is one where everyone who should pay doesn't and everyone who didn't do anything pays it all. Paulson is just making sure AIG and the rest of his pals get to board the plane before the real pain begins.

2008 Oct 26 11:28 PM

[punk_ash:]

a readable article for a change.

2008 Oct 27 01:35 AM

[tomsaffell:]

Interesting comments on timing the market - I mostly agree that the market cannot be timed. I certainly agree that most *people* cannot time the market.

I have done an analysis of the same data set to test whether investing money at times like these (a recent big fall) is any better than investing at a random point in time. It's on my blog. It's not financial advice, and I'm not selling anything - it's just for curiosity :)

2008 Oct 27 03:53 PM

[kkingou:]

I dont think you can compare the Japanese Nikkei to our Dow Jones. Japan was a WAY bigger bubble than we have ever dreamed of having. In the 1980s, their stock market value was twice the US value even though they had less than half the GDP of the US.

2008 Oct 27 05:31 PM

[Larry Swedroe:]

EX15:26
Re the life insurance. I never said ALL life insurance. I specifically referred to a company that is not the highest rated. I own a policy with Mass Mutual, a very strong company. Different situation

Also wasnt claiming to share "anything" new. Just trying to explain what is happening in clear English so ordinary people could understand it, and talk about what IMO is the prudent response.

2008 Oct 27 10:37 PM

[Adam O.:]

This is one of the few more realistic and rational articles in that past few days. Thanks.

2008 Oct 27 11:58 PM

[carey_jim:]

A little more "thinking outside the box" is needed at this point.

The American corporation is, metaphorically speaking, "the box" and it is nearly impossible to rise within an organization without learning "corporate speak" and "corporate manners" which makes thinking outside the box, for all of us, even more necessary now.

Your analysis is sound from a microeconomic point of view but doesn't take into account the bigger picture which involves geopolitical, cultural, religious and linguistic conflicts .... including war.

For example, can we really forget (or, will the world LET US FORGET) that 3 billion people on earth live on less than two dollars a day, that we are in the middle of a true energy crisis which will fundamentally change our lives, that the American legal and medical systems are BOTH broken, that Social Security is broken, that there is more inequality of wealth distribution in America than in any other advanced country, that our borders are not secure, ....

I'm afraid "there are more things in heaven and earth, Horatio,
Than are dreamt of in your philosophy." Hamlet

2008 Oct 28 02:51 PM

[Dividends A...:]

Good rational presentation. I wish more authors here took the time to give candid articles rather than pumping personal positions or discussing the same mundane topics over and over again.

I look forward to reading more of your insights Larry.

2008 Oct 29 03:26 PM