Market Not Out of Woods Yet

After breaking new lows (for this bear market and the 2001-2003 bear market) the week before last, the stock market ended the month of November on a positive note. But it is a reflection of how unsettled markets remain that few observers are willing to declare a bottom.

Given that we are dealing with a broken financial system and a crisis of confidence like no other in our lifetimes, it is no surprise that volatility and uncertainty remain at historical extremes. Over the past 50 trading days, the average daily change in the S&P 500 has been 3.8% - a level of volatility unlike anything seen in the markets since the Great Depression. Most investors at this point would be content simply with a period of stability in the markets.

Unfortunately, with the VIX volatility index still at an historically high level of 55, with 3-month T-bills yielding 0.04% (the next step from here would be stuffing money under a mattress), and with many credit markets still highly dislocated (evidenced by record spreads on corporate and municipal bonds), we cannot with any confidence state that the financial panic is behind us.

Despite mind-boggling government policy actions, including last week's move by the Fed to buy, with newly printed dollars, up to $800 billion of mortgage-related securities, the downward spiral in asset prices associated with financial sector de-leveraging does not yet appear to be broken. The unwinding of leveraged positions on the books of banks, hedge funds, and other institutions has involved a vicious circle of selling, exacerbated by the negative feedback loop now at work with public psychology and real economic activity. To a great extent, this "crisis" is self-generating. The instantaneousness of financial news propagates the fear that creates the panic runs on various debt instruments and financial institutions and the self-reinforcing liquidations of stocks.

Trust and confidence are the keys to our financial markets and economy. Both have been badly damaged, and there is no way of knowing when confidence will return. Given that stocks are on track to deliver an even worse return in this decade than in the 1930s, and that the public's trust in the financial system has been shattered, large numbers of investors may be turned off of equities for some time to come. This is most unfortunate since financial assets are trading at their most attractive levels in decades, which implies that prospective multi-year returns are likely to be quite attractive by historical standards.

The scary aspect of the negative cycle at work in the markets is that if we don't reverse it soon, you really do start to worry about the worst-case economic outcomes. Clearly we are in the midst of a deepening recession, but it remains a very open question how dire the ultimate outcome will be. Investors can take comfort in the fact that the markets have already priced in a deflationary bust. Today, most asset classes are trading at levels consistent with the unfolding of the worst recession since the 1930s. The key question is whether markets are right to price in such a severe recession, or do asset prices at current levels represent an over-reaction based on forced and panic selling.

In truth, it is impossible to project with any confidence how bad this recession will be, since so much depends on confidence, which Warren Buffett aptly described as the oxygen the economy requires to breathe. Between the massive loss of wealth that has occurred in the past year, and especially the past six months, rising unemployment, falling incomes due to economic contraction, and the incessant headlines warning of a 1930s-style depression, U.S consumers and businesses are understandably scared to death.

Today, the biggest problem in the world economy is the flight of capital out of private sector assets into paper money and government bonds. To grasp the present degree of risk aversion and lack of confidence in the future, one need look no further than the 0.04% yield on 3-month T-bills. In this type of environment, the foremost goal of government policy is to convince investors that there are better uses for their savings.

Ultimately, the present extremes in risk aversion will abate, but how much more damage will be done in the short-term unfortunately remains an open question. Our hope is that if confidence can be revived to some degree and stability can return to markets, the recession won't be as bad as is currently feared and investors who have endured the pain of the last two months will be rewarded for not abandoning their commitments to risk assets.

Comments

[prudentinve...:]

Today one of the websites reported that the sum of all "bailouts" has exceeded $8 TRILLION. This represents an enormous transfer of wealth and resources away from productive taxpayers, whether individuals or corporations, both current and future, to bail out irresponsible consumers and mismanaged financial institutions. Can any rational long-term investor find solace or derive confidence from such acts of astonishing folly?

2008 Dec 01 04:21 PM

[Respirate:]

"Market Not Out of Woods Yet"

And the Understatement of the Year award goes to ..."

Relaxing over my Sunday paper (WSJ 'Getting Going' feature), the absolute dumbest article of all time tells us poor schmucks at home to 'fight fear', and go out and 'splurge' a little. Gotta do your part for the sick economy, you understand.

Uhhh ... ok. My IRA's down 55%, three local companies announce extended layoffs in a single week, and the largest employer is filing for bankruptcy. The article's author, a president of FiLife.com, is simply clueless. It's not up to the individual consumer to generate confidence.

Steinhilber said it well: "Trust and confidence are the keys to our financial markets and economy. Both have been badly damaged, and there is no way of knowing when confidence will return. " "In truth, it is impossible to project with any confidence how bad this recession will be, since so much depends on confidence ...".

Econ 102: A monetary economy rests on the participants' faith in the sovereign government.

Only the federal government has the resources to repair the damage and restore confidence caused by its own negligence.

2008 Dec 01 05:11 PM